Archegos and the efficient markets hypothesis

Good morning. Wall Street rose yesterday, then faded. Sentiment is poor, and surprisingly strong results from Facebook (still boycotting “Meta” around here) after the bell seem unlikely to change that. But readers have suggested plenty of good reasons to be cheerful: It’s spring, Trump is out of the White House, and Russia is losing. Keep coming. Email me: robert.armstrong@ft.com.

Archegos and the efficient markets hypothesis

According to an SEC complaint filed yesterday, Bill Hwang and three of his Archegos colleagues did the following:

1. He bought staggeringly huge amounts of shares, in highly concentrated positions, mainly using money borrowed from investment banks.

2. He bought tons more of those same stocks indirectly, using total return swaps (again with borrowed money), thus avoiding public disclosure of his huge and concentrated positions.

3. He kept buying those same shares, directly and indirectly, in a manipulative way that supported their prices.

4. They told lies to get more loans from their banks, which would have refused to provide funds had they known how large and concentrated Archegos’ positions were.

Then in the spring of last year, some of the stocks fell sharply in price, there were margin calls, and the whole thing blew up.

As Matt Levine has pointed out, the most interesting thing about this story, told by the SEC, is not that some people in finance are liars or that the disclosure rules for swaps could be much better. What is interesting is that there is no discernible way that this “fraudulent scheme” (SEC’s term) could have turned out well for Bill Hwang and his colleagues.

Could the entire operation have been a “pump and dump” scheme on a scale never before imagined? Consider Archegos’ position size in March of last year:

Archegos held those shares worth $97 billion, plus another $63 billion in other assorted positions, at a leverage ratio of 344 percent, according to the complaint. That is, for every $1 you have invested, the fund has $3.44 in money from the banks backing those positions. Concentrated? At the end of March 2022, the company’s exposures amounted to half or more of the outstanding shares of four of the stocks listed above.

I contend there can’t be enough buyers of these stocks at these volumes for them to be sold, however carefully, without hurting prices, triggering margin calls, and bringing down the entire facade. If any merchant disagrees, please email me.

Levine has floated the idea that Hwang and his team may have thought the shares were actually worth the prices they were (supposedly) forced to rise to. This is possible, although the stocks they chose (did you see Viacom’s financials last year?) make me a bit skeptical.

But assuming this to be true just makes the four Archegos seem a little less crazy. One thing you learn about your second day as a stock picker is that when you think a stock is grossly mispriced, you’re wrong most of the time. If you are wrong just a few times, you are very smart and you get rich. But because the company’s stakes were huge, concentrated, and leveraged, they had to be right almost all the time if their business strategy was going to work.

The standard way of explaining how people get involved in obviously unsustainable schemes is that they do it little by little. They tell a little lie and then have to tell another one to cover it up, and soon they’re living in a wobbly tower of lies. You could apply this theory to Bernard Madoff, say, and maybe even Enron. But it doesn’t work with Archegos, because these guys grew their portfolio incredibly fast. According to the complaint, the gross exposure went from 10,000 million dollars to 160,000 million dollars in one year.

Hwang isn’t just (supposedly) dishonest. He is also (apparently) crazy. And he brought at least three other people with him on his trip to bonkersville.

Crazy people exist. This is not news. Nor does it excuse the alleged dishonesty of the Archegos team, or the notable stupidity of banks lending money to the company while several red flags were waving. But whichever version of the efficient market hypothesis you subscribe to, you must incorporate the fact that one or more crazy people can work in a seemingly respectable company, control a huge amount of capital, and, for better or worse, be on the other side side of the transaction you are about to make.

China’s ‘impossible trilemma’

China’s covid-zero approach may cause serious damage to its economy and thus to the world’s. Craig Botham, a Chinese economist at Pantheon Macro, noted that the country’s economic policy response to its own pandemic policy appears to be spinning:

The State Council on Monday urged the implementation of already announced tax cuts, refunds and fee reductions to support SMEs and manufacturers, including a further reduction in unemployment premiums. These cuts were supposedly implemented from April, so this hints at fiscal transmission problems. ..

eleventh president [Jinping], speaking at the meeting of the Central Committee for Financial and Economic Affairs, called for efforts to boost investment in infrastructure on Tuesday. This confirms our expectations that the government will continue to lean on this favored stimulus tool, rather than capitulate to Covid-0 or the housing crackdown. . .

This returns to the “impossible trilemma” of zero-Covid, 5.5 percent growth, and stable debt to GDP.

China cannot lock itself out, hit its growth target, and stop buying growth with debt all at the same time (in the long run, the latter two may be incompatible even without the former). The recognition that something has to give resonates throughout an excellent story by my FT colleagues Sun Yu and Tom Mitchell:

Chinese regulators led by Vice Premier Liu He are concerned that the government is underestimating the economic impact of its crackdown on the property sector and Covid-19 lockdowns. ..

Two other vice premiers, Han Zheng and Hu Chunhua, have sided with the Housing Ministry in wanting to keep up the pressure on developers. ..

Faced with the worst economic conditions and prospects in China since at least the start of the pandemic, financial policymakers have responded in recent weeks with only modest easing measures. Their reluctance is partly due to fears that stronger stimulus measures would only have limited effectiveness, especially in regions crippled by Covid containment lockdowns.

Can Beijing boost exports and growth by dodging the trilemma by weakening the renminbi? Probably not, for reasons Unhedged’s friend Michael Pettis pointed out in Alphaville. A weaker currency helps manufacturers, but it also raises the cost of living, which weakens domestic consumption, something China needs more of, not less, if it wants to grow sustainably.

Which dilemma horn do you think the government will choose? My money, like Botham’s, says that idle debt-financed investment will increase before long.

a good read

President Ulysses Grant’s reputation—brave, naive, alcoholic, strategic, loyal, simple, terrible with money, fantastic on horseback—is resurfacing. My favorite president.