Former Federal Reserve chairs Ben Bernanke and Janet Yellen are raising questions about the role hedge funds played in the March market tumult.
The duo pointed out in an essay that says the Fed was pushed into action as a result of a breakdown in market functioning triggered by massive hedge fund selling in the early days of the coronavirus pandemic declaration.
As the market became flooded with Treasurys and other long-term securities, buyers bailed out and the Fed had to step in with liquidity facilities and asset purchases aimed at maintaining basic functioning. The Fed's purchases caused its balance sheet to swell past $7 trillion, or nearly double from its size earlier in the year.
"Although risk and liquidity premiums in these key markets have returned closer to normal, at some point the Fed and the Treasury will need to review why the market-making facilities in place before the pandemic hit did not work more efficiently," Bernanke and Yellen said in a blog post for the Brookings Institution, where they are both distinguished fellows.
Both former central bankers served during the financial crisis, Bernanke as chair and Yellen as president of the San Francisco Fed. Yellen succeeded Bernanke and guided the Fed through the early days of policy normalization after the extraordinary measures taken during the crisis.
Their essay touched on a number of points drawing on their crisis experience, largely praising the Fed for its response to the pandemic. The current leaders again dropped overnight borrowing rates to near zero and dusted off multiple credit facilities first introduced during the 2008 crisis.
However, this Fed extended its powers even further into direct business lending and purchasing corporate bonds.
Bernanke and Yellen said officials may have to do more.
For one, they noted that the Fed has restricted banks from buying back shares and limited their ability to pay dividends, and that may not be enough to ensure stability.
"Based on our experience in the global financial crisis, we think the Fed may find it needs to go further," they wrote. "Although banks are currently strong, it is possible the pandemic will so damage the economy that credit losses mount rapidly. For a successful recovery, the banking system must remain strong and able to lend."
They said the Fed also may have to adjust the terms of some of its other facilities such as the Main Street Lending Program. Considered the most ambitious and complicated of the dozen or so programs unleashed, it has attracted only modest interest from borrowers and lenders thus far.
"Broadly speaking, though, the Fed's response has been forceful, forward-looking, and comprehensive," Bernanke and Yellen wrote.