Macro Folks: Why didn't COVID cause a 94/02/08 Style Crisis?

Hoping the macro folks can weigh in here.

I understand COVID wasn't a crisis caused by economic factors, but why didn't we see the financial impacts like 2008?

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Comments (18)

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  • Analyst 1 in HF - Macro
Aug 21, 2021 - 4:11pm

For a few weeks in the beginning of March, it was actually worse than 07-08 in some respects. UST intermediation never broke down during the GFC, but it did in March 2020. That's why the Fed just made the SRF and FIMA repo facility permanent and why they're considering mandating UST central clearing. The moves in USTs during that time period were insane, I don't think there's any historical precedent for what happened during that time period. One of the deepest, most liquid markets in the world basically completely broke for a few days. 

In terms of why there weren't any bank/dealer failures - you can thank post-crisis legislation. LCR liquidity requirements require fat cushions of liquidity for large banks in the form of reserves, USTs, and MBS - but reserves are highly preferred due to Dodd-Frank's resolution planning rules (re: intraday liquidity) and behavioral changes post-crisis like the drop in use of daylight overdraft/intraday credit at the Fed. SLR captures ALL activity, on- and off-balance sheet, so you don't have Lehman's and Bear's leveraged 50-70x or more this time around. There's obviously some discretion in terms of calculation of position size for OTC notionals, but it's far more restrictive than Basel I/II. So basically the large banks and dealers really do have fortress balance sheets.

Unfortunately, those fortress balance sheets come at the cost of providing potentially risky, but very necessary financial intermediation functions - like making markets in USTs during period of extreme volatility. 

We almost had some pretty big blowups during that period (outside of market participants impacted by Dodd-Frank and Basel III) but the White House meeting at the 11th hour saved Citadel's ass as well as probably quite a few others. Citadel had some "basis trade issues" and by "basis trade issues" I mean they were probably worth less than $0 for a few hours. Probably some type of LTCM-esque deal to help them unload that position without breaking the UST market anymore than it already was.

TBH I don't think the Fed played that big of a role except clearing balance sheet space off the primary dealers (who were limited by SLR and their own risk management) by removing duration from the market. Obviously, the alphabet soup facilities helped to backstop the MMFs and some of the potentially unstable IG/HY bond ETFs, but that wasn't a huge factor IMO (outside of the impacting the psychology of equity/credit PMs who were just looking for an excuse to buy the dip anyways). If you remember March 15th was the day the Fed announced their bazooka on Sunday afternoon/evening. When the S&P futures market opened it was just lock limit down and Monday tanked as well. Nothing they said or did fixed anything, it was almost beautiful/glorious in a fucked up kind of way.

IMO it was Mnuchin stepping up on March 23 and issuing $1.7T of T-bills, which plugged the collateral hole (people were selling long bonds and buying bills and OTR notes/bonds b/c bonds were being repudiated as repo collateral due to the historic volatility of long bonds) and stopped the worst of the liquidations. 

If you're talking equities, I don't even wanna go there ... The S&P was basically still fine in May - August of 2008 when the whole world was falling apart in all the places that mattered since August 2007. It didn't start crashing until Lehman. 

  • Analyst 1 in HF - Macro
Aug 22, 2021 - 4:29am

That was definitely a big part of it. We had a lot of other extreme fiscal policies that we didn't have back in 08, not just unemployment assistance (eviction moratorium, stimmy checks, paycheck protection program, etc.) that were able to plug a lot of holes so that people weren't getting evicted/losing their house. We were also able to save a lot of jobs through PPP and many businesses weren't directly impacted by the lockdowns and could switch to remote relatively easily.

Obviously a lot of the small and medium businesses which are direct business-to-consumer (restaurants, stores, etc.) suffered heavy losses and many have permanently gone out of business. I think the full reckoning of the effects of the damage towards this sector of the economy hasn't fully been realized yet because we're still in "war finance" mode and haven't take a step back to look at the long-term effects yet. But many of of the unemployment benefits were more generous than what these people were making while working, so that spending got redirected towards large retailers (Target, Walmart, etc.) and deliveries (Amazon, Uber Eats, etc.) and wasn't permanently lost. The size of fiscal policies this time around were roughly equivalent to the hole that got blown in GDP.

I think 07-08 was a pretty big hit to household wealth, which reduced consumption further. Also, for many small and medium businesses, home equity lines of credit (HELOCs) were a primary means of obtaining business loans, so decline in housing value didn't just hurt household wealth/consumption, but also SMB investment. I think people tend to underestimate how important SMBs are for the economy - they're responsible for ~ 50% of private payroll and GDP and 60% of net new job creation.

I think a lot of the difference in terms of psychological reaction has been muted towards the economy because of unemployment/stimmy checks as well as the fact that everyone is so focused on the virus. 

Another thing is that compared to 07-08, this was very deep and painful, but also quick. You had restaurants shutting down and laying off/furloughing workers but they were able to rehire again when they opened back up. By comparison 07-08 seems painfully slow and we had waves of panic followed periods of calm. The whole thing from August 2007 to March 2009 took almost a year and a half with multiple "false dawns" before the ultimate climax. 

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  • Associate 2 in S&T - Comm
Aug 22, 2021 - 10:27am

Okay, so in 08, there's weren't a lot of help from the government (no fiscal policies except TARP, which didn't benefit people as much), so that's why people panicked then. 

Can you elaborate on that 08 false dawn part? We keep getting hope of post-COVID normality, but with variants aren't those false dawns as well? ( I guess it's not as relevant b/c the balance sheets of households/biz are much better this time around -> easier hole to dig out of?)

Another argument I heard was that in 02/08, China wasn't as big/connected to the western economies, which helped in 08. But in 2021, it's extremely connected and that we won't fully return to a pre-covid economy until China fully recovers?

  • Analyst 1 in HF - Macro
Aug 22, 2021 - 3:40pm

I should have been more specific. When I referenced the "false dawns" in regards to the GFC, I meant that financial market participants, economists, and central bankers kept expecting that the banking sector would recover, but it never really did.

From CS's macro research November 2009:

Just as the devastating wholesale funding run on the shadow banking system prefigured a collapse in commercial bank  willingness to lend, it is now leading the way in restoring credit availability to markets and the economy... Of course, it  would be quite wrong to suggest that this improvement in securitized lending to better quality borrowers reflects a full credit recovery. It is, however, likely to "foreshadow" a more general improvement in credit conditions... More obviously, credit is not flowing (for both demand-side and  supply-side reasons) to commercial real estate, non-agency mortgage lending, and small business lending. Of course, most commercial mortgages and small business loans, and some non-agency (jumbo) mortgages are not securitized, and so this partly reflects the commercial banks' current extreme caution with their balance sheets.

From Ben Bernanke in 2009:

Interbank and other short-term funding markets are functioning more normally; interest rate spreads on mortgages, corporate bonds, and other credit products have narrowed significantly; stock prices have rebounded; and some securitization markets have resumed operation. In particular, borrowers with access to public equity and bond markets, including most large firms, now generally are able to obtain credit without great difficulty. Other borrowers, such as state and local governments, have experienced improvement in their credit access as well.

From 2012: 

Even with growth conditions improving and some signs of life in private credit demand emerging, the Federal Reserve seems to be itching to do more – or at least to make clear its willingness to do more should growth falter or new threats to recovery emerge. That in turn makes perfect sense given that the stock of liquid private collateral – the source material of "shadow money" – still isn't growing. That's consistent with an economy operating well below its capacity. It is the modern monetary counterpart of large output gaps. That is, by the way, not some arcane technical point; it is above all about jobs, hardship and hope in the high foreclosure counties and states, where recovery in income, spending and collateral values have clearly lagged the rest of the country. Indeed, it is only now that there are tentative signs of stabilization in those areas. Housing equity is frequently used as collateral to start or expand small businesses, so it is not just current spending but business formation and jobs growth that suffer. More generally, home-equity lines of credit allow households to monetize their main asset and hold lower deposit amounts in general. So the decline in home equity leads directly to higher money demand, which needs to be accommodated to assure recovery and prevent disinflation or worse.

From 2014: 

We believe the financial system will eventually bounce back in a vibrant new form, but the next few years will be a period of transition. Until a new system emerges, the private sector will struggle to create liquidity, financial transaction volumes will be low, and it will be necessary to maintain reflationary policies such as low interest rates. Market price action is likely to be "jerky," characterized by bouts of illiquidity in which prices gap lower while buyers are temporarily absent, as in June of this year ... The newly emerging system is likely to be much less elastic and liquidity-generating than the old version. Market  participants must navigate through a period when  liquidity is reduced and financial balance sheets are shrinking due to both weak real recovery and new regulatory headwinds. For the time being, the financial system  is  paying a double penalty for the crisis. It is shrinking unprofitably, and struggling to maintain liquidity along the way. In our view, however, the financial system will  bounce back vibrantly in a new form. As long as liquidity can be profitably provided, entities will arise to do that business.

Note the persistent optimism that the "real" recovery is just around the corner... This is what I mean by false dawns. 

Sure the COVID restrictions are annoying, but what do they really impact economically/financially? Restaurants, hotels, gyms, concerts, other in-person events, etc. - mostly hospitality related jobs. Hospitality is only ~ 10% of GDP.

Everyone else has been working through COVID restrictions with minimal impact after the first 6 weeks of strict lockdowns. Businesses adapted if they could and switched to remote work, grocery stores remained open, and online and delivery businesses boomed. The downtick in services was matched with a corresponding uptick in goods spending. Restaurants going out of business is not a systemic economic event - that's probably just the long and short of it. 

Furthermore, not every state/city has had the same open/close whiplash. Texas and Florida, two of the largest state economies, have largely remained open after the initial 4-6 weeks. Not every state/city is like Los Angeles, New York, Chicago, etc. 

The whole country was basically able to lean into the HQLA buffers that had been built up so commercial banks could provide funding, which combined with unprecedented fiscal backstops, were able to get us through the worst of the economic disruption, which only lasted a short period of time anyway. 

I can definitely see the China argument. China has been the marginal consumer/source of growth in the global economy for a long time - so they can definitely drag down the global economy. They also have a lot of their own idiosyncratic issues which are worse than just COVID and they've been walking a tightrope now for longer than most people thought they would be able to with the instability of their financial system. 

I think many people have been scarred/impacted by 07-08 so that if there isn't another Lehman failing it doesn't seem like a big deal. There are worse fates than that (i.e. Japan).

  • Analyst 1 in HF - Macro
Aug 23, 2021 - 2:22am

I agree we will have to go through a debt-default cycle at some point. You're talking to the guy who thought the CLO market was going to implode. Somehow everything still seem to be more or less OK for the moment.

I think part of the reason we didn't/haven't seen that yet is the Paycheck Protection Program (fiscal), the PPPLF (Fed), and Main Street Lending Program (Fed) allowed banks to basically lend at will to businesses and not worry about loan defaults/non-performing loans. The banks weren't necessarily offering loans/loan extensions out of the goodness of their hearts... 

For comparison (kind of a bad comparison, but whatever) think about the wave of O&G defaults during 2014-2016. That wasn't really systemic, and I don't think that hospitality will be either. I think one of the BIG ticking time bombs is commercial real estate, especially with WFH and Delta concerns. We'll see how that plays out over the next 12 months.

Nice talking with you too. I always like discussing macro because writing out my ideas forces me to be more clear/honest with my viewpoint. Also enjoy talking to sellside traders because you guys are much more in the weeds than I am with many of these developments. I just try to piece things together from a distance, but you guys are the ones up front and center and often have a more intuitive understanding that isn't necessarily observable from a chart or study. 

  • Consultant in Consulting
Aug 22, 2021 - 1:28am

Wow, I honestly understood very little of this but it sounds really interesting. Do you have any recommendations (books, podcasts, etc) on how to get smart on how the financial system works? 

  • Analyst 2 in IB - Gen
Aug 22, 2021 - 12:57pm

Very insightful post. So what's your outlook on the next 12-18 months and what should we be paying close attention to during this time frame? Do any of the issues that were mitigated have the near-term potential to resurface? 

  • Analyst 1 in PE - LBOs
Aug 22, 2021 - 5:55pm

Wow. Great read and thanks for sharing. Do you mind elaborating on what happened at Citadel? I frankly have no idea how a place like that works and couldn't find good reading on the internet.

Aug 22, 2021 - 5:16am

The difference was the rich got poorer in 94/02/08, everyone from all social classes suffered. What happened in 2020 was that the fed made the rich richer. Wealth inequality has widened even further post COVID. The bottom 50% have it worse now than they in 2008. Inflation is at a record high while wages continue to be stagnant for the middle class. 


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  • PM in HF - Other
Aug 24, 2021 - 10:46pm

What role do you think the overall shift in the economy/efficiency has taken helped shift this crisis quickly? I think you nailed one of the points about "O&G debt crisis" not being a systemic risk in 2014-2016 nor in 2020 as energy products basically went to zero. Unlike 20 years ago the "O&G" industry is not a huge component of the economy anymore and as you mentioned neither are the financial firms based on the new rules/policies. The major systemic risk you also explained was the liquidity crisis that the fed/treasury dealt with asap to fix.

But the other side is that "covid" allowed a whole new series of industries to grow and be created. In 2008, I do not think any good came out the rubble. While the largest firms (FANG tech) were able to take an even greater chunk of the economy and get stronger in this short-term crisis.

Aug 24, 2021 - 11:15pm

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