On the highway, the most dangerous time is when everything is calm and the outlook is great, because that’s when you put on the cruise control, turn up the music, and miss the recreational vehicle coming out of it. ‘rest area.
It’s the same in the markets. Booming stocks and fabulous yields allayed the concerns of risk departments, leaving some banks nursing multibillion dollar losses when Archegos Capital Management’s concentrated bets went from 90 mph to an emergency stop.
The question for the rest of us is whether Archegos is just an accident on a lonely road or a waiting pile-up. I think this is probably a unique case, but the issues that plagued Archegos could force others to brake too. There are four dangerous elements:
* Leverage. As always, too much debt is at the heart of any explosion. Leverage turns millionaires into billionaires and billionaires into poor. And there’s a lot of debt around: Credit to the U.S. private sector topped 160 percent of GDP for the first time since its brief surpassing around the global financial crisis in 2008, according to the Bank for International Settlements.
The more debt there is, the less hardship borrowers can take before getting into trouble. The good news for the economy is that household borrowing hasn’t increased much, as government aid and lack of spending opportunities have boosted savings.
The bad news is that corporate debt hit a new high of 84% of GDP last summer, limiting companies’ ability to withstand any further economic shock or their ability to refinance.
These figures do not include hedge funds, however. Hedge fund borrowing hit a new high in January, according to Goldman Sachs, which foreshadowed a brief period of poor performance for funds as they were hit by short pressures such as
and reduce leverage.
I am quite optimistic about the prospects for deleveraging, which is hurting investors more broadly. Part of this is because the markets have moved broadly even though hedge funds have reduced debt this year. Since the January high, gross leverage – which combines bets on both rising and falling prices – among Goldman brokerage clients has fallen 260% to 242%, while the S&P 500 has reached new heights.
But we have to accept that when a few companies that a few have heard of turn out to have taken insane risks made possible by banks that have not probed deep enough, the road ahead could be more chasm.
* High prices. You might think that stock prices are high – and they are high! – is a good thing. But lenders relax their guard in good times and tighten up in bad times, so falls from these highs have the added pain of less lending.
Fund explosions become a problem for the markets, either when there are a lot of them at the same time, as in 2008, or if they are so large that they threaten to bring down the banks, as with Long-Term Capital Management in 1998. The only way to achieve this a lot at once is when many hedge funds (and similar vehicles such as Archegos) focus on the same strategies and are pulled out by the same unexpected market moves.
We have to hope that the banks weren’t stupid enough to allow many others to borrow so much for such concentrated transactions as Archegos, who appears to have avoided risk management for betting on a handful of Chinese stocks. and American media groups.
Isolated background blasts are exciting, but they are a spectator sport for the rest of us. The risk at the moment is that hedge funds will be united in their bets in two areas: inflation and speculative technology stocks.
* Crowded positions. There is strong unanimity among the markets on reflation trading, which involves betting on rising Treasury yields and stocks that benefit from a booming economy, and against safe stocks that have gained in the background. from the economic weakness of last year. If something goes wrong, many people will be caught off guard. Some will surely, in the words of Warren Buffett, swim naked, with way too much debt on what seemed like a safe bet.
Speculative technology stocks are less dangerous simply because they have been so volatile that it is difficult to take large loans against them. But hedge funds have been the winners in technology bets, initially the big names in safer technology such as
and more recently, riskier games like PSPC.
As T-bill yields rise and the economy proves more options for growth, many of those stocks have pulled back and PSPCs have had a horrible time. The Goldman index of the 50 most popular stocks with hedge funds fell more than 5% from its peak last month, even as the S&P 500 rose 1%. If tech speculative stocks continue to fall, any hedge funds that weren’t nimble enough to have already exited will lose.
* Derivatives. One of the reasons banks were surprised by Archegos was that it used total return swaps to gain exposure to stocks such as Viacom, rather than using a loan to buy the stocks directly. Because the US disclosure regime is severely broken, Archegos did not have to go public with its large swap positions, so each bank was unaware of the debt of the others.
I have little sympathy for the bankers who try to blame the regulators here. Banks could still require disclosure before lending, and the scale of a single customer’s losses is an indictment of their risk management. But the Securities and Exchange Commission should follow the UK’s lead and update its rules to treat equity derivatives exposure the same as direct equity ownership. There is no point in setting up a disclosure regime that can be so easily played.
Market declines will always and everywhere be accelerated by leverage, and investors always like to take on more debt when markets are high and have risen than when they have fallen and are low. I think Archegos looks like an isolated crash, akin to the collapse of the natural gas hedge fund Amaranth Advisors in 2006.
But in an age when money is virtually free and nothing is more fashionable than savage speculation, investors need to keep their eyes on the road and be prepared to sidestep the wreckage.
Write to James Mackintosh at [email protected]
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