Doug Noland: When Ponzi Finance Goes Boom

Archegos and Ponzi Finance

by Doug Noland

I’ve been a longtime enthusiast for Hyman Minky’s analysis. His work plays prominently in my analytical framework. Financial structures evolve over time, and there is an innate propensity for this evolution to regress into a cycle of ever-increasing excess, fragility and instability. Success in finance – by borrowers, lenders, speculators, investment bankers, investors, businesses, central bankers and the like – ensures only more exuberant risk embracement over the course of the cycle. Importantly, debt structures degenerate over time, as the boom is perpetuated by expanding quantities of debt of deteriorating quality.

Minsky’s “financial instability hypothesis” models three categories of debt structures: Sound “hedge finance” – where “cash flows are expected to exceed the cash flow commitments on liabilities for every period.” Less sound “speculative finance” – where cash flows, although inadequate to fully service debt in the short-run, are generally sufficient over the longer-term. And unsound “Ponzi finance” – “cash flows from assets in the near-term fall short of cash payment commitments” and only with some future “bonanza” will cash flows ever be sufficient to service debts and provide any realistic hope of generating profits.

Importantly, “a ‘Ponzi’ finance unit must expand its debt load to meet its financial obligations.” New money and credit in abundance are a necessity for perpetuating the scheme. The greater the ratio of speculative and Ponzi finance, the greater the fragility of the financial sector to rising interest rates and/or other shocks. Ponzi financed assets, in particular, are highly sensitive to both changing perceptions and higher interest rates. Traditionally, higher rates are problematic as debt service costs rise at the same time the present value of future cash flows drops. Quoting Minsky, “The rise in long term interest rates and the decline in expected profits play particular havoc with Ponzi units, for the present value of the hoped for future bonanza falls sharply.”

Minsky: “It can be shown that if hedge financing dominates, then the economy may well be an equilibrium seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation amplifying system… Over a protracted period of good times, capitalist economies tend to move from a financial structure dominated by hedge finance units to a structure in which there is large weight to units engaged in speculative and Ponzi finance.”

Minsky witnessed a lot, but he surely never imagined an environment of zero rates and endless Trillions of Fed monetization, and how such a backdrop – the perpetual “bonanza” – would extend the “deviation amplifying” Ponzi phase. The Archegos fiasco had me this week sharpening my focus on Minskian analysis. The facts are not altogether clear. But from numerous reports it appears Archegos had fund equity of around $10 billion. Positions have been estimated in the range of $50 billion to $100 billion, meaning a leverage ratio between 5 and 10 to one.

After an insider-trading settlement back in 2012, the hedge fund was converted to a so-called “family office” that enjoys much less onerous reporting requirements. Archegos maintained highly concentrated positions, with upwards of a $10 billion (equal to fund equity!) position in Viacom. And with a second huge position in Discovery, Archegos was willing to accept the risk of having media exposure significantly in excess of fund equity. Furthermore, Archegos held substantial exposures to volatile Chinese Internet stocks (including Baidu and Tencent).

Bill Hwang, the founder of Archegos, has operated in the markets since the nineties. Hwang was a protégé of hedge-fund legend Julian Robertson at Tiger Asset Management, before founding Tiger Asia Management (a so-called “Tiger Cub”) in 2001. In Hwang’s long and distinguished career, he has been in the catbird’s seat for extraordinary market cycles – including spectacular booms along with devastating bursting Bubbles.

Why would Archegos employ such a risky strategy – basically reckless leveraging of volatile equities exposure? We can only assume the firm was emboldened by the hyper-loose policy and liquidity backdrop. And why would the dominant global securities firms (including Nomura, Credit Suisse, Goldman Sachs, Deutsche Bank, Morgan Stanley and Wells Fargo) so readily provide the financing for such a daring scheme? It does support the view that repeated Federal Reserve market bailouts, along with unfathomable liquidity injections, have numbed the entire marketplace to risk.

It has been my thesis that we’re in the throes of a “blow-off” period of unprecedented speculative leveraging. And Archegos provides yet another anecdote that the expansive global derivatives marketplace is at the epicenter of leverage and speculative excess. Archegos could employ such egregious leverage through “over-the-counter” derivatives positions with various securities firms – in what are called “basis” or “total return” swaps.

These types of derivatives are big business for Wall Street. From the FT (Robert Armstrong): “Global banks earned an estimated $11bn in revenue in 2019 from synthetic equity financing including total return swaps, double the level of 2012… The business, which has grown rapidly since the financial crisis, accounts for more than half of banks’ total equity financing revenue… — 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.”

Pulling from my Q4 Z.1 analysis from a few weeks back: “Broker/Dealer Loans expanded a record $100 billion, or 84% annualized, during Q4 to a record $574 billion. For 2020, Broker/Dealer Loans surged a record $164 billion, or 40%. This compares to previous cycle peak growth of $79 billion in 2006 and $75 billion in Bubble year 1999. Total Broker/Dealer Assets jumped $168 billion, or 19% annualized, during Q4 to a record $3.676 TN.”

This is the Fed’s own data. Do they not have a team ready to investigate such extraordinary Wall Street lending growth during a period of conspicuous exuberance and speculative excess? Since the “great financial crisis,” Fed chairs have repeatedly expounded the view that monetary policy is not an appropriate tool to counter asset inflation and Bubbles. It was, instead, macro-prudential polices that were to safeguard financial stability. Archegos is one more example of the serious shortcomings of this approach. How many times have we been told how closely the Fed on a daily basis monitors for risks to financial stability?

The FT’s Gillian Tett posed the relevant question: “So was Archegos an anomaly? Or a trend?” I give her credit for being diplomatic. This was utter craziness. A long-term trend that more recently achieved powerful momentum; a perilous sign of the times.

Some have drawn comparisons to Long-Term Capital Management’s 1998 blowup. Archegos is smaller and its derivatives exposure only a fraction of the Trillion or so (notional) LTCM positions. It had not borrowed in the money markets and was not levered in Credit instruments, which would generally indicate less systemic impact. Yet, on its surface, Archegos’ positioning and leverage are more audacious than even LTCM.

There have been no allegations that outright fraud is involved. No humongous “fat finger” trading flub, or the shenanigans of an overzealous hedge fund titan wannabe. There were no flaws in risk models or aberrant market dislocation that blew up the strategy. Instead, it was one crazy roll of the dice by a seasoned operator betting on the perpetual bull market – gleefully financed by the who’s who of global speculative finance.

Archegos is emblematic of an out of control mania and a complete breakdown of responsible lending and regulatory oversight. It may not have posed a systemic risk, yet the Archegos fiasco is certainly an indictment of the entire system from the speculators to the financiers to the regulators and – most importantly – the institution entrusted as guardian of our “money” and financial stability more generally.

March 31 – Reuters (David Lawder): “U.S. Treasury Secretary Janet Yellen is facing pressure from Democrats to revive tougher scrutiny of hedge funds and other large pools of capital as she heads her first meeting of the premier grouping of U.S. financial regulators… The meltdown of leveraged hedge fund Archegos Capital Management this week… gives the Financial Stability Oversight Council fresh evidence to review. The council, led by Treasury and including heads of the Fed, the Securities and Exchange Commission and other major financial regulators, is scheduled to meet… to privately discuss hedge fund activity and the performance of open-end mutual funds during the coronavirus pandemic.”

What are the ramifications of the Archegos implosion? We can assume regulators will take a sharpened approach with leveraged institution oversight – hedge funds and “family offices,” in particular. Lending conditions in levered “securities finance” will tighten. JPMorgan analysts estimate losses to the big securities firms could approach $10 billion – with the largest hits to Nomura and Credit Suisse. For Credit Suisse, it’s somewhat a “third (fourth) strike” (Greensill Capital, York Capital Management and Luckin Coffee). At least at the margin, the big securities firms will be somewhat more circumspect in extending Credit to highly levered market operators.

Perhaps the most consequential near-term changes will unfold stealthily in the derivatives marketplace. Regulators will more carefully scrutinize the types of derivatives that allowed Archegos to go nuts with leverage. This should spur a more cautious approach from derivative counterparties (i.e. the big securities firms), with the upshot a tightening of conditions for the leveraged speculating community.

From the FT: “‘There is never just one cockroach,’ warns Andrea Cicione, head of strategy at research house TS Lombard. ‘If all this sounds familiar, it is because of the similarities with the beginning of the global financial crisis, when two hedge funds…had to be bailed out by their sponsor, Bear Stearns, following margin calls they could not meet.’ He adds: ‘To be absolutely clear, we are not calling [another financial crisis] here — there simply is not enough evidence to conclude that Archegos is anything more than an isolated case.’”

There is every reason to believe Archegos is but the tip of the iceberg. While not obvious, the comparison to the Bear Stearns Credit fund blowups in June 2007 is apt. Those two funds had employed egregious leverage in their subprime mortgage derivatives holdings. And this type of speculative leveraging had acted as a marginal source of liquidity during the “Terminal Phase” of mortgage finance Bubble excess. And while the Fed’s aggressive monetary loosening was instrumental in sustaining general Bubble excess well into 2008, the implosion of the Bear Stearns funds marked a momentous inflection point – a tightening of lending conditions at the margin (subprime) that marked the beginning of the end for a historic Bubble.

There’s a case to be made for characterizing Archegos as an egregious employer of leverage at the fringe of an epic Bubble in leveraged speculation – having provided a marginal source of marketplace liquidity. The collapse and resulting tightening of lending conditions will now mark an inflection point for the historic Bubble in leveraged speculation across the securities and derivatives markets.

My fascination with Bubbles goes back to the late-eighties Japanese Bubble period. A similar dynamic held through the many Bubbles I’ve analyzed over several decades: U.S. bond market 1992/3, Mexico, the SE Asian “Tigers,” the nineties “tech” Bubble, the mortgage finance Bubble, and others. In each case, I became convinced the amount of Credit, speculation and other egregious excess was extraordinary. And years ago I adopted a Bubble maxim: “I knew things were really bad. It was invariably much worse than even I imagined.”

April 2 – Financial Times (Katie Martin, Robin Wigglesworth and Laurence Fletcher): “The super-rich face challenges that the rest of us do not have to consider: yacht maintenance, selecting the right fleet of private jets, finding boarding schools for their offspring. Thanks to their roughly $6tn in combined family wealth, they now have to worry about Bill Hwang too. Hwang has shot from relative obscurity to become the key figure in global markets over the past two weeks, as the implosion of his Archegos investment house has hammered a handful of stocks and punched multibillion-dollar holes out of Credit Suisse and Nomura.”

I was unaware that “family office” assets had inflated to $6 TN – through an astounding confluence of policy-induced wealth redistribution and asset inflation. From the FT: “That golden age has brought a proliferation. In a report issued a year ago, business school Insead noted that the number of single family offices had grown by 38% between 2017 and 2019, to reach more than 7,000. Assets under management stood at some $5.9tn in 2019.”

We can safely assume assets are, at a minimum, now approaching $7 TN – and, with some leverage, the size of holdings could be double or even triple. And while many “family offices” would be cautiously focused on wealth preservation, there’s an element of “regulatory arbitrage” that we all should find troubling. As Archegos has illuminated, this structure creates a loophole for avoiding regulatory oversight and reporting requirements. Most of these operations are domiciled in lax off-shore financial centers outside the purview of credible regulators.

I have proffered tens of Trillions of speculative leverage have accumulated over this protracted Bubble period. The so-called “family office” universe has clearly become a key operator in global leveraged speculation. But let’s not lose sight of the big picture.

March 29 – Reuters (Gina Chon): “But broadly global watchdogs are eyeing opaque areas of the market. Assets among shadow banks have increased following the financial crisis, totaling more than $200 trillion in 2019, now making up about 50% of the global financial system, according to the Financial Stability Board, compared to 42% in 2008.”

Archegos is also a reminder of latent liquidity issues. For the most part, the fund trafficked in exposures to liquid equity securities. For example, Viacom traded 38 million shares on March 23rd, trading at $96 late that Tuesday afternoon. By Friday, some 20 trading hours later, the stock had been more than cut in half to $40.

Clearly, the large “margin call” block trades to unwind Archegos positions were a major factor. But how much selling came out of the woodwork in an attempt to “front run” this forced liquidation? Some smelled blood, and others panicked – and the market in Viacom stock turned illiquid, then quickly dislocated. It was the inverse of spectacular speculative melt-ups we became so accustomed to during the quarter.

It made me recall the March 2020 implosion of some popular corporate bond and small cap equities ETFs. After beginning the year at $37, Viacom was trading at $100 only nine sessions ago. Importantly, it was the speculative melt-up that set the stage for the inevitable reversal, dislocation and Archegos blowup/deleveraging. We should all be worried by the ongoing proliferation of ETFs gorging on wildly volatile and speculative company stocks. It’s all late-cycle “Moneyness of Risk Assets” “Terminal Phase” egregious excess. Just wait until the “front running” (selling/shorting/put buying), illiquidity and dislocation when these funds suffer major losses and panicked outflows (“runs”).

Q1 2021 – another quarter for the history books. The Banks (BKX) surged 24.0% (Nasdaq Bank Index up 28.7%), with the Broker/Dealers (XBD) gaining 19.2%. The small cap Russell 2000 jumped 14.1%, and the “average stock” Value Line Arithmetic Index rose 16.4%. The NYSE Arca Oil Index jumped 31.3%, while the Semiconductors rose 15.9%. The Dow Transports advanced 17.9%. Gamestop surged 916%, AMC Entertainment 342%, and Express 336%.

Vaccinations reached 100 million, while 900,000 jobs were added in March. Mind-boggling fiscal stimulus, and the Fed holding doggedly to $120 billion of monthly QE (for months to come). The Treasury five-year inflation “breakeven rate” jumped 66 bps during the quarter to 2.64% (high since 2008) – with manufacturing survey price indexes surging to multi-decade highs.

Ten-year Treasury yields spiked 81 bps to 1.72%. The Brazilian real and Turkish lira each dropped 8.9%. Erdogan threw a tantrum and sacked Turkey’s chief central banker. Turkish lira bond yields spiked about 500 bps during the quarter to 17.4%. Brazilian real yields rose 253 bps to 9.40%. Supply-chain finance leader Greensill Capital collapsed during the period, while Archegos imploded spectacularly at quarter-end. Melvin Capital and other hedge funds suffered at the hands of wildly unstable markets.

As Warren Buffet is fond of saying: “You find out who’s swimming naked when the tide goes out.” Get the women and children off the beach! It’s high tide, yet things are turning nasty already. Hyman Minky’s “Ponzi Finance” on a systemic (and global) basis – and the abhorrent scheme is showing its age.

Original Post 3 April 2021

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Categories: Perspectives