Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: Archegos, Ark, Japan’s financial socialism, Boris Johnson’s bad joke, and who really pays corporate taxes. To sign up for the Capital Note, follow this link.
Archegos and the Downside of Leverage
Reading about the mess surrounding Archegos Capital Management, a family office that has sustained huge losses as a result of a poisonous mix created by leverage, margin calls, and stocks moving in the wrong direction made me reach again for Jason Zweig’s The Devil’s Financial Dictionary, a recent purchase, that, as I have noted before, will be regularly referred to in this Note.
Turning to the entry for “Leverage,” Zweig concludes as follows:
The lethal combination of leverage and hubris has been the fuel for every boom and bust in financial history.
See also MARGIN.
Daniel Tenreiro discussed what happened in yesterday’s Capital Note, but didn’t anticipate much collateral damage in the broader market, even if some banks did take hits that were, as Daniel so rightly put it, “astounding,” especially, if, as reported, Archegos had “only” $10 billion (or a bit more) in regulatory assets under management. Nomura, noted the Wall Street Journal on Monday, “said it was owed about $2 billion by a U.S. client. A person familiar with the matter said the trades in question were related to Archegos.”
According to some estimates, reported Bloomberg, Credit Suisse could be looking at losses of between $3–4 billion. Bloomberg also related that JP Morgan has estimated “that banks roiled by the Archegos Capital fallout may see total losses in the range of $5 billion to $10 billion.”
A major part of the problem was that the unwinding of Archegos’s positions in order to meet the margin call by its lenders was, in the language of such things, “disorderly.”
As Daniel noted, there had been an attempt to coordinate this process.
The biggest counterparties of Bill Hwang’s Archegos Capital Management last week discussed ways to limit the market fallout from his collapsing bets on stocks including ViacomCBS, according to four people briefed on the talks, but the effort foundered and paved the way for days of chaotic trading.
Before the troubles at the family office burst into public view at the end of the week, representatives from its trading partners Goldman Sachs, Morgan Stanley, Credit Suisse, UBS and Nomura held a meeting with Archegos to discuss an orderly wind-down of troubled trades.
The banks had each allowed Archegos to take on billions of dollars of exposure to volatile equities through swaps contracts, and Hwang was struggling to deal with margin calls triggered by a plunge in ViacomCBS shares. An orderly wind-down would minimise the market impact and the hit to their own balance sheets as they worked to sell down stakes in companies that Archegos had amassed through the derivatives instruments.
That is not how it worked out.
The Wall Street Journal (Tuesday):
Goldman Sachs Group Inc. and Morgan Stanley were quick to move large blocks of assets before other large banks that traded with Archegos Capital Management, as the scale of the hedge fund’s losses became apparent, according to people with knowledge of the transactions. The strategy helped limit the U.S. firms’ losses in last week’s epic stock liquidation, they said.
Archegos was able to build up such a highly leveraged position as a result of the combination of incentive and opportunity.
The incentive for the investment banks that were its counterparties? Commissions. According to The South China Morning Post, Goldman had been wary of dealing with Bill Hwang, the Tiger alumnus who ran Archegos:
Bill Hwang, a former hedge fund manager who’d pleaded guilty to insider trading, was deemed such a risk by Goldman Sachs that as recently as late 2018 the firm refused to do business with him.
Those misgivings did not last. Wall Street’s premier investment bank, lured by the tens of millions of dollars a year in commissions that a whale like Hwang paid to rival dealers, removed his name from its blacklist and allowed him to become a major client. Just as Morgan Stanley, Credit Suisse Group and others did, Goldman fuelled a pipeline of billions of dollars in credit for Hwang to make highly leveraged bets on stocks such as Chinese tech giant Baidu and media conglomerate Viacom CBS.
And the opportunity? Total return swaps.
Total return swaps are contracts brokered by Wall Street banks that allow a user to take on the profits and losses of a portfolio of stocks or other assets in exchange for a fee. Swaps allow investors to take huge positions while posting limited funds up front, in essence borrowing from the bank.
That’s the plus, but Deloitte listed some of the risks associated with total return swaps here.
To summarize Deloitte’s summary, investment-return risk is born by the investor paying for the right to any return that it would have received had it held the share directly. The share itself is owned by the bank or broker. The investor assumes the risk of capital losses by making guarantee payments to the bank or broker that offset any drop in that share’s value.
And:
Many hedge funds . . . take leveraged risk to generate greater returns. If a hedge fund makes multiple TRS investments in similar assets, any significant drop in the value of those assets would leave the fund in a position of making ongoing coupon payments plus capital loss payments against reduced or terminated returns from the asset(s). Since most swaps are executed on large notional amounts between $10 million and $100 million, this could put the [the bank or broker that holds the stock] at risk of a hedge fund’s default if the fund is not sufficiently capitalized.
And that is where margin calls come in.
In the course of comments contained in the Berkshire Hathaway 2002 annual report, Warren Buffett famously referred to derivatives as “financial weapons of mass destruction.” He singled out total return swaps as one of those weapons:
One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.
Total-return swaps of this type make a joke of margin requirements . . .
Yes and no. As we have seen, the banks can set margin requirements, and can call them in. The question is whether those margin requirements are themselves too lax, and whether a tightening will come from the banks themselves (as Daniel mildly puts it, they “may rethink their risk protocols around equity derivatives”) or whether regulators will insist upon it. The first, I think, is a certainty, at least while memories of this debacle weigh heavier than the prospect of commission income. The second would not come as a surprise. Elizabeth Warren, needless to say, is already on the scene. Never let a crisis, and all that.
CNBC:
Sen. Elizabeth Warren is taking aim at Archegos Capital Management and the lightly regulated hedge-fund industry after their stock trades sent the market into a frenzy late last week.
“Archegos’ meltdown had all the makings of a dangerous situation — largely unregulated hedge fund, opaque derivatives, trading in private dark pools, high leverage, and a trader who wriggled out of the SEC’s enforcement,” Warren told CNBC in a statement Tuesday.
“Regulators need to rely on more than luck to fend off risks to the financial system: we need transparency and strong oversight to ensure that the next hedge fund blowup doesn’t take the economy down with it,” she added.
No matter that Archegos was not a hedge fund. Rather, it was a family office. To oversimplify, hedge funds manage, as the phrase goes, other people’s money. A family office will manage the money of a single (very rich) individual or family.
Family offices are entities established by wealthy families to manage their money and provide related services to family members, such as tax and estate planning, as well as managing philanthropic ventures.
In a 2021 report, consultancy EY estimates that private family capital now outstrips private equity and venture capital combined, with at least 10,000 single family offices globally – family offices servicing only a single family.
Globally, family offices managed nearly $6 trillion in assets as of 2019, according to market research firm Campden Research.
Single family offices generally are not regulated. Most family offices historically did not have to register with the U.S. Securities and Exchange Commission because the 1940 Investment Advisers Act exempted firms which advised 15 or fewer clients, according to the SEC.
The 2010 Dodd-Frank Act, which was passed in the wake of the 2007-2009 financial crisis, repealed that exemption to ensure hedge funds and other private fund advisers that may have fewer than 15 clients had to register with the agency. But the act in turn crafted a definition for family offices to which it applied the exemption.
As a result, any company that provides investment advice about securities to family members and is wholly owned and exclusively controlled by family members or entities is exempted from the Advisers Act, according to the SEC.
That seems reasonable to me. A family office is looking after a family’s own money. No outside clients are involved. It is hard to see why these private institutions should have to comply with the additional regulatory requirements (mainly involving disclosure) imposed on a “proper” hedge fund, with, arguably, one exception. As Reuters notes, hedge funds “with at least $150 million in assets must also file with the SEC information on the type and size of their assets via form ‘PF.’ That more detailed data, which is kept private, is in turn shared with the Financial Stability Oversight Council to help monitor systemic risk.” Perhaps there is a case to be made that the very largest family offices (which would have to be very large indeed — managing far more than $150 million — to constitute any systemic risk) should have to file a similar form.
Another potential area where regulators might get involved (and this involves all investors, not just family offices) concerns the disclosure of “holdings” in a company via a total return swap.
The Securities and Exchange Commission has so far taken the position that investors aren’t required to disclose positions in equity derivatives like total return swaps unless they have voting power over related shares. If an investor doesn’t have voting power, they aren’t deemed to be the ultimate owner of the shares—or what U.S. law calls the “beneficial owner.” Investors who become the beneficial owner of more than 10% of a company’s shares are also deemed to be corporate insiders, and thus must report changes in their holdings through other public filings.
So, even as Archegos was estimated to have had exposure to the economics of more than 10% of multiple companies’ shares, it didn’t have to report those positions.
In 2011, the law firm Wachtell, Lipton, Rosen & Katz asked the SEC to require disclosure of any derivatives that grant an investor a “profit or share in any profit derived from any increase in the value of the subject security.”
The SEC hasn’t acted on the request, but it is close to implementing a broad set of new regulations governing security-based swaps, including the type of swaps that Archegos is said to have used. Under rules taking effect in coming months after years of delays, banks and other firms that trade large quantities of such swaps must comply with a variety of requirements, including reporting each trade to giant databases that regulators can use for surveillance. The SEC was required to implement such rules under the Dodd-Frank Act of 2010 but took nearly a decade to finish writing them.
The latter, I would assume, is more for the purposes of assessing systemic risk, and would appear sensible, but, even if would not have made any difference in Archegos’s case, I would not be surprised to see additional disclosures (again beyond certain thresholds) on Wachtel, Lipton lines being imposed on holders of total return swaps. The way such investments were referred to in a recent Bloomberg report is, perhaps, a straw in the wind:
The forced liquidation of more than $20 billion in holdings linked to Bill Hwang’s investment firm is drawing attention to the covert financial instruments he used to build large stakes in companies.
Covert financial instruments!
With a new administration on the scene — and, in particular, this administration — the timing of this debacle is not, from Wall Street’s point of view, ideal.
Senator Warren may feel otherwise.
Around the Web
Ark concentrates
Cathie Wood has spent months defending Ark Investment Management from critics who say the money manager has too much cash tied up in too few stocks. The firm’s latest move is handing them fresh ammunition.
In a filing late last week, Ark altered the prospectuses for its exchange-traded funds to remove clauses limiting its exposure and concentration risks.
The changes eliminate a 30% cap on how much of each fund’s assets could be invested in the securities of a single entity, and a 20% limit on the amount of a company’s shares an ETF could own.
It also introduced language acknowledging funds may buy into blank-check firms and noting the risks of buying shares in special-purpose acquisition companies that haven’t yet decided what businesses they’ll own. The ARK Autonomous Technology & Robotics ETF (ticker ARKQ) last week bought shares of a SPAC backed by tennis star Serena Williams.
Japan’s financial socialism
The latest Bank of Japan comprehensive policy review is significant not for what it says but what it doesn’t. The cumulative effects of the central bank’s steadfast buying of exchange-traded funds have de facto turned Japanese equity markets into an unprecedented experiment in financial socialism. Officials seem to have no idea how to restore the functioning of free markets.
Like many central banks, the BoJ has aggressively intervened in bond markets and now owns almost half of its country’s public debt. Unlike others, the BoJ also now owns about 10% of Japan’s benchmark Tokyo Stock Price Index (TOPIx) equity capitalisation. This casts a shadow over Japan’s markets. The first question investors usually ask me is, ‘When will the BoJ start to sell?’ . . .
Boris Johnson’s bad “greed” joke
CapX:
It was a weak joke, delivered to (supposed) friends, instantly regretted and best forgotten.
But Boris Johnson’s equation of capitalism with greed is a common mistake on both sides. The caricature Wall Street financier Gordon Gekko proclaims that “Greed is good!” while Marx rejects the “werewolf greed” of capitalists. Indeed, people often define capitalism in terms of greed, concluding that no social good can result from such a base motive.
The Prime Minister’s comments resurrect this idea, all too well. By applying the common anti-capitalist trope, that greed drives companies, to what has been an act of national collaboration, pride, and selflessness on behalf of many, Boris shoots the capitalist cause in the foot. It is a fatal error: suggesting that corporations are pitted against people, when in fact they exist only to serve them.
In reality, capitalism is motivated by rational self-interest, not greed. Greed is acting on one’s own interests, accumulating things regardless of one’s needs, without a care for the interests of others, and with contempt for social conventions, even laws.
Self-interest, by contrast, is a natural human characteristic, without which none of us would survive. It prompts us to act in ways that fulfil our needs; but more often than not, that rational, long-term self-interest requires us to collaborate with and help others.
Through capitalism, fortunately, we have found a way to steer self-interest into producing a positive and productive society, rather than a chaos of self-serving individualists. In commerce, the only way to prosper is to provide others with what they want. Far from disregarding the interests of others, capitalism makes us keen to understand the needs of others and to serve them . . .
Random Walk
Who really pays for corporate tax?
Some German data via the LSE:
Our estimates imply that, on average, 51 per cent of the corporate tax burden is passed onto workers. This average effect is similar to other studies analysing the corporate tax incidence on wages . . .
We show that higher taxes reduce wages most for the low-skilled, for women, and for young workers. These results qualify the widespread view that the corporate income tax is highly progressive . . .
Somehow, I suspect that consumers may chip in a bit too.
— A.S.
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