How The Archegos Affair Could Look More Like 2008 than 1998: What Investors Should Watch

Now we know. The seemingly inexplicable collapse in some stocks at the end of last week actually had nothing to with those companies themselves. From Tuesday’s highs to Friday’s lows, there were some massive selloffs in some seemingly unrelated stocks. Viacom (VIACA) lost 57.5% and Discovery (DISCK) fell 50.8%, alongside Chinese tech companies Vipshop (VIPS), Baidu (BIDU) and Tencent (TME) that plummeted 46%, 34%, and 49.8% respectively.

It turns out that the dramatic moves were exaggerated by a kind of reverse Reddit/GameStop (GME) trade. That was a short squeeze; this was a forced squeeze of long positions. A previously little-known hedge fund, Archegos Capital, had accumulated massive, highly leveraged long positions in all the above and when the stocks started to fall, the banks that had enabled that leverage put out a margin call, meaning that they asked Archegos to put up some cash. They were unable to come up with the money and the banks executed forced sales of the stock.

It is tempting to look at that with a feeling of schadenfreude. Who is sorry that a hedge fund run by a man with a checkered past (Bill Hwang had previously settled insider trading charges with the SEC in 2012 and was banned from trading in Hong Kong in 2014) got hurt by massive greed, or that the result of it was some damage to the profits of the Wall Street banks that enabled that, also motivated by greed? That, though, is to miss the point, or at least the potential point.

A great piece by Robin Wrigglesworth in the FT compares this to the Long Term Capital crisis in 1998. That seems like an apt comparison as both are about over-leveraged funds getting caught out, but the real worry for investors is that this begins to look more like 2008 than 1998. Right now, it is a contained problem. There are seemingly four banks that got involved -- Goldman Sachs (GS), Morgan Stanley (MS), Nomura (NMR), and Credit Suisse (CS). The selloff seems to have been triggered by Goldman, who therefore probably took the smallest hit, with Nomura and Credit Suisse getting hit hardest. The stocks in those banks reflect that, but MS has yet to reveal how much of a hit they took.

What happened in 2008, though, was that it gradually became clear after Salomon Brothers went under, that they weren’t the only ones exposed to leveraged mortgage derivatives and, once that became widely known, banks started to lose confidence in each other. That caused them to cut lending and froze the credit markets.

Just to be absolutely clear, I’m not saying that we are at that point, but confidence is a fragile thing. So far, we can’t know if over-leveraging is a common thing, or if this is just one bad actor. Any hint of the former will make this a lot more of a problem than it is now as banks start to cut their exposure to each other.

If that happens, no amount of Fed-provided liquidity will help. It doesn’t matter how much cash the central bank is handing to Wall Street if those banks don’t move it around the system. If anything, in that scenario, the fact that the Fed has been pursuing ultra-loose policy for an extended period leading up to now would become a big problem in itself. What could they possibly do to help with a financial crisis when they are already using all their tools to help with a fiscal one?

There are a couple of things to watch. If we see more of these events it means that other banks are exposed to a similar situation and have learned from last week’s events that making margin calls early is the best way to limit damage. If that were to happen then, with no way of knowing the extent of the problem, confidence would collapse, and the selloff would quickly be about a lot more than a few targeted stocks. The first indication of that would come in overnight and repo markets, as banks tighten up credit lines for each other, so keep an eye on those normally esoteric, somewhat obscure areas for signs of problems.

I should stress again, right now there is no evidence that this is anything more than it seems: an inevitable and justified come-uppance for a greedy Wall Street fat cat who bent the rules too far and got busted. Stock in the sold-off companies should bounce back as the move has nothing to do with their intrinsic value, and stock in the affected banks will take a temporary hit as they reveal the extent of their involvement and the damage they suffered, and that, theoretically, is where it should end.

It is worth noting, though, that both the 1998 LTCM affair and the 2008 credit crisis started with the forced unwinding of over-leveraged positions, and as that was done, it became clear those positions were ubiquitous. I hope I am wrong, but it seems to me that this has more potential of being “the big one” than all of the more hyped issues that we have seen recently. To quote Hill Street Blues: "Be careful out there."

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