The “repo market” is a form of short-term borrowing–typically overnight–using securities as collateral. The largest collateral type for repo trades is the US Treasury securities market. The largest repo traders are banks, who often need overnight borrowing to smooth short-term cash requirements inherent in the business of banking. Bank repo borrowing has been active since at least 1958.

Until Sept. 16, 2019, the repo rate of interest hovered just below 2%. In practice, this meant that hedge funds and other financial entities could borrow from repo financing sources for short term uses at a rate below 2%. But on Sept. 16, 2019, the repo rate skyrocketed to 10%–literally overnight. This created serious liquidity problems in the repo market, since fund providers suddenly were not comfortable lending money to hedge funds and other financial entities without a huge interest rate premium. This overnight jump in interest rates (from 2% to 10%) seized up the repo lending market, putting loaned funds in jeopardy.

What caused this overnight interest rate spike? Speculation at the time centered around the then-imminent bankruptcy of the WeWork company, which threatened to collapse the global commercial real estate market, and related financial problems with WeWork’s principal investor, the Japanese hedge fund Softbank.

Lehman Brothers is the infamous poster child for an asset manager choosing a head-in-the-sand approach re: asset values that were dropping across the board.

By mid-2007, the quality and value of Lehman’s asset holdings were under scrutiny. So its management team evaluated ways to reduce its dangerously high leverage. But Lehman found itself with a dilemma. It did not want to raise capital on public markets, lest it send a signal of weakness to the market.

 On close examination, one sees that all fund collapses are triggered by one of these risk factors: interest rate risk, leverage risk, duration risk or asset quality risk. When these risk dominoes fall, the result is liquidity risk, or sometimes liquidity failure.

In Silicon Valley Bank and the UK Pension Fund, the collapse was triggered by an unexpected spike in interest rates, where leverage was high and collateral values were compromised by long maturities of illiquid assets.

In the 2019 repo market crisis, the most likely catalyst was compromised collateral value that led to an immediate spike in interest rates. In a highly-leveraged hedge fund trades that depended on repo market for their continued existence, collateral risk led to interest rate risk, and then a liquidity crisis that threatened the entire structure of our economy.

The 2008 Great Financial Crisis was also triggered by a collateral risk, as counter-parties refused to accept MBS and other asset-backed securities as collateral for leveraged loans.

An overriding lesson is that its never “different this time”– emergence of a risk factor triggers the other risk factors in domino-like fashion.

Again, the concern for 401(k) plans is that the vast majority of such plans have exposure to illiquid assets through a collective investment trust–and are therefore exposed to an accelerating pension risk cycle that will inevitably destroy pension value.

Pension fund managers should significantly reduce exposure to illiquid assets in a fund–or at the very least, should clearly inform pension participants of inherent risks of these investments in a climate of rising interest rates.

Whether the Federal Reserve fully appreciates the impact its increased interest rates has on the risk cycle is an open question. But there is little doubt that interest rate risk will filter through the economy–landing with hedge funds and private equity funds who depend on low interest rates to maintain their very existence. It is only a matter of time until these exposures become evident.