Archegos vs. Long Term Capital Management (LTCM)

When I was thinking about leaving my job as a conventional global equities portfolio manager, I briefly considered setting up a hedge fund. I changed my mind pretty quickly, however, when I spoke with the investment bank I was considering to be my prime broker. The conversation was an eye-opener. It was clear from the outset that the broker had no interest in me or the product I would create. Its support in raising assets would be completely a function of the amount of financial leverage I would be willing to take on–the higher the better.

This mindset, more than anything else, explains for me the demise of Archegos, the hedge fund that collapsed last week. If press reports are accurate, the founder, Bill Hwang, had assets of about $10 billion (initially, at least) in his hedge fund. He had assembled a group of primer brokers, all large global banks, none of whom seemingly knew about any of the others. Hwang apparently called them together last week, after he was unable to meet calls for more collateral, to work out an orderly liquidation of Archegos’s holdings. The banks learned not only that their Hwang relationship wasn’t exclusive, but, more worrying, that they had collectively lent him somewhere between $50 billion and $100 billion to buy stocks like ViacomCBS and Discovery.

It sounds like the lenders fell into two camps. US-based firms wanted to liquidate immediately and non-US firms, in their vintage fashion, wanted the group to bury the losses in some dusty corner of their balance sheets and hope for the best. As soon as the meeting broke up, the Americans appear to have begun to line up buyers for the Hwang holdings, with the idea of cutting their losses as quickly as possible.

Perhaps the two most notable aspects of this situation are: that Hwang was able to borrow so much, despite a 2011 conviction for insider trading; and that foreign banks were so slow to act once they learned how fragile the Hwang situation was, allowing competitors to exit their positions first (meaning, at higher prices).

What ties Archegos and LTCM together is an enormous amount of leverage. Otherwise, they couldn’t have been more different. LTCM was founded by John Meriwether, former head of bond trading at Salomon Brothers, the powerful bond house in 1994. LTCM also had on its board two famous finance professors as front men. Its main trading strategy was a relatively pedestrian arbitrage in the Treasury bond market, which others on Wall Street at the time made fun of as something any commercial bank did in the normal course of business. LTCMs twist was to do this on a very large scale, to use sophisticated mathematical models and to apply large amounts of financial leverage.

A simple version of the strategy: A quirk of the Treasury bond market is that the issues that are components of bond derivatives (these bonds are “on the run”) tend to be highly liquid and to trade at somewhat higher prices than virtually identical issues that are not components (“off the run”) but can be highly illiquid. As they near maturity, the prices of on the run and off the run converge, since the Treasury will redeem both for $1000. What LTCM did was capture this price spread: short on-the- run issues, use the money to buy similar off-the-run issues and wait for price convergence.

Unfortunately for LTCM and its backers, after three years of success, the world economic situation changed. First came the 1997-98 Asian financial crisis, followed by the 1998 collapse of the Russian ruble and that country’s default on its foreign debt. This generated an enormous flight to safety by global investors, which pushed up the prices of on-the-run bonds. Off-the-run bonds didn’t follow because they were too difficult to buy.

The LTCM operation was large enough that a forced liquidation in a fearful time would have the potential to destabilize even the US government bond market. This worry compelled the Federal Reserve to orchestrate a rescue by a consortium of 14 banks that had been prime brokers to LTCM.

The similarities between the two cases are that both involved large amounts of money, a lot of financial leverage and ultimate failure. The differences, however, are a lot more important, I think. In the Hwang case, one individual with a sketchy past persuaded a number of banks to lend him a surprisingly large amount of money. When his firm failed, he did damage to his lenders, but it looks as if his holdings were unwound in a matter of weeks.

In the LTCM case, in contrast, the firm was chock full of bond market stars. The strategy was clear and the prime brokers appear to have known about each other, if not about the amounts lent. LTCM’s failure, however, was a much more serious affair. It threatened the stability of the US government bond market. Unwinding took the better part of two years.

the Basics

I’ve had several requests recently to talk about investing basics. I thought I could refer to past posts, but I don’t appear to have put down in one or two places how I think the markets work and what possible investments are available to you and me. Hence, this series of posts.

stocks, bonds, cash …and you and your family

have a financial plan for your household

Most Americans invest for two reasons: to send their children to college and to fund their own retirements. A friend who’s a teacher in the Netherlands points out that outside the US neither may be the burning issue it is here, since a lot of that is taken care of either by the national government or by your job. Still, I’d imagine we all think of investing as a way to have a better future lifestyle.

Individual circumstances for each of us will determine a lot about how we approach investing. Part of this is when you’ll need access to the money we’re investing. Part is risk preferences (how willing or able we are to suffer a loss). Part is the security of your job and other assets/ liabilities you may have (like house/mortgage).

The outlines of a financial plan, however simple, will probably identify the kinds of risk you might consider taking and what, in contrast, might be out of bounds.

three classes of liquid investment

The three are: cash, bonds and stocks (equities).

–cash. a bank account, a money market fund, a very short-term Treasury bill or CD. You lend your money in return for its safe storage + at least partial protection from the reduction in purchasing power that inflation causes. Often, you can direct your cash to a third party. But what really distinguishes cash from other liquid investments is that it is returnable to the owner on demand.

–bonds. lots of different maturities and levels of creditworthiness, from government bonds to corporate to low credit-grade “junk” or tax-advantaged municipal. In each case, though, there’s a bond agreement that specifies what interest payments will be paid to the holder, and when, plus the length of time after which the lender must return the principal. One key difference between In today’s world, the benchmark bond is the 10-year US Treasury note. That’s in part because there are a lot of them and some issues (called “on the run”) figure in bond derivatives, in part because the 10-year is the long bond standard in the rest of the world. (Note: so-called “perpetual” bonds do exist, meaning the loan never terminates and you (some exceptions) never get your principal back. But there are few of them, so let’s ignore them.)

Bond analysis centers around the value in to day’s money of its stream of future payments, the degree of certainty that the borrower will make those payments, the alternatives available and one’s ability to buy and sell.

Long-term studies I’ve seen years ago suggest that a 10-year government bond should yield inflation +3 percentage points per year. Over the past decade, however, the 10-year US Treasury has yielded inflation +~0.5% annually.

–stocks. In contrast to bonds, which are loans to a (hopefully) trustworthy party which entitle the lender to interest payments and return of principal at a specified time, stocks give the holder an ownership interest in an ongoing enterprise.

Because of this, analysis of stocks, i.e., the question of what an ownership interest is worth, is not as straightforward as with bonds. Two schools have emerged in the US as the main approaches to dealing with this question. This doesn’t mean these are the only approaches–in fact, my experience is that markets abroad can operate on very different principles. But I find them good explanations for the way Wall Street behaves.

The older of the two schools is value investing. It originated during the Great Depression of the 1930s, a time when many companies were trading below the value of their net working capital and sometimes below their net cash. “Net” here means left over after paying all company liabilities. “Working capital” means cash + inventories + short-term trade receivables (normally paid within, say, 90 days).

Benjamin Graham, the father of the movement, said, in effect, these companies are like $100 bills lying in the street. Why bother with anything else?

As the world recovered after WWII, and all these bargains disappeared, the value school evolved into a search for asset-rich companies whose profits, and stock prices, are temporarily depressed for business cycle reasons or because of poor management (on the uniquely US idea that the responsible individuals could and would be replaced). Another line of attack is to locate conglomerates whose parts, if separated, would sell for (much) more than the group all clumped together.

The second school is growth investing. It’s goal is to find companies where the current stock price implies a lower growth rate in revenues and profits, and/or a shorter period of superior growth, than the firms will end up achieving.

The same studies that suggest the “right” annual return over long periods of time on government bonds is inflation +3 percentage points opine that the similar figure for equities should be a return of inflation + 6 percentage points. I’m not sure either figure is really that relevant in the present market situation, but at least it’s a point of reference to start a discussion from. And I think at least the conclusion that the return on stocks should be higher than that on government bonds–to compensate for the greater risk of the former–is spot-on.

For what it’s worth, I started out as a value investor and I worked for about half my career in value-oriented organizations. My view changed in the mid-1980s, when I started to manage money in Pacific Basin markets. I was immediately attracted to mid-cap industrials in Hong Kong that were trading at single digit price-earnings multiples, despite having enormous growth potential stemming from their roots in the mainland. After a few years of this, I realized I’d shifted from focusing on the multiples to the potential for explosive growth–I’d become a growth stock investor!

today’s discounting mechanism

Discounting is the word stock market professionals use to describe the market process of factoring into current stock prices its anticipation of how the future will unfold, both for the market as a whole as well as for industries and individual stocks.

There’s a fear/greed aspect to this, just like everything else on Wall Street, or maybe every human activity. In a bear market, investors’ willingness to look ahead–even a month or two–diminishes severely. In contrast, at the height of a bull market investors may be factoring in expectations more than two years out. My experience has been that whenever the market is justifying today’s prices by citing events to happen more than two years hence, it’s a sign of speculative excess.

In the middle of the business cycle, the stock market typically looks about a year ahead. In June or July, Wall Street starts to seriously consider what the following calendar year will look like.

Viewing the bond market as an outsider, it seems to me that bonds, unlike stocks, are typically strongly anchored in the here and now, responding to events as they occur, but not much, if any, time before.

How is it possible for stocks to see into the future, as it were? An army of securities analysts. When I entered the business, both brokerage houses (the sell side) and institutional investors (the buy side) had large staffs of analysts constantly speaking with companies about the tone of their revenues and about business conditions in general. Firms were very willing to share their thoughts with their investment bankers and with long-standing large holders of their stocks.

Starting maybe 25 years ago, the buy side began to realize that many times its staff of analysts did little original research, but relied very heavily instead on reports they received from sell-side analysts (paid for by directing trading commissions) which they summarized for portfolio managers. Around the same time, the internet allowed reports to be sent through email (saving brokers something like $125,000/year per recipient in printing and deliver costs, so the number of copies of research was no longer an issue). The result was that many buy side firms signed their PMs up for brokers’ research emails and fired their analysts–creating huge cost savings, at least in the short term.

In the depths of the financial crisis of 2008-09, the big banks fired most of their veteran $2 million/year analysts, however, saving a bundle by replacing them with trainees.

As the skilled professionals who survived the two purges began to retire, it seems to me that the collective ability of Wall Street to predict the economy’s path and individual companies’ fortunes has eroded to some degree. If so, that’s good for you and me, who don’t have privileged access to this information and are able/willing to do our own research work.

In other disciplines, the academic world would also be an important information repository. Finance professors, however, are by and large lost in their imaginary world of efficient markets.

A relatively new substitute for human researchers has been computer-driven trading. One form of this is super-fast reading of corporate and industry news and equally quick buying and selling in response. Another direction is based heavily on academic conceptions of how the market works. A third, nor really prescriptive, looks for valuation deviations among stocks, bonds and their associated derivatives. There are surely more that I’m unaware of.

The result of these changes has been, I think, a substantial shift in the stock market discounting mechanism. As I see it, there’s an increased emphasis on the here and now–on the minutia of highly predictable things that may happen next week or next month, as well as re-discounting things that have already happened yesterday. There’s also a decreased focus, I think, on trying to imagine what the world, and company prospects, will be six or twelve months in the future.

Two implications, if I’m right:

–greater day to day price volatility in stocks than was the case, say, ten years ago. In academic-speak, this means stocks are riskier than they’ve been in the past. I think this conclusion is as crazy as anything else that comes from finance professors. Yes, the day-to-day water may be choppier, but I also think the chances of someone with a longer-term horizon buying at a more favorable price as the surf churns increase as well. More important,

–if fewer market participants are trying to puzzle out fundamental trends that will shape the world six months or a year ahead, which is what I think any sensible investor should be doing, then the rewards for being correct stand to be that much larger as the AI-driven market apparatus catches up with us.

thinking about Special Purpose Acquisition Companies (SPACs)

Over my years working on Wall Street, it was invariably a sign of ultra-frothy markets when equity offerings called “blind pools” or “blank check companies” began to pop up. The pitch was typically: so-and-so is a great investor; give him (Wall Street has been one of the most anti-woman places in the US) and he’ll do magic (but unspecified) things that will make us all rich.

These were part of the underbelly of the market, a cut above Wolf of Wall Street brokers and their “pump and dump” schemes, but not by a whole lot. I can’t recall one that worked out well.

In today’s world, the functional equivalent is the SPAC. Lots of law firms have online articles outlining the nuts and bolts of how SPACs work. My version is below. There’s also a good, and often referenced paper from the Social Science Research Network laying out the plusses and minuses.

The conceptual justification often given for the existence of SPACs is that they’re an innovative way to lower the cost for a company of going public, accomplished by disintermediating the expensive traditional broker IPO process. The SSRN paper argues, persuasively, in my view, that the cost savings claim is factually incorrect.

SPACs are faster to get SEC approval for listing than traditional IPOs, since at that point they’re shells rather than operating companies. As/when the SPAC finds a company to buy, the transaction is technically a merger, rather than an IPO of the target, so SEC involvement is minimal.

One clear characteristic of recent SPACs is that they involve mostly early stage companies, the kind that in the past would have marinated for several more years in the venture capital world before being considered close enough to profitability or business maturity to appeal to the public market.

For me, the backdrop for today’s SPAC world resembles the bubbly market of 1999. At that time, the IPO calendar was filled with early-stage companies. These were hyped by Wall Street star analysts like Henry Blodget and Mary Meeker, and aggressively bid for by institutional investors based on their reports. At the time, I had thought (one of my dumber ideas, as it turned out) that I might be witnessing an evolution of the public markets that would replace private venture capitalists much earlier in companies’ development (the implications I saw were that PEs wouldn’t count for as much and original research would count for more). Back then, it wasn’t the market evolving, however. It was mostly hype in a frothy market. In fact, Blodget was ultimately barred from the securities business for his role in stoking the speculative fires with ultra-favorable recommendations that his private emails showed he didn’t believe.

how SPACs work

Hang onto your hat! This is a really convoluted process.

the pitch

The starting pitch is the same as with traditional blind pools: the sponsors, a luminary of some sort, together with a financial backer like a hedge fund, create the SPAC to raise funds in the public market and then find an operating company to buy and merge with.

step one: sponsors take a big cut

At startup, the sponsors get to buy 20% of the SPAC for a nominal sum.

step two: conventional IPO

The sponsors take the SPAC, which at this point is basically a shell, public through a conventional IPO. Units, which consist of one share plus a warrant, typically sell for $10 each. Each warrant gives the holder the right to buy some fraction (this varies) of a share of stock for $11.50. Sometimes, the sponsors also toss in a right–like a warrant only no payment required–for a fraction of a share.

In addition to the warrants/rights, IPO shares have another important perk. Holders are able to redeem their shares and get their $10 back (keeping their warrants and rights) at any time before a merger is completed. In SPACs that have been launched so far, most initial holders either redeem or sell their shares in the open market, meaning that there’s a big difference between the shareholder base pre-merger and post-merger.

step three: two years to look

The SPAC is required to find a partner to merge with within two years. If it doesn’t, the SPAC is dissolved and any remaining money returned to shareholders. The sponsors get nothing–implying that sponsors have an enormous incentive to complete a deal.

step four: more financing, using PIPE investors

PIPE stands for private investments in public equity. Because IPO investors can redeem their shares, and many do, the typical SPAC ends up having only about 2/3 of its initial funds on hand when it finds a merger partner. So it ends up doing private placements to institutional investors to get the money needed to complete the deal. PIPE investors buy new shares, but don’t get warrants or the ability to redeem. They do get to know the identity of the merger partner and see its financials. Since the combination is technically a merger and the private placement transaction is not an IPO, the SEC has no problem with this.

recent history

SPACs made up about half of the US IPO market in 2020. So far in 2021, SPACs are a lot bigger chunk of the IPO scene than that. 90%?

One consequence of the popularity of SPACs is that there are a lot of them looking for merger partners, maybe $100 billion in their collective pockets upon debut, even without PIPE money. As a rough rule of thumb, sponsors can earn, say, 15x their money from making aa top-quartile acquisition and 3x from a bottom quartile one. So sponsors have a strong incentive to close any deal within the two-year window rather than walk away with nothing.

Buy and hold investors in SPACs, in contrast, have tended to make some money, although generally less than they would from holding a growth-oriented index funds. A mad rush to buy at any price wouldn’t do you or me much good at all.

Because of the potential imbalance between the number of sponsors with money burning a hole in their pockets, the relative lack of potential targets and the dire consequences for sponsors for coming up empty. I’d much prefer to be holding potential merger targets. However, these tend to be early stage companies still in private hands, so that option isn’t open.

canaries in the coal mine?

Yes is my short answer. The SPAC market really does have the feel of the IPO market of 1999.

implications for us

What the implications are for us as investors today, if that’s right, are less clear to me.

2000 opened to Y2K as a non-event, a collapse in orders for internet and cellphone equipment (followed by a more general downturn)–and a massive rotation into very defensive stocks, particularly utilities, consumer staples and housing-related, all of which had been serious laggards over the prior several years. (An aside: many now-famous hedge fund managers were value investors fired during the epic value drought of the late 1990s. 2000-2002, in contrast, was perhaps value’s last hurrah. To my mind, sticking with this vintage-1935 investing school explains a good deal about hedge funds’ poor record since then.)

Of course, if Wall Street form holds true, the least likely thing to happen in 2021 is a repeat of 2000.

For what it’s worth, I think reopening stocks will continue to be good performers, especially non-mall specialty retail and restaurants. My guess is that this area will continue to be top of mind for investors for a while, as well as the main focus of the market rotation toward business cycle sensitives that’s now underway. On the other hand, I expect stocks whose main attraction is their appeal to quarantined consumers will continue to fizzle. Here, I’d try to make a distinction between pure (pure=bad, in the way I’m looking at things) covid stocks and those where the pandemic has given a company an introduction to consumers who will continue to pay for products/services even when things get back to normal. I have no particular insight into winners vs. losers in this arena.

In any event, I think two big differences between now and 2000 are that; we likely have cyclical recovery ahead of us rather than recession; and the 10-year Treasury is yielding about 1.75% now vs. 6.3% this time 21 years ago. In the most simplistic terms, a yield of 1.75% supports a PE of 57 and 6.3% supports a PE of 16. I conclude from the current level of yield support that, absent a steady rise in interest rates (which I think is unlikely), chances of a 2000-style market meltdown aren’t high. If I had to prioritize, rising rates, as always, are the #1 threat to the overall market.

something I have less confidence in, but still…

Just a minute ago (Sunday night), I looked at a chart of the Russell 2000 vs AARK, the Ark Innovation ETF, that latter as a proxy for the capital flight market of the Trump years and the pandemic defense of 2000. Since the November election, the R200 has been on fire, gaining 45%+ through last Friday. Until a month or so ago, AARK was more than keeping pace. Then the yield on long Treasuries began to rise. Since then, AARK has dropped by 22%, while the R2000 is flat. That’s significant. But it’s not the whole story, in my view. Over the past 12 months–from the depths of the market’s pandemic swoon, the R2000 is up by 110% but the AARK has risen by 220%. I find it hard to work up conviction for the idea that a 20% relative decline makes up for the previous 120% relative gain. To me the numbers say that R2000 is going to outpace AARK for some time to come. (In addition, from what little I’ve read about the ARK funds, they don’t believe in playing defense to try to mitigate short-term declines.) To be clear, I’m not advocating trying to time short-term shifts in markets. That’s a recipe for disaster. But for me it would make a lot more sense to try to upgrade the secular growth portion of my holdings rather than to increase their overall weighting in my portfolio.

Since I’m writing about SPACs in a negative light, I think I should note that I own a small position in DraftKings–a case of consistency and hobgoblins.

the last two hours yesterday

I’m working on a post about SPACs that I thought would be done today …but isn’t. Definitely Monday, though.

This is just to say I think the sharp drop in stocks, particularly NASDAQ, during the last two hours of NY trading yesterday, and the ugly half-hour after the opening today, are significant from a market psychology point of view.

What typically happens in a selloff is that we all hang tough to start with. But downturns are mostly uglier than an optimist like me ever imagines. When I was working, I knew we were getting close to the bottom (at least temporarily) when I would see my hand inch involuntarily toward the phone so I could scream “Sell!” into it.

We’re not near that psychological point at all for me, although these days I no longer bear the burden of the trust of others in my skills to enable them to send their kids to college or retire in comfort (the two biggest reasons for Americans to invest).

Still, the afternoon fall seemed to come out of nowhere. It was also very sharp–which I interpret as market makers seeing a wave of selling coming toward them and tried to blunt its force by swinging their bids down as fast as they could.

Was this a selling climax–meaning investors succumbing to fear and selling everything not nailed down? I don’t think so. Yesterday’s fall was too small and volume wasn’t high enough (less than a quarter of this time last year). It was a tremor, not a March 2020-vintage earthquake. It was a notable event, though.

Two reasons:

–it’s the first real fear I’ve noticed in a long while. That’s good, because it implies that the market is becoming less Panglossian than it has been, and

–it’s a signal to look through our portfolios to see what did worst yesterday, and what has recovered today or not recovered today. So it’s food for thought about each of our holdings and its role in the portfolio.