A Hedge Fund Bailout Highlights How Regulators Ignored Big Risks
WASHINGTON — As the coronavirus began shuttering the global economy in March, critical parts of U.S. financial markets edged toward collapse. The shock was huge and unexpected, but the vulnerabilities were well known, the legacy of risk-taking outside regulatory reach.
To head off a devastating downward spiral, the Federal Reserve came to Wall Street’s rescue for the second time in a dozen years. As investors sold a vast array of holdings and rushed to the comparative safety of cash, the Fed pledged to become a buyer of last resort to restore calm to critical markets.
That backstop bailed out many people and investment firms, including a class of hedge funds that had been caught on the wrong side of a trade with ample risks. The story of that trade — how it went wrong and how it was salvaged — offers a cautionary tale about important issues Congress did not address in the 2010 Dodd-Frank financial law and the Trump administration’s hands-off approach to regulation.
A decade after Dodd-Frank, America’s sweeping post-2008 crisis fix, was signed into law, commercial banks like JPMorgan Chase and Bank of America are better regulated and safer, but they may be less willing to help smooth over markets in times of stress. Tougher regulation in the formal banking sector has pushed risk-taking to the shadowy corners of Wall Street — areas that Dodd-Frank left largely untouched.
In addition, the powers that policymakers have to deal with persistent vulnerabilities have been undermined by Trump administration officials who entered office seeking to weaken financial rules. Treasury Secretary Steven Mnuchin, who leads a panel created by Dodd-Frank to identify financial risks, has moved to release big financial firms from oversight and abandoned an Obama-era working group that was examining hedge fund risks.
The result is a still-brittle system, one in which financial players rake in profits in good times but the government is forced to save them or leave the economy to suffer when things go awry.
“It’s very dangerous to have a regime in which you know this can happen,” Janet L. Yellen, the former Federal Reserve chair, said in an interview. “The Fed did unbelievable things this time.”