Record Leverage & Archegos – The House of Cards

Yesterday we spoke to the explosion of inflation in assets off the back of near free money on offer and Fed Chair Powell’s reiteration on 60 Minutes that he will let inflation run before stepping in to change that.  Arguably none more than the US sharemarket has benefitted from this debt fuelled largesse.  The official figures (as at 28 Feb) for margin debt on Wall Street have exploded to $814b, up an eye watering 49% from a year ago.  The last times such gains happened were in 2007 just before the GFC and 1999 just before the crash.

That figure, being lending to buy more shares secured by shares, you would think, should be front of mind for the head of the very central bank fuelling this wild leveraged speculation.  In that same 60 Minutes interview, when those figures were put to him, Powell incredibly responded as follows:

“That sounds like margin debt. I don’t know that statistic. I really can’t react to that statistic. I would say the main thing that we do is we make sure that the financial institutions that we regulate and supervise understand the risks that they’re running, manage them well, have lots of capital, lots of liquidity, and highly evolved risk management systems so that they do understand the risks they’re running and have plans to deal with them.”

Moving past the “I don’t know that statistic” mic drop, it is important to look at what he says next, particularly after the Archegos event.  The $20b collapse of Archegos last month was entirely due to excess leverage and hubris.  Importantly though, the same body monitoring that margin debt, Wall Street’s self-regulator, FINRA, had absolutely no idea about the scale of leverage used by Archegos through large Wall St banks such as Credit Suisse, Nomura, Goldman Sachs and JP Morgan Stanley.  Archegos used complicated ‘total return swaps’ to hide the leverage from the banks but to be fair the banks were guilty of not exactly looking either.  They are quite lucrative after all.  Insiders say Archegos is just one of many using these instruments to circumvent FINRA, the banks’ reporting obligations and rules around 50% leverage where, for example, Archegos was using 6 to 1 leverage!

Archegos was just one of around 3000 family offices around the world and combined with other hedge funds, this clever rule dodging instrument ‘business’ presents a massive amount of unreported leverage in Wall St banks.  From the Financial Times:

“The business, which has grown rapidly since the financial crisis, accounts for more than half of banks’ total equity financing revenue, Finadium calculates — more than traditional margin lending and lending out shares for shorting combined. Synthetic financing continued to take share from other forms of equity financing in the first half of this year.”

That of course changes that already massive $814b and puts it well into the trillions.  JPMorgan Chase alone was carrying $2.65 trillion in reported shares derivatives as of December 31, 2020.

What is maybe most remarkable about the Archegos collapse is that the market barely shrugged.  A $20b collapse including billions in losses in major Wall St banks and… nothing!  The similarities with the Long Term Capital Management (LTCM) collapse in 1998 is the obvious comparison.  That $4b collapse rocked financial markets around the world, seeing huge falls in sharemarkets globally, and saw a US Government instigated bailout fund of $3.65b quickly implemented to allow an orderly liquidation.  $4b compared to $20b… 

Easy money and easy ways around the rules combined with Wall St greed is a recipe for disaster.  Greed and hubris are a dangerous combination.

Yesterday we talked about the opportunities to be had with the access to cheap money to buy assets that could ironically gain from the very reasons that cheap money is on offer.  The US sharemarket in particular, but a global fallout of its failure by inclusive default, on the other hand appears to be a highly leveraged house of cards that is anything but.  The problem is, that house of cards could well keep stacking and lessons of ‘don’t fight the Fed’ post the GFC fresh in investor’s minds will see it continue.  The problem is, the higher the stack, the bigger the fallout of a ‘disorderly unwinding’ of that leverage on its inevitable fall.