Originally published in April 2021.

“Daddy was a bankrobber, but he hurt nobody. He just liked to live that way, stealing all your money…”

As Greensill and Archegos roil markets and cause losses, it brings the question: Who is next? Why is 2021 turning into the year the scams are unravelling? Will leverage on leverage trigger wider implosion or will it be something else, like liquidity?

Back in the day… Archaos was a terrifying alternative French circus. They were brilliant and shocking – anarchy on steroids as they juggled chainsaws, played with fire on motorbikes, and ignored the conventions of gravity on the high-wire!

In contrast, the collapse of Archegos Capital is anything but brilliant. It seems to be a developing theme for 2021: the year the shysters of finance are being revealed as their get-rich-quick schemes unravel. Bill Hwang of Archegos and Lex Greensill share a common trait – being able to insert themselves seamlessly into the game. They have both been exposed – raising the question: Who hasn’t? What other shocks are still embedded in the system?

I could have started this morning’s porridge with a comment about there being “something rotten in the state of global finance”, but that would be too easy. Everyone in the financial markets is just an actor in the bigger picture, but to understand why market participants act in certain ways and their motivations, or why banks and funds are willing to provide unlimited leverage to clients in overcooked markets, or why bright young bankers enable it, you need to understand the way the institutions work.

There isn’t time for a full sociological analysis of the business, but for the last month we’ve seen a deluge of stories about how unfairly young intern bankers are treated – 100-hour weeks and no sleep, while their bosses use the company jet to holiday in the Caribbean and as a taxi back to the big house in the Hamptons. The bosses play that way because that’s what they learned back in the 1980s. They got rich on big bonuses from extracting value from the system by supplying solutions to financial problems. Everyone wants to be the boss. The interns may whine it’s unfair – welcome to finance.

In investment banking, no one is listening when you scream. These same put-upon interns today will be the salespeople and bankers of tomorrow looking for opportunities (and commensurate bonuses) from selling their firms’ solutions to extract value. The markets move very quickly to the next thing: the hedge funds that were once gaming bank capital, before switching into distressed assets, are now offering to provide leverage – and charging for it. In a world of 0.15% bond yields, clients need leverage to pay the bills. They’ve discovered that leverage on leverage generates returns and big pay-checks.

Unlike the bank robber in the quote above, who “hurt nobody”, the financial chicanery rife in markets causes substantial harm. The financial press is writing all about the losses suffered by the banks that didn’t dump their Archegos positions fast enough, and explaining parallels with the 1998 collapse of Long-Term Capital Management, but few folk are wondering how a 40% collapse in the stock price damages that firm’s long-term prospects, and blights the careers of its workers. (An opportunity to buy back stock cheaper?) Few folk are talking about the pension savers who’ve been impacted.

Few folk are talking about why there is an ongoing blight of complex, barely legal manipulation of complexity across financial markets. You can guarantee there are more dangers out there than just the leverage on leverage of the Archegos saga, or dressing up dull-boring-predictable supply chain finance as high-return/risk-free long-term assets by Greensill.

Apparently the largest 100 unregulated ‘family offices’ hold over $150bn in assets. Add that to the sheer scale of the essentially unconstrained shadow-banking system of funds, and the potential for mayhem is apparent. The ever-increasing complexity of financial regulation, the legions of risk officers and the compliance mentality encouraged across finance, was supposed to address the issues of financial players gaming the systems.

Hardly.

One thing trumps regulation every time. Returns.

Since the last big financial crisis that began in 2007, ultra-low interest rates have been the dominant force on markets. Returns is why investment funds exist. The desperation of investors to garner any real returns is simply driving greater and greater complexity as the investment banks and other bad actors seek to profit from the insatiable demand for returns. Their apparent success and the plethora of implausibly successful investments (from EV makers, virtual art, SPACs and whatever-nexts), has sucked in more and more marks – because everyone wants to make returns.

I was talking to a fund manager the other day who told me her kid’s nanny has lost money on bitcoin – bought high and sold low. As Ben Graham might have said, “When the shoe-shine boy tells you he’s bought ethereum and digital NFTs, it’s time to sell.”

The current market has got 1929, 1987, 2000 writ in bold blood red letters all across it.

Yet, that won’t stop us gaming the market. The consensus is that nothing will change until central banks let rates rise. Sure, the ten-year Treasury may be headed for 2% (currently 1.73%), but the central banks aren’t going to let a sudden rise panic markets, triggering a meltdown that would crush recovery, are they?

The losses experienced by Credit Suisse, Nomura, MUFG and others from Archegos are painful, but not terminal. But what if happens again, and then again? As it threatened to do in 2008. Could we see another run on just how levered the financial system is? It’s another reason central banks are so anxious to avoid a meltdown.

It now looks like the massive losses for Nomura and Credit Suisse were triggered when Morgan Stanley and Goldman Sachs took the decision to jump early and sell their exposures, leaving the other ‘prime brokers’ providing Archegos leverage on leverage holding the can. Bear in mind Wall Street is not club. It’s a pack.

Wounded pack members don’t last long. In 2008 my old firm Bear Stearns was first to go, snapped up by JP Morgan for pennies after the rest of Wall Street declined to support it. It was payback – in 1998, Bear made the call not to support the other investment banks caught the wrong side of the LTCM meltdown. When Lehman went down in 2008, the fact none of the pack trusted its CEO, Dick Fuld, was a primary reason no one wanted to buy it.

Meanwhile, I wonder just how seriously a leverage crisis may morph into the next piece of the problem – a liquidity crisis.

Let’s return, for a moment, to the other big scam – Greensill. It’s looking inevitable its demise will shortly trigger default by its main client, the Gupta-owned GFC Alliance.

I understand a single large UK pension fund, M&G, holds the entire £370m Lagoon Park financing, arranged by Greensill and marketed by Morgan Stanley, of the GFC Alliance’s purchase of the Lochaber aluminium smelter and hydro power station. Initially it only bought 50% of the deal, but then acquired the rest when GAM sold its portion. You may recall GAM suffered “difficulties” when a fund manager was suspended over transactions connected to Greensill, which triggered a massive run from investors demanding their money back.

The investment management team at M&G will not be unconcerned about the deal. Not because Gupta will default – but because the deal is guaranteed by the Scottish government. They will be worried about the credit outlook for Scottish debt rated Aa3 as part of the UK if the SNP succeeds in a second independence referendum.

A heavily redacted report by EY (and I mean practically everything is black-lined – do read the overview of the transaction on page 7) on the Scottish guarantee says the deal made commercial sense, but makes clear that if the smelter fails it becomes a liability of the Scottish government.

The Scottish guarantee is extraordinary – it is granted in favour of SIMEC (Sanjeev Gupta’s father’s business in Singapore) in respect of obligation by Liberty (part of GFC) to pay for energy from the hydro scheme. In the event of a default, the Scots will pay. Incidentally, I further understand Scotland has the right to borrow or guarantee £2bn, according to my sources in London.

The obvious question to ask is: Why did Scotland guarantee the deal? Whoever thought Nicola Sturgeon and former UK premier and Greensill employee David Cameron could be so aligned?

Gupta’s promised wheel factory and jobs never materialised. The Scots’ liability to pay isn’t just the £370m principal amount, it’s also a further 25 years of interest payments – say £500m in total. Well done, Scotland – 25% of its borrowing limit blown already. The SNP really are financial geniuses. The security package backing the guarantee? A smelter in Lochaber no one except the Guptas were interested in.

The really interesting thing about this Lagoon Park deal is how liquid these bonds are – despite the fact I suspect M&G is the only holder. I am told by an external investor he believes these bonds trade regularly. According to Bloomberg, there are regular prices posted. I wonder… could it be that brokers supportive of the deal are posting imaginary prices between themselves?

It would be a crying shame if it turned out that wholly illiquid bonds were being painted as liquid. I mean, what would the regulators think of a fund holding illiquid bonds that were described as liquid so they appear eligible as liquid UCITS eligible investments? A shade of Woodford? Naughty – if it was happening… Ahem.

I am absolutely sure all these junk bonds and corporate debt deals held by fund managers will prove illiquid as set concrete if/when the market’s day of reckoning arrives…