The bailout of the overnight repo market by the NY Fed has raised a lot of questions. Why was the financial market unable to respond without Fed help? What caused such an unpredictable surge in demand that caused rates to double overnight? Such conditions are ripe for theories and I have mine.

Never attribute to conspiracy what can be explained with incompetence. It is possible that the traders converged in a perfect storm and failed to comprehend the impact of a confluence of large trades in a short period of time. I do not find that satisfying. Perhaps a foreign sovereign (Iran) liquidated Treasuries to raise cash pending a conflict. This would seem to be easily verifiable, so I find this lacking.

Markets will always have short term periods of unusual and hard to predict volume and markets usually have the capacity to absorb them. Perhaps this is a warning shot that Dodd Frank has crippled the ability of the markets to absorb such incidents.

For years astute bond traders have been concerned about the capacity of the bond market to absorb a large volume as a result of the restriction of the market making capacity of the traders under the regulations of Dodd Frank. With record low interest rates, a surge in rates would cause a mass exit challenging their ability to handle the volume.

Bond mutual funds are particularly vulnerable since such a rush would cause them to sell the higher quality holdings first and degrade the quality of the remaining inventory. I have avoided these funds.

In 1998 the demise of Long Term Capital and the subsequent bailout forced on the large Wall Street funds by the Fed under Alan Greenspan was a warning shot to the outsized risks taken by the best and brightest of the investment world. Long Term Capital was made famous for its Nobel prize winning PhD economists, and their belief that quantitative models could reduce risk and thus justify extreme leverage. They replaced a philosophical understanding of risk with delusional mathematical certainty.

Long Term was treated as an outlier rather than a sign of systemic hubris which became far more obvious ten years later. The lessons we should have learned only become obvious too late. If the lesson here is the restraint of the capabilities of the market by excessive regulation in the wake of the 2008 collapse, now is the time to make the necessary adjustments.

I am way out of any field of competence here and there may be other factors at play that I can not comprehend. Bad regulations can be as harmful as no regulation and due to the complexity of the field, the two are often confused.

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