On Friday, an otherwise not-especially-dramatic day for stockmarkets, a few big stocks suffered huge declines as the market was roiled by a string of “block trades”. That is, big chunks of stock hitting the market all at once.
Companies including Chinese tech giants Baidu and Tencent, plus US stocks such as ViacomCBS and Discovery, saw their share prices tumble, with each of the latter sliding by 27% at one point.
What’s going on? It turns out that a big trader has just run out of road with his creditors.
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Margin calls, and why investors trade with borrowed money
Archegos Capital Management, a family office run by former hedge fund manager Bill Hwang, was forced to sell more than $20bn-worth of shares on Friday.
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According to Bloomberg, nine stocks bore the brunt of the selling – six China listed and three US listed, mostly big names and mostly in tech or communications.
So what happened? In short, the two little words that no trader ever wants to hear: “margin call”. A margin call is one of the biggest risks of trading with borrowed money, or “leverage”.
The easiest way for normal people to understand the notion of leverage and why investors use it, is to think about buying a house using an interest-only mortgage. Let’s say you buy a flat as an investment. The flat costs £100,000. You have £50,000 as a deposit, and you borrow £50,000 from the bank. By the end of the year, house prices have gone up by 5%, and you sell the flat for £105,000. You give the bank back its £50,000, and you now have £55,000.
Note that the value of the flat went up by 5%. But you have made a 10% profit (£5,000 on top of £50,000), because you used borrowed money to pay for half of it. This is why borrowing money is called "leverage" or sometimes "gearing" – because it amplifies the effect of any move in the value of the underlying asset.
Now say you have a generous (or risk-hungry) banker. Rather than put down a £50,000 deposit, you put down a £5,000 deposit and borrowed the other £95,000. When you sell, you repay the mortgage, and now you have £10,000 instead of £5,000 – a 100% return. Not bad! Better yet, you only needed to tie up £5,000 instead of £50,000. So you could have bought another nine flats with 95% loans and really cleaned up.
Here’s the "but". (You all knew it was coming).
When betting on tick goes wrong
Say things went wrong. House prices (gobsmackingly) actually fall 5% instead of going up. Your flat is worth £95,000 at the end of the year. In the first example, with the £50,000 deposit, if you sell, you’ll end up with £45,000 after you’ve paid the bank its chunk. That’s a 10% loss. And in the second example, with just a £5,000 deposit, you’ll have nothing. You’ll have made a 100% loss because you need to pay the bank back all the money from the sale.
So that’s the risk with leverage. It boosts returns when asset values are going up, and it exacerbates your losses when asset values are falling. But there’s another risk. In the first example, you would probably decide not to sell. You’re a great believer in good old bricks’n’mortar, and surely a drop in house prices in this “crowded little island” is merely a blip. So you cross your fingers and hope for better times. Your short-term investment matures into a long-term one to save your blushes.
The second example is not so simple. The bank might look at this loan and think: "Hang on. We now have no cushion. If house prices fall any further, and it turns out that this property investor isn’t good for the shortfall, well, we could end up losing money here."
So the bank might turn around and say: “Actually, we need to call this loan in. Or we need you to refinance it. Or we need you to put up another chunk of deposit. In short, we’re on the hook for more than we’re comfortable with right now, and unless you do something to alleviate that concern, we’re calling your loan and repossessing the house.”
This is a “margin call”. And while you don’t see it happen often in the residential housing market, you do see it pretty regularly when people make bets on the stockmarket with borrowed money. Anyone who has burned their fingers while spreadbetting will probably recognise it. What happened here is that the banks who had funded Hwang’s leveraged trading grew uncomfortable.
It’s been a choppy few months in the stockmarket. There’s a battle going on between the long-running “growth” trend and the hopeful challenger, the “value” trend. Put very simply, it means that everyone who had grown used to betting on growth is now finding things much harder.
And Hwang was clearly at the very sharp end of this – he must have been losing money on his positions. So the banks lending him money in effect said: “You need to put down a bigger deposit, or we’ll sell out of these positions to reduce our exposure to you, because we’re no longer comfortable with it”. And they dumped the stocks.
As with the near-negative equity example above, this is not necessarily any fun for the banks either. It’s not entirely clear yet, but it looks as though Goldman Sachs is the one who pulled the plug first and so presumably got out with most of its money intact.
Losers so far appear to be Nomura and Credit Suisse. According to Credit Suisse this morning, “while at this time it is premature to quantify the exact size of the loss resulting from this exit, it could be highly significant and material to our first quarter results”. Meanwhile shares in Nomura tanked by about 16% this morning due to concerns over its exposure.
What does this mean for my money?
It’s important to note that this is not existential. This is not 2008 territory. So far it’s just a painful learning experience for the risk managers involved.
So this probably doesn’t matter for your own portfolio, unless you were also making heavily leveraged bets on the same specific individual stocks as Hwang, in which case you’re already well aware of this story and I can’t help you.
However, it is a useful reminder of the dangers of trading with borrowed money. Moreover, it is interesting to see a big fund blowing up in what is, after all, still an exceptionally forgiving investment environment. These sorts of detonations are yet another toppy indicator in a very toppy-looking market.
Why do these things happen near the top? For the usual reasons. Everyone has grown more afraid of missing out on gains than of losing money. So they glut themselves on leverage, chasing the highest returns possible without proper consideration for risk.
And because the lenders feel the same way, they are prepared to hand out money, without considering the risk that they won’t get it back. I mean, believe it or not, as recently as 2018, Goldman was refusing to do business with Hwang, reports Bloomberg. So they knew he was high risk – they just couldn’t resist the fees.
In short, everyone is overconfident and betting on everything being perfect and going smoothly all the time. So there’s no margin of safety to fall back on if even the slightest thing goes wrong.
So while this doesn’t look like it’s going to trigger a domino effect, it does highlight the fragility of the market. As Shuli Ren notes on Bloomberg, Hwang was hardly going against the crowd with these trades. He was clearly particularly aggressively positioned. But there will be others feeling the pain too.
Investment banks will also be eyeing their own exposure and wondering whether they need to be just a little more cautious in future. Remember, Goldman (and Morgan Stanley it seems) appear to have got out first. It’s the laggard banks, including Nomura and Credit Suisse, who have been left to take the bigger hits.
So there’s an incentive on the lenders’ side to be the first to pull the rug out from under their clients. If they tighten up enough as a result, then even if Archegos is the only big blow-up, it all adds impetus to the shift away from what’s been popular (and thus very overstretched) towards investments with a greater margin of safety. Or to put it more explicitly, the longer-term swing from “growth” to “value” should continue.
We’ll have a lot more on that in forthcoming issues of MoneyWeek magazine. Get your first six issues plus a beginner’s guide to bitcoin absolutely free here.
Until tomorrow,
John Stepek
Executive editor, MoneyWeek
