Using a leverage-heavy strategy that was popular before the 2008 financial crisis, Element Capital Management LLC has been making large moves in the $12.8 trillion U.S. Treasury market in recent months. The strategy has been very profitable for the company, averaging a 20% return since its inception in 2005.
After rumors began swirling that the company has bought over $12 billion in treasuries, regulators are increasingly eyeing the firm in anticipation that history could repeat itself.
Regulators are particularly worried because the company has been buying so many treasuries that in recent months it has been the largest buyer. This position is usually occupied by countries and not individual financial firms.
After hedge funds and other banks began to leave the Treasury market following the financial crisis, Element began to account for a larger portion of that trading volume. Hedge fund Long Term Capital Management (LTCM) pursued a similar strategy in the 1990s using much more leverage, before collapsing in 1998 following the Asian and Russian financial crises.
Element’s strategy involves shorting treasuries using borrowed funds leading up to a Treasury auction. During a Treasury auction, the new influx of securities can temporarily depress prices, during which time Element can complete its trade, profiting off the small price differential.
Element had until recently been shorting bonds, in anticipation of higher interest rates. As the world economy displays indications of increased volatility, expectations in the near term that the Fed may raise rates have dwindled, leading Element to abandon this strategy to more heavily favor Treasuries.
Element CEO Jeffrey Talpins should well remember the lesson of LTCM as a demonstration of the danger of leverage. LTCM’s failure lead to a bailout agreement among 16 major financial organizations, including the infamous Lehman Brothers, under direction by the Federal Reserve. The company lasted only four years, posting similar returns to Element. Perhaps Talpins should be happy that he has already more than doubled their record.
Those familiar with the Treasury market have called the strategy “eyebrow raising,” as regulators have discouraged such behavior in the wake of the 2008 crisis. Although Congress has passed some measures of finance reform since then, Element’s strategy is still within the law.