A couple of weeks ago, we reported on various examples of stock market mania that have exploded in 2021.
Now it’s time to examine a major event that could be a clear harbinger for “the big one” to come. It starts with a name you never heard of before March, a modest hedge fund operating as a "family office" named Archegos Capital, and it ends with some of the world's biggest brokers engaged in a mutually destructive fire sale that wiped out $35 billion in market value.
Let's take a closer look at what Slate's Alex Kirshner calls The Dumbest Financial Story of 2021 (so far).
Leverage: Fantastic on the Way Up, Hideous on the Way Down
Bill Hwang, convicted inside trader, founded Archegos as a "family office." Kirshner explains this legal nicety "functions like a hedge fund but manages the assets of just one or a few wealthy families. In theory, a family office gives a problem trader less opportunity to harm others, because they are not playing with outsiders’ money."
At Forbes, Antoine Gara explains why this matters: "a family office exempts it from the Securities and Exchange Commission’s reporting requirements for investment firms."
Hwang's new firm approached big banks including Goldman Sachs, Morgan Stanley, Japan's Nomura and Switzerland's Credit Suisse. These firms extended leverage, or margin loans, to Archegos, which invested heavily on swap trades:
Swaps are an effective tool to take big risks without disclosing much. Total return swaps, for instance, allow an investor to negotiate a trade with their broker to own the total return of a stock, or basket of stocks, for a predetermined size and period of time, and at an agreed cost. They require a fraction of the cash of buying a stock outright, and they’re discreet. [emphasis added]
Although Archegos owned tens of billions of dollars in exposure to U.S. stocks, its huge portfolio was basically invisible to regulators (and to other banks and brokers). Archegos was never the actual owner of record for any of these swaps.
Leverage is "fantastic on the way up" because success begets success. Brokers typically lend more as portfolio assets rise. So when you're winning, you get handed more money to gamble.
Bloomberg reports the world watching in astonishment as one of Archegos's favorite stocks, ViacomCBS, shot up about 300% in weeks. Meanwhile, banks around the world kept extending loans based on Archegos's skyrocketing portfolio value. Archegos built positions in at least 9 stocks sufficient to rank among the largest holders, all powered by leverage estimated at 10x ($1 in collateral, $10 in loans) compared to a mere 7x-8x leverage associated with the largest hedge funds.
This feedback loop could've lasted forever, so long as the Archegos portfolio kept going up. But it didn't.
ViacomCBS announced an additional issue of $3 billion in new stock. Market analysts, who couldn't figure out why the stock was going up in the first place, poo-pooed the offering, which spooked investors, which led to a sell-off.
According to The Street, a margin call occurs when:
an investment incurs enough losses that the investor's margin account goes below a certain amount, known as the maintenance margin. When a margin call happens, the brokerage will demand to add funds or securities to the margin account to get back over the maintenance margin.
In the case of Archegos, the banks' margin calls created a problem. When the banks needed to start selling Archegos assets, they realized there actually weren't any. The banks themselves owned the stocks. All Archegos had was the (increasingly worthless) ViacomCBS swaps. So the banks were forced to sell the stocks and eat the losses as they sold off positions related to Archegos.
It was bad. Specifically: “World banks may lose over $6 billion from the downfall of the U.S. investment firm Archegos Capital, sources told Reuters.” And that’s just the banks' losses.
Even Goldman Sachs and Morgan Stanley are liquidating a staggering $19 billion in assets, mainly consisting of media companies:
Goldman Sachs explained the sales with “forced deleveraging,” and Financial Times reported “the move could indicate that a big hedge fund or family office faced some serious problems.”
CNBC revealed signs of panic from Wall Street: “The Securities and Exchange Commission has been closely watching the impact from Archegos’ margin call default. ‘We have been monitoring the situation and communicating with market participants since last week,’ an SEC spokesperson said Monday.”
Wall Street Loses Big on Its Unprecedented Gamble
It's all fun and games until someone gets hurt. Enjoy the Schadenfreude for a moment before you remember this little dumpster fire could have already cost average investors big, according to Slate's Kirshner:
Anyone who owns any of those stocks – and a lot of these are common, big-name stocks that could be held by anyone – took a bath because of the Archegos margin call. Countless people might have felt the effect of the ripple.
Kirshner goes on to highlight the unethical nature of these banks before the margin calls: “thousands of people, as well as several companies, took on huge losses not because they did anything wrong, but because a handful of huge banks decided to bet on one shady securities trader with a demonstrable history of being a crook.”
And that's the story of how a humble family office built a $100 billion position through leverage, and cost its brokers at least $6 billion all outside the SEC's notice.
And that raises an even bigger, and perhaps more important question...
How many more firms like this are operating in the shadows? What happens when the record explosion of margin trading comes to a head, and the bill comes due for more than just a few huge banks?
Be Prepared Whether Markets Crash or Soar
Like we wrote a couple weeks ago, margin calls are bad news:
Forced selling to meet margin calls puts downward pressure on an already-declining market. As prices fall, more speculators try to dump their stocks, which increases supply at the same time other gamblers are trying to raise cash.
We've just seen that happen, right now. And based on the astronomical levels of margin debt, we're set up for a much bigger collapse. The next phase involves rapidly dropping prices and portfolio values tanking. Margin calls trigger forced selling, which triggers margin calls, and the vicious cycle repeats.
So you need to be well-positioned to thrive even when the house of cards collapses around you. Consider adding hard assets to your portfolio like physical gold and silver. They both have a history of acting as a “safe haven” during market turmoil, and if the “big margin call” does hit, you will be on your way to a more secure financial future.
Peter Reagan is a financial market strategist at Birch Gold Group. As the Precious Metal IRA Specialists, Birch Gold helps Americans protect their retirement savings with physical gold and silver. Discover more by clicking here now.
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