News of the week summary - 11/12/2023

Ken Griffin warns regulator against their increased scrutiny of hedge-funds' basis trade

Ken Griffin, the founder and CEO of the $62 billion US hedge fund Citadel, has expressed concern about regulators' focus on hedge funds in addressing risks associated with leveraged bets on US government debt, particularly the Treasury basis trade, which has reached new highs recently.

• The Treasury basis trade involves selling Treasury futures while buying the same treasuries on the spot, profiting from the small gap between the two using borrowed money. Global regulators, including the US Securities and Exchange Commission (SEC), have raised alarms about the growing risks stemming from this trade.

Griffin argues that instead of increasing regulation on hedge funds, regulators should concentrate on overseeing the risk management practices of banks that facilitate these trades by lending to hedge funds. He suggests that if regulators are genuinely worried about the size of the basis trade, they should request banks to conduct stress tests to ensure they have sufficient collateral from their counterparts.

The Bank for International Settlements (BIS, which cooperates with central banks) and researchers at the Federal Reserve have warned about the risks associated with the rapid buildup of hedge fund bets in the Treasury market, amplified by leverage levels that can exceed 100 times. Regulators fear that if the trade moves against hedge funds and they are forced to sell their Treasury bonds simultaneously, it could lead to a collapse of the world's most critical bond market.

Griffin warns against recklessly impairing the basis trade, emphasizing that it plays a crucial role in funding corporate America. Disrupting it could increase the cost of capital for businesses and result in higher debt issuance costs, ultimately affecting US taxpayers. 

Warren Buffet shuns stocks

During the third quarter, Berkshire Hathaway, led by Warren Buffet, continued to divest shares in publicly traded companies, selling over $5 billion in stocks. This move adds to Berkshire's divestments, totaling nearly $40 billion over the past year. Proceeds from stock sales and cash flows from Berkshire's businesses were directed toward cash and Treasury bills, resulting in a remarkable increase in the company's cash pile, reaching $157.2 billion.

The company's portfolio of shares experienced a decline from $353 billion at the end of June to $319 billion by the close of the third quarter. This reduction is attributed to the broader stock market decline, driven by the belief among investors that the Federal Reserve would maintain high interest rates for an extended period. Notably, Berkshire sold more than 12 million Chevron shares before acquiring Hess for $53 billion.

Buffett's investment decisions are closely monitored for insights into where he perceives attractive returns. The legendary investor strategically navigated the impact of rising US interest rates, revealing that the interest income earned on Berkshire's insurance investments reached $1.7 billion in the quarter, contributing to a total of $5.1 billion over the past 12 months. Berkshire demonstrated confidence in its own shares by repurchasing $1.1 billion worth of stock during the quarter.

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US Treasuries trading altered by cyberattack

Cybercriminals recently targeted a New York unit of the Industrial and Commercial Bank of China (ICBC), the world's largest bank in terms of assets under management, disrupting trading in U.S. Treasuries. While the impact was relatively minor, the incident has heightened fears in a Treasury market already on edge due to concerns about its liquidity and increasing yields.

This attack has brought to light a long-feared scenario where hackers not only steal money but also hold ransom the financial system's data and information flows. The incident involved ICBC Financial Services, a New York-based entity that serves as a clearinghouse, ensuring brokers' trades and transactions go through. The attack forced ICBC to disconnect and isolate some systems, leading to disruption in the Treasury market as ICBC manually cleared trades.

The hack affected the repo market, where banks and financial institutions exchange trillions of dollars with Treasuries as collateral. Over $62 billion of U.S. Treasuries failed to deliver on Thursday, indicating either sellers didn't send securities or buyers didn't receive them in time to settle a trade. This disruption adds to the existing concerns about the fragility of the Treasury market.

While ICBC is a major global bank, its significance in the Treasury markets is relatively limited. The hack didn't halt overall trading for U.S. bonds, but it did create uncertainty for clients whose trades were routed through ICBC. The incident has also prompted discussions about the resilience of the Treasury market and potential risks associated with a breakdown in clearing U.S. Treasuries.

This cyberattack demonstrated that even well-protected financial systems are susceptible to disruption. As Washington works to address these challenges, concerns linger about potential cascading effects on derivatives contracts and broader market stability in the event of prolonged interruptions in clearing U.S. Treasuries.

WeWork files for bankruptcy

WeWork has filed for bankruptcy, marking the collapse of the company that was at one point the most valuable startup in the United States. The firm is seeking court approval to reject 69 commercial real estate leases, more than half of which are in New York. WeWork is also engaged in discussions with hundreds of landlords to modify other leases.

CEO David Tolley said that approximately 90% of the company's lenders have agreed to convert their debt into equity, erasing about $3 billion in debt. Under the proposed reorganization plan, most of WeWork's existing shares will be worthless.

Once valued at $47 billion, WeWork faced challenges due to its rapid and expansive growth, signing numerous long-term office leases at the market's peak in the late 2010s. The demand for its co-working spaces dwindled during the pandemic, resulting in increased vacancies, and the company struggled to meet billions in rent payments to landlords. Co-founder Adam Neumann, who established WeWork in 2010, was ousted in 2019 amid a failed attempt at an initial public offering and significant losses.

Despite cost-cutting efforts by new management, the company found it challenging to turn a profit in a weakened office market. Rent and interest payments consumed approximately 80% of WeWork's annual revenue as of June 2023, as a $5 billion bailout by SoftBank was to be paid with a floating interest rate.

This collapse raises concerns about the broader challenges faced by office landlords struggling with the shift towards hybrid working models. The crucial question now is whether the issues affecting the flexible office sector are limited to WeWork or if other players may be brought down by the headwinds affecting the industry.

The rise of flexible office brands hopes to capitalize on companies seeking cost savings by moving away from large static offices by switching to smaller flexible spaces, and some flexible workspace providers are currently experiencing record performance.