James Aitken – Systemic Risk in a Crisis (Capital Allocators, EP.126)

Episode Summary

Executive Summary: James Aitken argues the market selloff was driven by fragile pre-existing leverage, not just the pandemic and oil shock. Central banks are acting to preserve market plumbing and bridge the economy to fiscal support, but the deeper risk lies in credit, non-bank leverage, and liquidity mismatches. He sees severe dislocation creating future opportunities for patient capital.

Main Topics: Pre-existing leverage and market fragility (Priority: 5/5): Aitken says the crisis exposed vulnerabilities built up over years of low rates, cheap credit, and high leverage in risk assets, rather than being caused solely by the immediate shock. Why the selloff was so fast (Priority: 5/5): He attributes the violent move to forced deleveraging, repo dependence, changing stock-bond correlations, and volatility-scaling strategies that had to unwind simultaneously. Central bank response as a bridge (Priority: 5/5): He frames monetary policy as emergency market-function support intended to bridge the economy until fiscal stimulus and health measures take over, not primarily as a bailout of asset prices. Treasury market dislocation and plumbing stress (Priority: 4/5): The Treasury curve and futures market were disrupted by RV and risk-parity unwinds, dealer balance-sheet limits, and operational strain, prompting Fed purchases to restore functioning. Credit market stress and liquidity mismatch (Priority: 5/5): He warns that credit pain is only beginning, with ETFs, leveraged loans, CLOs, and high yield likely to face more forced selling and repricing as liquidity dries up. Systemic risk is shifted from banks to non-banks (Priority: 5/5): Regulated banks are better capitalized and less levered than in 2008, but risk has migrated to non-bank asset managers and vehicles holding illiquid assets with daily liquidity. Opportunistic long-term investing (Priority: 4/5): Despite near-term turmoil, he argues that fully funded investors with a multi-year horizon should be preparing to buy credit and other assets at attractive prices.

Key Arguments: The selloff was enabled by years of low rates, suppressed volatility, and high leverage in risk assets, so the trigger mattered less than the underlying fragility. Forced deleveraging in relative-value Treasury trades and risk-parity portfolios created a feedback loop that distorted the Treasury curve and impaired market functioning. Volatility scaling made many strategies vulnerable: when volatility rose, everyone reduced exposure at once, amplifying the crash. Central banks are not trying to reflate asset prices directly; they are trying to keep banks liquid and markets tradable until fiscal policy can address the real economy. The Fed’s 50 bp cut helped expose Treasury RV financing stress by collapsing OIS rates relative to repo, forcing unwinds. Credit markets are more dangerous than equities because people are selling what they can, not what they must, and liquidity in ETFs and leveraged credit is failing under stress. The true systemic vulnerability is in non-bank financial institutions that hold illiquid assets while promising liquidity to allocators. A new opportunity set is forming in credit, but only for investors with durable capital, patience, and strong underwriting discipline.

Data Points: Fed rate cut: 50 basis points - Aitken says the Fed’s sudden cut helped trigger deleveraging in Treasury RV financing. ECB bank funding rate: minus 75 basis points - He cites the ECB’s extraordinary lending terms to eligible banks. ECB total bank borrowing capacity: up to 2 trillion euros - Maximum liquidity banks could access from the ECB under the described facility. Fed asset purchase target: at least $700 billion - Fed purchases were launched to restore Treasury market functioning. Potential U.S. fiscal response: $750 billion to $800 billion - He expects a major U.S. fiscal package to be announced soon. Bank of Japan dollar liquidity takedown: $32 billion - He notes the BOJ’s first dollar liquidity operation in 12 years. Leverage in RV Treasury books: 40 to 50 times - He describes the leverage used by some relative-value fixed income funds. Positive carry in Treasury basis trade: 5 to 7 basis points - Approximate spread earned by buying Treasury bonds and shorting futures. Treasury RV financing term: every 24 hours - He characterizes overnight repo as a daily refinancing risk. Investment-grade credit issue: widening out - He observes IG credit spreads moving worse as stress grows. American Airlines buybacks: $15 billion - Used as an example of capital structure questions around potential bailouts.

Pivotal Quotes: "The very strong actions with potential for more that central bankers have taken thus far are designed to provide a bridge to the necessary medical and fiscal response to address the COVID-19 disruption." — James Aitken: Explaining the purpose of central bank intervention. "I fear the pain in credit has barely begun." — James Aitken: Describing his outlook for credit market stress and forced selling. "The risk is now in non-bank financial institutions and often in vehicles that own illiquid assets with daily liquidity, which is absolutely absurd." — James Aitken: Identifying where he believes the main systemic vulnerability sits.

Implications: Expect continued volatility and further credit repricing, but also major opportunities for patient capital. The key risk is not banks failing like 2008, but non-bank liquidity mismatches and market plumbing stress.