The InterPrime Newsletter - Issue #9 - Archegos margin call & Q1 2021 market update

It’s never been a more exciting time to be in the markets, but recently we have seen glimpses of what can happen when things go awry. The Archegos blow up being the prime example, and the tech sell off in the high flying stocks earlier in the year.

We are going to shed some light on what went wrong with Archegos and share our perspective on how we currently see markets.

Archegos is the family office of Bill Hwang who trained under Julian Robertson at Tiger Management, and is part of the mafia known as Tiger Cubs. He was the head of Tiger Asia Management, a prolific hedge fund that was shut down in 2012 after they settled with the SEC on insider trading charges in Chinese stocks. When his fund shut down he started his family office Archegos to manage his personal capital. He was considered one of the best in the industry, and what people would call a “pro’s pro”. 

However, sometimes even the best blow up, and when they do, they blow up big - $10 BILLION big. Archegos lost $10 Billion in 2 days, and led to several Billion in losses for the banks that gave them margin loans. I’m sure books will be written about this, but if one was to point to the one factor that led to this blow up, it would be EXCESSIVE LEVERAGE.

Bill was able to do this by using an over the counter instrument called a Total Return Swap (TRS). This is not an instrument that you or I can use, and is restricted to professionals. Simply put it’s a contract between 2 counter-parties that “passes through the gains or losses incurred by the securities held on behalf of the buyer, in exchange for a fee paid to the seller”. 

So, what was happening is that these big banks were buying the stocks and holding them in their name, and passing on the gains/losses to Archegos and were getting paid a nice fee.

Additionally, these very same banks were providing leverage in the form of margin loans to Archegos to put on this trade. You can see how this was very enticing to the banks. As long as they “managed their risk” they could not lose!  

Archegos ran a very concentrated portfolio with 5 stocks making up the majority of their portfolio - Discovery, Viacom, Baidu, Tencent and a couple others. Things were going well for them as these stocks started trading up likely due to their buys, in a self fulfilling prophecy. But, when Viacom took advantage of their soaring stock price and issued $3B in new shares, the game was over. The market was not expecting this and was not able to absorb this “fresh supply”, and Bill’s positions moved against him - resulting in the dreaded MARGIN CALL.

This was no ordinary margin call though. Bill’s positions were spread across 7 big banks’ prime brokerage divisions. These were the banks that had entered into the Total Return Swaps with Archegos. It was around this time that they all realized that Bill was highly levered and would not be able to post the capital required by their margin call. They could call and call, but no money would come!

It is then that panic set in. The banks realized that they were going to be the proverbial “bag holders”, and could end up losing Billions if they did not act swiftly. They met, and tried to see if it was feasible to do an orderly sale of the securities. But when they realized the size of the positions it was every “bank” for themselves - they had all the goods, and there were no buyers to be found! 

Goldman Sachs & Morgan Stanley were the first to break rank amongst the banks and were able to sell their positions first with limited losses (about a Billion each), but Nomura & Credit Suisse got left holding the bag to the tune of several Billion! Credit Suisse may end up losing close to $7 Billion from this one relationship with Archegos; for context their equity capitalization is $26B. This is a huge hit from just 1 customer! Clearly there were issues with their risk management practices, and this blow up led to the resignation of their Head of Risk Management.

At first glance, one may think that it was Bill Hwang of Archegos who is to blame for this entire fiasco - why did he take on so much leverage, why were his positions so concentrated, did he not know what he was doing etc. However, the real culprits here are the banks who in their greed of easy “fee generation” offered excessive leverage to their client, and ultimately ended up losing their investors money. At least Bill just lost his own money.

This saga reminded me of the fantastic scene (Senior Partners Emergency Meeting) from the 2011 movie Margin Call starring Kevin Spacey, Stanley Tucci, Jeremy Irons & Demi Moore. Just replace the mortgage bonds with the holdings of Archegos and you can see a spitting image of what was likely going on inside big banks that had Archegos exposure.

The big lesson to learn from all of this is to tread very carefully with leverage and always know that the banks are not on the same side of the table as you. They play for themselves.

The world passed the 1 year anniversary of COVID-19 recently. There was little celebration for that birthday. Many say the last calendar year was a blur, maybe our brains are trying to forget it.

 

Global economies continue to mend. Industries that had a target on their back are coming back.  The green shoots of the roaring 2020s could be near with the speed of the vaccination efforts.

With Q1 now in the books, it’s a good time to look at the key asset classes and what the future may hold. View these as lenses to help look at markets.

It’s amazing to think how just one year ago investors expected a complete collapse of the global economy. Amazingly that was averted, but it did take unprecedented efforts from central banks.

In the 2020 year end review we discussed how the US Federal Reserve back stopped industries and held off the implosion. Many consider this a short term fix because it is supported by incredible amounts of money printing and stimulus - but so far it’s working!

The government has supported industries in the past. However the stimulus to pay citizens has been unprecedented!. So far 3 rounds of payments have hit bank accounts and there’s potential for more to come.

This free flowing pipe of money has triggered AND sustained an incredible US equities rally. For example, the S&P 500 has risen ~88% from the March 2020 low to April 13, 2021!

To put that near 100% return in context. Think about the rule of 72. The rule of 72 tells you how long it will take for your capital to double. Historically the S&P 500 has returned 8 - 10% a year. That means it usually takes between 7 - 9 years to double your money. Yet in the face of a global pandemic it almost happened in 1 year!

Another banner year like that simply can’t be possible, can it? No one knows the future but there are two factors that help paint a positive picture for the remainder of 2021.

The US Federal Reserve continues to tell investors they will keep interest rates low for the foreseeable future. Fed officials reiterated that with the most recent dot plot from the March 2021 FOMC release. If the dot plot is accurate, short term rates will likely be pegged near zero till 2023.

This low interest rate environment is constructive for economic growth. Which in turn can benefit corporate earnings and stock prices. Additionally, the Biden administration is focused on an infrastructure bill and potentially more stimulus payments to citizens. These can also benefit economic growth and stock prices.

This one-two punch of Fed induced liquidity and stimulus has things humming. That does not mean there are no potential risks on the horizon. Here are 3 that can derail the positive future outlook.

The global vaccine race is on. This is important for both humanitarian and economic contexts. If the rollout continues at a brisk pace there is potential for a covid stamp out later in 2021 or early 2022. However, if variant strains start to overwhelm the current vaccines, all bets are off. A new variant that blasts through current vaccines could slide the world right back into another period of shambles.

The US Federal Reserve has a mandate to maintain an average inflation rate of 2%.They only seek to raise rates if inflation starts overshooting this level. Inflation has started to kick in with the most recent March 2021 CPI data showing consumer prices rising more than expected.

This is a step in the right direction toward interest rate normalcy but far from a 2% average. IF inflation continues to build the FED may need to quickly raise interest rates before what the dot plot is showing. An unexpected raise of rates could pour cold water on the warming economy.

Read our previous post “The US Federal Reserve” to understand why the FED uses rate changes to adjust how fast or slow the economy moves.

No good market outlook is complete without touching on the potential for military sparks. Right now there are two hotspots people are watching.

The Chinese focus on bringing Taiwan back to mainland control is always a flashpoint. They recently flew military aircraft through Taiwan airspace in a show of force.

These situations are one mistake away from disaster. If bullets start flying the US will be tasked to step in. Diplomatically or militarily.

The US is a supporter of Taiwan and any step back would leave Taiwan in a no win situation. This would have economic implications as it would bring the US & China face to face again.

Russia & Ukraine are in a similar situation. Russia is desperate to bring Ukraine back to their control and initiated that process by retaking Crimea.

The tensions have recently flared up with Russia placing close to 80,000 troops near the Ukrainian border. This makes it a powder keg ready to explode at any misstep.

Bond yields remain at low levels. With the FED influencing the bond market there is not much to expect in terms of change. The following charts can be used to get an idea of when interest rates may move in the next quarter.

Longer maturing bonds (10 & 30 year) influence things like mortgage rates and corporate debt issuance. 

Shorter term bonds (1 & 2 year) influence cash management practices. i.e bank savings, CD’s and money market accounts rates.

The 10-year Treasury bond has now reversed the full COVID rush to safety trade from 2020. This puts 10-year rates back in the 1.45 - 2% balance zone. We will have eyes on that zone as movement through either side should set off the next larger move.

30-year Treasury bonds have also reversed the 2020 rush to safety trade. They are now sitting in the previous 1.93 - 2.48% balance zone before COVID ran rampant. Like the 10-year, having eyes on the zone extremes could provide the next indication of interest rate movement. 

The 2-year yield collapsed after the FED took rates near zero. They have now settled into a .10 - .20% balance zone. If / when the 2 year starts to move above .20%. We would expect to start seeing higher interest rates from banking products.

Overall there is not much for fixed income / bond investors to get excited about. The FED is still in control of interest rates so near term things should be status quo.

The crypto market remains both a place of speculation and innovation.

Q1 of 2021 saw institutional interest in Bitcoin rise along with the price. Notable companies like Square and Tesla added Bitcoin to their corporate treasury and expanded their transaction capabilities.

You can read our take on why Square and Tesla dipped their toe into this asset in our post “Why Tesla, Square and Microstrategy Bought Bitcoin(and why you probably shouldn’t).

Bitcoin price appreciation from Jan 1 2021 to April 14 2021 clocked in at ~ +120%! 

Be it speculation or adoption - this asset moves and is very volatile! And for that reason it is still too early to consider it for cash management.

Your corporate cash is for running and growing your business. Not trying to double your reserves in a year. The risk of negative price movement is too great. Remember, what goes up, can go down!

In summary, Q1 was no news is good news. Stocks marching higher makes 401k holders happy. HODL’ers in Bitcoin / crypto are REALLY happy. And as usual the bond / fixed income investors are meh.

If the green shoots of economic recovery continue to sprout. We may finally see interest rates adjust higher in the bond market. This would be warmly welcomed by investors starving for yield and safety. 

The markets are always driven by themes. And right now COVID, inflation and a tense eastern part of the world will shape Q2. We will continue to monitor these themes and are always happy to talk markets if you have questions.