God Can't Protect You From a Leveraged Disaster

More about the Archegos blowup... God can't protect you from a leveraged disaster... The bad actors are losing their disguises... Credit Suisse could be the Lehman Brothers of today... The dangers of swimming with sharks...

I (Dan Ferris) have more to say about the Archegos story...

Last week, I outlined the blowup of Bill Hwang's firm Archegos Capital Management, and got into the disturbing and costly details.

We showed you how Hwang used derivatives called "total return swaps" to buy as much as $50 billion worth of stock with just $10 billion in capital. As I explained last week...

A total return swap is a pretty simple arrangement between a bank and a client.

The client makes a stream of payments to the bank, usually based on an interest rate. And the bank agrees to send the client a stream of payments based on the total returns generated by an asset. In this case, the assets were large positions in several stocks – including ViacomCBS (VIAC), Discovery (DISCA, DISCB), and Baidu (BIDU), among others.

And I wrote that when these positions soured recently, Hwang got a "margin call" from the banks asking for more collateral, which he couldn't meet...

Hwang's brokers then quickly sold him out in a fire sale that sent the prices of his largest positions crashing the last week of March.

I offered Hwang's story as a typical sign of late-cycle hubris gone horribly wrong...

After that, a Twitter follower of mine suggested that "maybe he didn't do it for personal greed or ego but of a passion to be charitable."

This theory comes about because of Hwang's charity, The Grace and Mercy Foundation, which has about $500 million in assets and has provided a lot of generous grants to religious groups.

I told the commenter that even that scenario, "requires a massive ego component."

The fact that Archegos is a leveraged firm that blew up after missing a margin call tells you all you need to know... And I don't think you can lever up a $10 billion portfolio 5-to-1 without being guilty of hubris.

In fact, I find the attempt to attribute Hwang's risky behavior to his religious, charitable streak as a typically crazy sign that we're late in the cycle...

Now, I fully understand I need to tread carefully when mentioning religion, so let's get something straight...

I believe religion is overall a good thing. Without it, I don't believe I'd have received as good of an education as I did. Religion brings people together to learn wisdom and humility.

Among other things, religion is about acknowledging the uncertainty of living in a world we don't truly understand. When we don't know something, we say, "God only knows." Religion's rituals and traditions comfort us and bring us together. And, at least where the Bible is concerned, it's the source of thousands of years of collected wisdom.

The first problem here is simply the intersection of money and religion...

Hwang, a devout Christian, said in a 2016 interview...

Money is a gift that God has given me to share with others.

A recent Financial Times article reported that Hwang called his firm Archegos because the Bible describes Jesus as the archegos or "author" of salvation.

The way I see it, though, when a rich person tells you God is on his side and he's levering up 5-to-1 to prove it... polite, quiet suspicion is a reasonable response.

Archegos is a family office which doesn't manage outside capital. The implication is that money made by Archegos is the author of the Hwang family's salvation. The notion is especially poignant, considering that shortly before the firm was founded, Hwang was fined $44 million for securities violations and banned from the industry.

Maybe Hwang should have paid more attention to the Book of Job 1:21. It says...

Naked came I out of my mother's womb, and naked shall I return thither: The Lord gave, and the Lord hath taken away; blessed be the name of the Lord.

The Lord keeps giving money to Hwang, then taking chunks of it away.

Hwang reminds me too much of Goldman Sachs CEO Lloyd Blankfein's 2009 assertion that the firm was "doing God's work" by paying big bonuses after he and his wealthy bankers helped blow up the financial system and admitted to selling their clients toxic waste.

These are cynical, self-serving uses of religion...

Since when is the unmistakable greed inherent in the use of five times leverage via total return swaps a Christ-like behavior?

Don't get me wrong, if in fact Hwang was taking these risks to benefit his charity, the end result could have helped people. But it didn't work... and there is something to be said about how you get there anyway.

In the name of charity, wouldn't it have been more plausible to first allocate money to the charity... and then take risky bets with money that might not ever go to the charity in the first place?

To me, Hwang seems more like a TV evangelist looking for his next big payday than a follower of the humble Nazarene carpenter...

And Blankfein is just a typical Wall Street gazillionaire, whose wealth is backstopped by the Federal Reserve because he's running a too-big-to-fail bank.

Why am I telling you this today?...

In other words, why bother philosophizing about a few bad actors invoking God in their quest for money by questionable means? They're certainly not the first...

Because, I think the farther we get into the biggest financial bubble in history, the more despicable you'll find the behavior of the worst actors in the market.

Invoking the protection of God over big, leveraged positions is a disaster waiting to happen. It'd be like if convicted fraudsters and former TV evangelists Jim and Tammy Faye Bakker started a hedge fund called Levered Up to Fight Satan.

As usual, stupid, risky, and possibly unethical behavior on the part of too-big-to-fail banks is at the heart of the Archegos disaster, echoing loudly since 2008...

Credit Suisse (CS) was one of the worst-hit banks in the Archegos blowup. The Switzerland-based bank said Tuesday it would take a $4.7 billion write-off from the Archegos debacle, more than half its annual profits.

The Wall Street Journal reported yesterday that Credit Suisse ignored warning signs for years about Archegos and the blowup of another client and financing firm Greensill Capital.

Credit Suisse could wind up as the Lehman Brothers of the current speculative episode...

I recommended shorting Lehman in April 2008, just months before it went bankrupt in September of that year in the most panic-stricken moment of the financial crisis...

Lehman had every financial malady of the time under one roof: subprime mortgage lending, overvalued real estate, massive leverage (about 30-to-1), overvalued private equity, accounting gimmicks to hide losses...

It was all there... and it all blew up... at just the moment when the Federal Reserve was afraid of bailing out one too many Wall Street banks.

Besides the Archegos and Greensill blowups, Credit Suisse is also among the biggest managers of collateralized loan obligations – pools of risky loans that are sliced and diced into arcane financial structures. These are similar to the collateralized debt obligations full of risky mortgages that were featured prominently in the financial crisis.

Credit Suisse was also the biggest underwriter of SPACs last year, a source of business that will dry up, blow away, and will never be replaced. They are almost guaranteed to lead to some type of embarrassment... since many SPACs wind up buying garbage companies that go nowhere.

Credit Suisse was involved in selling securities in two companies that blew up as frauds: China-based Luckin Coffee (LKNCY) and Germany-based Wirecard AG (WCAGY).

The company's share price is down roughly 27% in less than two months. I'll be shocked if it doesn't fall 50% this year. Credit Suisse is proving the old Wall Street adage, "There's never just one cockroach."

But there's another lesson here...

It's about the risks you face simply by choosing to become active in the stock market. I've quoted the writer and former options trader Nassim Taleb about this topic before...

The stock market, in brief: participants are calmly waiting in line to be slaughtered while thinking it is for a Broadway show.

It's one thing to get slaughtered thinking you were going to see a show. It's another to have bought the tickets at a discount from a trusted friend...

That's what happened to Morgan Stanley's hedge-fund clients, another big bank at the heart of the Archegos blowup...

Morgan Stanley is Archegos' biggest "prime broker," banks where investment managers house their money and assets. As our Stansberry NewsWire editor C. Scott Garliss explained in the throes of the GameStop (GME) saga...

When hedge funds are shorting stocks, they need to borrow shares from someone. That's one type of service prime brokers provide. And they also provide things like leverage for funds to employ in an effort to increase returns.

Bill Hwang gave Morgan Stanley permission to sell shares it owned (or held interests in via total return swaps) to the bank's hedge-fund clients...

Morgan Stanley told the hedge funds that one of its other clients had a margin call and they'd be helping prevent a big blowup due to another client's margin call. In return for their help, the bank sold the shares at a discounted price.

This all took place the evening of Thursday, March 25, the night before all the wild selling that caused the share prices of Archegos' biggest holdings to really tank the following day.

The thing is, the hedge funds never knew the whole story... They never knew what they were getting into when they agreed to buy out those Archegos positions...

According to CNBC, Morgan Stanley did not tell hedge funds that the shares it was selling them were only the first of a massive wave of selling that would start the next morning.

Needless to say, those hedge-fund clients felt betrayed by their broker.

Even the biggest fish in the sea can't escape the dangers of swimming with sharks...

Even when they're paying the sharks to work for them!

I won't make a moral judgment here. But it's worth pointing out that the stock market is the most hypercompetitive, cut-throat arena on the planet, and it quickly descends into an all-against-all melee when the system gets stressed.

It's a more dangerous place for most people than they realize.

It'd be one thing if Morgan Stanley and the other banks involved in the Archegos blowup were charging zero commission like online brokers, but they're not. They're prime brokers. Like I said, prime brokers help clients with sophisticated financial operations like the use of leverage and derivatives and borrowing shares for short selling.

A couple of years ago, Morgan Stanley called prime brokerage "the center of the machine" in its equity trading division – and for good reason.

Prime brokers are expensive... Money manager Phil Ordway recently said on Twitter that Goldman Sachs "kicked him out" as a prime brokerage client because of his lack of leverage, trading activity, or short selling.

Goldman told him its minimum acceptable commission and fees were about 750 times what he'd been paying them (and 1,000 times what he was paying his new prime broker).

This makes me wonder exactly what God wants Goldman Sachs to do to its clients...

It seems like maybe he wants the firm to churn their accounts to get paid more. Its clients seem to have more right than Bill Hwang to look skyward, or at least straight at Goldman, and ask, "Why have you forsaken us?"

I feel like I understand the bubble Wall Streeters operate in...

Back in the early 2000s, a billionaire in the finance industry had read my Extreme Value newsletter and contacted me.

He thought my report had caused heightened interest in a company in which he owned a large stake, pushing the share price higher. He liked the work I'd done and said I should be managing money, not writing a newsletter. He also said I needed a prime broker if I chose to pursue that route.

When I started pursuing it and actually spoke with a few prime brokers, I realized the strategy I told the billionaire I'd use didn't require any prime brokerage services. It wasn't the first or last time someone who should've known better tried to steer me in the wrong direction.

But this billionaire had made his fortune on Wall Street, and he didn't know any other way. To him, if you managed money, you needed a prime broker, and that's all there was to it.

While we're at it, we should update you on another speculative affair...

I mentioned it briefly already... I'm talking about the GameStop story, still working itself out in the public markets. By now, you probably know some of the details...

The videogame retailer's stock was below $4 in July 2020 and soared as high as $483 in a massive short squeeze in January of this year.

GameStop sold its roughly 1,300 AT&T stores in 2018 for $700 million. They were the only reason to own the stock, since buying and trading vintage video game discs has been relegated to a niche market.

The gaming world today, or at least the most lucrative part of it, has moved almost exclusively online.

Last month, the company reported about $250 million of operating losses in 2020. Its market cap today of nearly $12 billion puts the company's valuation near 50 times operating losses.

That's bad.

Earlier this week, as Nick Koziol of our NewsWire team wrote, GameStop management said it would sell as many as 3.5 million new shares to the public. At GameStop's recent share price, that'd be well over half a billion dollars. And all for a mere 5% dilution of the outstanding share count.

Management is doing exactly the right thing... They must know their business is headed for extinction, and they also must know that there's no way it's worth anywhere near $12 billion.

It's losing money, with no hope of turning a profit unless it pivots into something entirely different.

The market gods have given them a gift in the form of an extremely high valuation and a legion of Reddit message-board fans. The only rational thing for management to do is sell as much new equity as possible, while they can do so at an elevated valuation.

As an aside, there's a good lesson here for all CEOs and CFOs of troubled companies or highly cyclical ones... don't wait to raise capital when you need it. Raise it when the market offers the most favorable terms.

That's what GameStop management is doing. And they've structured the equity offering to fit the environment. It's an "at the market" offering, meaning that it can sell as much or as little as they like, from time to time in the open market.

There's no obligation to sell any amount. That means they don't have to go around trying to find deep-pocketed investors to buy the shares and bail them out.

The execs know the best chance the company has of raising money is by selling to the people who ran the stock up in the firsts place: all the little speculators who don't understand that the ticker symbol represents a real business.

Think of GameStop as some people would think of a Jackson Pollock painting...

He's the guy who laid canvasses on the floor and dripped and splashed paint all over them.

One of his paintings sold for $32 million in 2013. I like Pollock, but maybe you think any idiot can spill a bunch of paint on a canvas the way he did and that people are crazy to pay $32 million for it. (I agree with that last part!)

GameStop's value today is highly questionable and might even be zero or negative. But the market has fallen in love with it, pushing its price to exorbitant extremes. And now, management has said it'll raise what could be hundreds of millions in new equity.

Does this mean I like the stock and think you should buy it?

Absolutely not. There's no way it's worth $12 billion... or $1.2 billion... or even $120 million as far as I can tell. Remember, the only reason for the massive short squeeze is that there was a huge short position in its shares.

It wasn't hard to believe the stock could go to zero. A business that lights money on fire has little or no value.

Also, the effect of diluting shareholders will be a reduction in the share price, which has already occurred since the offering was announced earlier this week.

With a fresh new war chest full of cash, maybe GameStop execs can come up with a game plan for the company that will turn it into a viable business. Just remember what Warren Buffett says... "most turnarounds don't."

If you've been playing around in GameStop shares, you might want to take your winnings (or cut your losses) and walk away. From here on out, I'm willing to bet the market will get increasingly bored with this stock.

A fall back below $4 would surprise no one who has looked at its financials and thought about its business for more than a few minutes. But, sadly, we know that the folks who sent GME shares skyrocketing don't really care about that...

The point is this...

The speculative froth seems to be coming off the worst situations in the stock market...

We see it with the idea that playing with five times leverage in the name of charity or religion makes it somehow more palatable or OK...

We see it with big banks ignoring or missing the risks they've carelessly piled into... and prime brokers screwing clients and scrambling to save themselves when things go wrong...

We see it with GameStop execs raising money when they can, and not a second later...

And I'd bet all day long the stories I've covered in recent Digests barely form the tip of the iceberg.

These are the things you see in a frothy, juiced-up market. These are things that can lose people a lot of money, even if their motivations are pure. Be very careful that you're not too heavily involved in any of them.

Longtime Digest readers know we don't write about these stories for fun. They're warnings and cautionary tales.

You can avoid most of this nonsense in the equity markets by owning high-quality companies that can weather most market environments and keeping a diversified portfolio based on your goals, time line, and risk tolerance.

And if you are going to get into more sophisticated, leveraged positions, like options for instance, you must know what, precisely, you are putting your money into... what could go wrong, as well as what could go right.

In the swirl and pressure of the Archegos story, that's a concept that some of the so-called sharks on Wall Street didn't even seem to know... or their brain told them to forget... right when they should have remembered it most.

New 52-week highs (as of 4/8/21): Comfort Systems USA (FIX), Alphabet (GOOGL), Intel (INTC), IQVIA (IQV), Microsoft (MSFT), ProShares Ultra Technology Fund (ROM), ProShares Ultra S&P 500 Fund (SSO), Seagate Technology (STX), Vanguard S&P 500 Fund (VOO), Waste Management (WM), W.R. Berkley (WRB), and Zimmer Biomet (ZBH).

In today's mailbag, feedback on Kim Iskyan's Thursday Digest about how to protect yourself from stupid people... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

"WOW! For 60 years I have too often felt like I was living in the twilight zone! Kim's Digest today was absolutely fabulous! How true it really is!!!! Great Digest today!!!! Love to meet several of [you] folks in person some day! I think we are of kindred spirits!" – Paid-up subscriber C. O.

"Kudos to Kim for his piece on stupid people. I hadn't laughed that much in a good while. Thanks!" – Paid-up subscriber Shalako S.

"Thank you, Kim for another excellent Stansberry essay. I am always impressed with Dan's opinions...

"Today, your thoughts defined most of the stress I suffer with as I try to wind down my career as a CPA. Stupidity. The stupid clients I deal with, certainly the minority of them, and my own stupidity for tolerating that minority.

"Hopefully I will outsmart the herd with my investments as rise above the effects of stupidity to enjoy the rest of my life as one of the intelligent." – Paid-up subscriber Tim L.

Good investing,

Dan Ferris
Somewhere in the Great Northwest
April 9, 2021