Almost two weeks before the May 19 market crash, the Federal Reserve warned that it was closely watching rising asset prices in stocks and other securities, saying they were poised to face “significant declines” that could pose an increased threat to financial systems.
In its semi-annual financial stability report, the Fed highlighted how rising appetite for risk across a variety of asset markets is stretching valuations and creating vulnerabilities in the U.S. financial system.
“With investors ebullient on expectations for a strong rebound, it is important to closely monitor risks to the system and ensure the financial system is resilient,” Federal Reserve Board governor Lael Brainard said in a statement released alongside the U.S. central bank report.
“A few recent episodes have highlighted the opacity of risky exposures and the need for greater transparency at hedge funds and other leveraged financial entities that can transmit stress to the financial system.”
The Fed flagged Archegos Capital Management and meme stocks such as GameStop as examples of “elevated” risky assets. It said commercial real estate remains potentially vulnerable after a pandemic that may lower demand for office space.
In January, traders on Reddit message board WallStreetBets fueled a battle over meme stocks such as Gamestop (GME) and AMC Entertainment (AMC). Melvin Capital Management, one of the hedge funds that held bets against those companies, experience billions in losses.
Two months later, Archegos triggered multi-billion losses at a number of international banks after it faced a margin call on its stock bets. The private firm, which managed the wealth of Bill Hwang’s family, leaned on total return swap agreements and other derivatives in its positions.
“The Archegos event illustrates the limited visibility into hedge-fund exposures and serves as a reminder that available measures of hedge-fund leverage may not be capturing important risks,” Brainard said.
She said the situation bears watching and pointed out the importance of making sure the system has proper safeguards. The regulator was considering asking banks to increase their capital requirements as a buffer against downturns, Brainard added.
Listen to GHOGH with Jamarlin Martin | Episode 74: Jamarlin Martin Jamarlin returns for a new season of the GHOGH podcast to discuss Bitcoin, bubbles, and Biden. He talks about the risk factors for Bitcoin as an investment asset including origin risk, speculative market structure, regulatory, and environment. Are broader financial markets in a massive speculative bubble?