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.