104% China Tariffs Came into Effect at Midnight. We Instantly Entered this Crisis’s “Lehman Brothers” Moment

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Since I will be getting a bunch of new readers for this piece, I’m trying to explain every single moving part so this is very long. I will certainly do abbreviated mainstream Op Eds based on this piece. Skip ahead if you know financial markets well.

Understanding what’s going during the Trump Tariff stock market panic each day is extremely difficult. Crisis moments always are: because everyone is tired and stressed, things move very quickly, and all of the most intricate and obscure questions about the Financial System’s “plumbing” become relevant all at once. We don’t truly know what has happened in full until what happened is dissected after the fact, often using data which only gets published (or at least reported on) in the following weeks and months. Sometimes years. I have a good track record of course. I covered all the intricate aspects of the Federal Reserve crisis facilities during Covid. I have, of course, burnished my reputation in the Trump-Musk Payments Crisis (to say the least). I also did pretty good in the Silicon Valley Bank crisis. All my pieces from that time got praise and many of them got Media coverage. From my opening salvo “Every Complex Banking Issue All At Once: The Failure of Silicon Valley Bank in One Brief Summary and Five Quick Implications” all the way to a piece correcting the record on FDR’s position on bank deposit insurance.. 

My favorite piece was, of course, on Zoltan Pozsar, a legendary wall street guru and financial system “plumbing expert”. Titled “The Night They Reread Pozsar (in his absence)” (a reference to a short 2009 blog post/long LSE lecture from Paul Krugman entitled “The Night They Reread Minsky” which is in turn a reference to a 1968 Musical Comedy by Norman Lear). The focus of the piece was the irony that the world’s foremost expert on the production of “shadow money” as a result of the limitations of deposit insurance (read the piece to understand what any of this means!) could not comment on a shadow money crisis. That's because his employer, Credit Suisse, was caught in the maelstrom. Less than six weeks later I was quoted in a Wall Street Journal profile of Pozsar:  

“Zoltan always keeps the reader a step removed. [...] There’s always a sense that he knows a little bit more than you ever will, and there’s no real way you can get to his level, but you can get close by reading his stuff.”

Given that Mr. Pozsar’s work is closely tied to the issues that sparked this year’s banking turmoil, some on social media had wondered why they hadn’t heard much from him recently.

A March 30 blog post by Mr. Tankus featured an image made in jest of Mr. Pozsar’s face on a milk carton. [Emphasis added]

I will forever love the fact that I got the phrase “an image made in jest of Mr. Pozsar’s face on a milk carton.” into the Wall Street Journal.

Anyway, while I’m proud of the coverage I did of the Silicon Valley Bank crisis, I did make a major mistake. In a piece on the treasury market that first week I posited that the dysfunction was related to uncertainty about whether the Fed would cut rates because of macroeconomic reasons (which aren’t relevant today). I learned not that long after from well placed sources that while my argument was coherent, it was false. In September 2023 I finally wrote up that I was wrong in a piece straightforwardly titled “I Was Wrong About Post-SVB Treasury Market Strains- Here’s Why”. I heard two explanations for what happened to the Treasury Market during Silicon Valley Bank, but the central one is also the central one in the current Trump Tariff Stock Market Crisis: “The role of high frequency trading desks and hedge funds”.

Let's take a step back for a second. To understand any of this, we have to understand what “liquidity” is. The key, and most intuitive notion, is the idea that an extremely “liquid” asset is one that you can sell—or send as a payment to a creditor—at or near some “accounted for” value. The most obvious “accounted for” value is the very front of a physical dollar bill. If you have one dollar, you can give it to your friend in payment for your one dollar debt to your friend. Your checking account is another one. 

That checking account balance is “liquid” when it's easy to convert 100 dollars of your balance into a 100 dollar credit card payment, 100 dollar utility payment. If a “chase dollar” fluctuated against a “Wells Fargo” dollar, they would both be less liquid (unless one was the persistently stronger one). This happened in the United States banking system all the time before the Civil War! Other “accounted for” values are the acquisition cost of an asset or the most recent “market price” quotations. Think of selling a house. Few people believe they will be able to sell their house in a day at the price their neighbors house just sold for. The crucial thing is that liquidity is, as the social scientists love to say, a “social relation”. It’s not something that is “within” objects. It's a relation between an asset and a financial ecosystem. And the ecosystem can change rapidly.

In essence, the highest form of “money” is also the most “liquid” asset (we will be skipping the deep, fascinating, but far too involved philosophical question “What is Money?” on today’s emergency crisis coverage). But, generally speaking, people do not speak about liquidity in terms of “money” and “not money”. They treat it as a spectrum. Money itself is a spectrum, hence the term “moneyness”. By chance, I spent some of this weekend rereading a transcript of a secret December 10th 1949 Executive Session Congressional hearing that ultimately led up to the Federal Reserve’s “independence” (the providence and context of this document is a whole other story!) One particular quote stood out from one of my favorite forgotten economists, the Columbia University professor Albert Hart. It is an extremely well stated summation of precisely the point I am driving at with today’s piece:

I enthusiastically agree that we must not draw the line at a particular point between what is money and not money and disregard the liquidity of things we fought to classify as money. But I do think we have to pay a lot of attention to the degree of liquidity of the liquid assets, both as between classes of assets and for the same asset at different times.

This insight from Hart is absolutely essential. In a very real sense, the core problems the financial system has faced (prior to the current constitutional payments crisis) is the total disregard of his insight by policymakers. As I had started commenting way back in September 2019, regulatory requirements on “too big to fail” banks have made their balance sheets more rigid, especially to lower and even “no default risk” assets like treasury securities. What does it mean for a balance sheet to be “rigid”? In essence, it means that it can’t expand its liabilities very much to acquire more assets.

Think about this in terms of Fonzie from the half-century old sitcom Happy Days. Fonzie has a balance sheet. It has assets on one side and liabilities on the other. Subtract all of Fonzie’s liabilities from his assets, and voila! You have his net worth. Fonzie’s “Leverage” is measured by dividing Fonzie’s liabilities by his net worth. The higher the ratio, the more “leveraged” Fonzie is. “More Levered Fonzie” has bought more assets by taking on more liabilities, but has the same net worth. That means he’s more leveraged. To recap, leverage is liabilities divided by net worth. Of course, it gets much more complicated than this. But the complications are just added detail that makes it harder to follow. At its core, this is what people mean when they say “leverage” or say a company or person is “highly levered”.`

So, to return to the topic at hand: when balance sheets are said to be “rigid” what it means is that they can’t “expand their balance sheet” and get more highly leveraged (read: issue IOUs) to buy assets. The “rigidity” that was regulatorily imposed on the largest banks in the world was done as a result of the Great Financial Crisis of 2007-2008. Regulators, in particular the international committee the “Basel committee on Banking Supervision”, sought to solve liquidity problems by simply requiring large banks to hold “High Quality Liquid Assets” (HQLA). They sought to solve solvency problems- essentially banks not having enough net worth- by putting an absolute cap on how many assets they could own relative to a given “net worth”. 

In other words, they put “leverage requirements” on banks- specifically on “bank holding companies”. Before the Great Financial Crisis banks could get their leverage ratios as high as 40 to 1 i.e. their net worth was 2.5% of their assets. They could do this by having the part of the company that “wasn’t a bank” take on that leverage.. You can read about the history of the Basel committee in my very first academic publication, a book review, published in 2013.

The committee’s approach to liquidity essentially treated “high liquidity” as something assets inherently have rather than something that monetary and financial infrastructure produce. In a certain sense, the highest tier of “High Quality Liquid Assets” were treated as inherently money and, to use Hart’s phrase, the Basel Committee “disregard[ed] the liquidity of things we fought to classify as money”. It also ignored “the degree of liquidity [...] for the same asset at different times”. The results have been a chronic problem with varying severity ever since the regulations were fully implemented. 

At the same time banks were required to hold large amounts of either treasuries or settlement balances (essentially the “checking account balances” of banks at the Federal Reserve), their role in providing liquidity to the treasury market was undermined. There were a lot of problems leading into the 2008 financial crisis, but one of its strengths was that big banks could always expand their balance sheets to purchase treasury securities since these were classed as “no risk” assets by the previous iteration of international financial regulatory standards. Banks could lever up (issue more liabilities relative to their net worth) to buy treasuries and then turn to the central bank when they needed liquidity. In other words, there’s a question of how much of the largest bank’s leverage was “bad” and how much served a purpose: taking treasury securities on their balance sheets when needed.

This is one of those ecosystem questions discussed above. If large banks, technically “large bank holding companies”, aren’t going to “absorb” treasuries: who will? In 2020 I claimed that financial markets are only generally liquid, to the extent they are generally liquid, because the government “franchises” the ability to create dollars to chartered banks and those chartered banks, in turn, “sub-franchises” liquidity throughout the financial system. Of course, the government can also provide liquidity directly to non-bank entities. As Columbia Law professor Lev Menand and former New York Federal Reserve Senior Policy Advisor Josh Younger pointed out in a paper two years ago, the Federal Reserve has been “franchising” liquidity directly to non-bank financial institutions for at least 70 years through entering “repurchase agreements” with them (read about what repurchase agreements are in this piece I put out in late February). Then of course there’s the Fed’s “emergency powers”.

What ended up happening is that hedge funds, entities who take on lots of leverage based on investment from “accredited investors” (read rich people or institutions like pensions or universities), have stepped into the breach. They have taken on leverage to buy treasuries and then manage their risks with other derivatives that reference treasuries. I’m gonna skip the details because I just have too much to cover. The point is, hedge funds and other similarly placed entities have become “shadow dealers”, to use Lev Menand and Josh Younger’s phrase. This is what I said about this in my 2023 “I Was Wrong” piece::

In reading this paper I have become convinced that I have underrated the role of these high frequency trading desks and hedge funds. The core issue is one of monetary design, but these institutions reflect that lack of monetary design. Rather than being sideshows, their behavior in recent years reflects the opportunity to partially take the place left behind by more rigid balance sheets of dealers, who remained part of bank holding companies. At the same time, since “shadow” dealers are further outside the reach of the “regulatory perimeter”, they don’t have the same obligations as licensed dealers. They don’t have to regularly participate in treasury markets, and provision liquidity. Nor do they have access to the backstops that licensed government securities dealers have.

These HFT desks and hedge funds run from treasury markets at the first sign of trouble, and that’s precisely what they did after SVB failed. On the other hand, I was not wrong in 2019 or 2020 to think that regulating these entities more wouldn’t solve the fundamental problem. Making their balance sheets more rigid will just drain liquidity from treasury markets further, which would need to be offset one way or another. [Emphasis added]

The financial stability problem is that hedge funds, and other similarly placed entities are extremely “procyclical”. That is, they expand greatly when times are good and they pull back sharply in bad times. Specifically, both their “internal” risk limits and external regulation encourages them to “have” a certain amount of “capital” (think “have a certain net worth”) for how much “risk” they are taking on. How do you know how much risk you’re taking on? Well you don’t. But for risk management purposes and external regulation purposes “risk” gets administratively and legally defined as “what a model says”. Specifically the institution’s “Value at Risk” (VaR) statistical models. You can predict what happens next. When volatility spikes, they are supposed to take less risk. Which means having fewer liabilities for the same level of net worth. Let alone net worth falling as asset values fall!

Wall Street, in its infinite wisdom, has made a handy measure of expected volatility. Well actually, not Wall Street. This handy tool is a product of LaSalle Street, Chicago’s “Wall Street”. If New York is the center of stock trading in the United States, Chicago is the home of derivatives. The Chicago Board of Trade was founded in 1848 and has traded derivatives ever since. Now, of course it started with “physical delivery” futures contracts for agricultural commodities. But fundamentally, it's the same business nearly two centuries later. Anyway, this handy product was created by the “Chicago Board Option Exchange” (CBOE), an institution quite a bit younger (in fact with a 1993 birthday it's younger than I am.) This product is simply called the “CBOE Volatility Index”

On Monday we talked about “index providers” and “index funds”. While those are different businesses, CBOE has a lot of vertical integration i.e. it provides the index and it provides the product that “references” the index. CBOE created the “CBOE Volatility Index” and it has created “Cboe Volatility Index® (VX) Futures” as well as the “Cboe Volatility Index® (VIX®) Options”, plus a bunch of other products. As you can see from the graph above, VIX has spiked to a level only comparable to March 2020 (Covid) and the Great Financial Crisis. I saw someone on CNBC yesterday afternoon call a VIX futures or options contract price the “price of a parachute”. 

Why has volatility spiked? Well, Donald Trump of course. Financial market participants have finally caught up to the fact that Trump’s second presidential term is a completely different beast. There is nothing currently constraining the global economy, and thus global financial system, from running on Trump’s moment to moment erratic behavior. Hence why 104% tariffs against China came at midnight. As the headline of this piece says, it was those tariffs that tipped the Treasury market over into deep distress. 

I am writing these words at 7:08 AM and I have spent all night trying to put all this into a readable form. My information is basically out of date as of 3:00 AM so I’m not going to make definitive claims about what is happening. Nevertheless, I’m willing to stake out this position: today was the Trump Tariff Crisis’s “Lehman Brothers moment” i.e. the moment where things shook loose and there is no turning back. When Lehman Brothers went into sudden bankruptcy there was no wishing that crisis away. The same is true here. While we are still in the fog, and my information is hours out of date, I firmly believe April 9th 2025 will be a date remembered like September 15th 2008.

What is clear is that until there is a fundamental resolution to this situation, volatility will stay extremely high. With volatility extremely high, the global financial system will continue trading on every piece of Trump news. Hence the 15 minutes on Monday where the stock market rallied and went up, in aggregate, 2.5 Trillion dollars based on a random twitter account’s tweet reporting false claims about a change in Trump’s approach to tariffs. Once the “conventional wisdom” among stock market traders and this was judged to be false, those 2.5 Trillion dollars evaporated. The stock market is trading in an erratic “hyper-fundamentals” fashion where the only fundamentals that matter are the current state of Trump’s “thinking”. In essence, the every financial market in the globe is finally trading in a manner similar to how MSNBC has been making its viewers feel every day for the past few months. This is because of a combination of the intense volatility and the overwhelming fear.

Stock traders are still desperately seeking any sign of hope that this will all go away which is why the stock market is prone to these bizarre rallies, before another crazy Trump statement or action brings them back to reality. In a certain sense, they have no other choice. Financial markets are not remotely able to function on this kind of volatility continuously. In essence, this kind of extreme instability is definitionally a crisis because it must be resolved so that the basic stability, even if it's a “false” stability produced by highly motivated conventions, can be established or reestablished.

Putting this all together, financial regulators have been regulatorily treating United States Treasury Securities as “money” without making sure that the infrastructure was there to guarantee its liquidity on a 24-7 basis. More generally, we’ve increasingly relied on institutions like hedge funds to hold large amounts of financial assets as we discouraged large banks from doing so. Hedge Funds run on leverage. As market volatility explodes, they sell assets in an attempt to deleverage. But they were absorbing assets for the rest of the economic system. For every seller there must be a buyer. So more buyers must be forthcoming or prices need to decline to fit these big assets in the ever smaller amount of “free balance sheet space”. Think of a clown car.

Hedge Funds, and other similar non-bank firms,  attempts to shrink their balance sheets will lead others to try to shrink their balance sheet which will just cause further market dislocations in superficially unrelated markets. This deleveraging pressure is clearly happening globally. Perversely, the erratic unreliability of the U.S. is, just as it did in 2008, getting the rest of the world to ever more desperately chase down dollars. Pricing in the Trump-Musk Payments Crisis has not happened, and I do not expect it to happen anytime soon, as I wrote about yesterday. Ergo no running from the dollar.

Still, the question remains, who absorbs assets from the asset absorbers?

Why, the Federal Reserve of course. Unlike a lot of commentators, I think they will step in and stabilize financial markets domestically. The tricky question is… will they do so globally? In 2008, and again in 2020, “Swap Lines” (think “lines of credit") with other central banks has been critical to stabilizing global financial markets. This time is different. Why would Trump want to cut off the rest of the world until they end their trade deficits with the United States, as well as cut off foreign aid, but be okay with Jay Powell and the Federal Reserve lending trillions of dollars to foreign central banks? European policymakers already started to, correctly, think about this possibility weeks ago.

Trump’s orbit may not have known about Central Bank Swap Lines in the first term, but they do now. Which brings me to a grim thing I posted on Facebook on December 30th 2016:

The worst day of the Trump presidency might be when someone tells Trump what Central Bank Liquidity Swaps are.

This is all the international commentary I have time for in this already long piece. I’m going to bed. Good morning, and good luck. On the bright side, Democracy surviving in the United States looks so much better than it did two weeks ago.