Author: Gary McCarthy

Ok, I admit I did watch the Ireland-Qatar game last night. Will I ever learn? Ten games without a win but still I was drawn to the action from our eleventh attempt in Budapest. Action mighty be stretching it. That ship in the Suez seemed to be moving quicker than some of our players but our winning day will come; that’s the beauty of sport.

However, financial markets are different. It’s not a game and some losing streaks never ever change. The consequences of extreme leverage are always guaranteed and always ugly. We have written many times about the dangers of dependence on “other people’s money” but the latest installment from Wall Street is particularly bizarre. The implosion of a little-known family office called Archegos Capital was triggered by other people, banks in this case, demanding a return of their money.

More specifically, this was a margin call – banks uneasy about the falling value of Archegos’ investment portfolio required more collateral(cash) to offset the increased risk. The only problem in this case was that each of the banks had no idea how many other banks had funded Archegos’s trading activities. That changed last week. A meeting of the lending banks seemed to crystalise the impending disaster and set off a stampede for the exits. The frenzied selling of Archegos’ portfolio of stocks generated some eye-catching losses. Here’s a taste of the carnage:

• Viacom, the media giant, saw its share price collapse by 23% on Friday 26th March on massive selling volume.

• US companies were not the only ones battered. China education player, GSX Techedu, lost 52% of its value in just two days trading.

• The Archegos portfolio is estimated to have cratered by 40% which in the world of leverage means other people’s money not only does not get a return but actually doesn’t get returned.

• Japanese investment bank, Nomura, was the first to alert the market as to the quantum of potential losses for the lending banks with an estimated $2 billion hit.

• Credit Suisse, fresh from its Greensill debacle, was less forthcoming but talked of ‘significant’ losses. Market commentators believe the Swiss bank is still unwinding its positions and could be facing losses of over $3 billion.

• Archegos Capital is believed to have lost all $15 billion of its estimated assets.

This financial story is an exact replica of every other leverage implosion in history. The result has zero surprise value but the quantum of loss will raise eyebrows and a few new troubling questions. The following snippets deserve more scrutiny by investors and regulators:

• Archegos Capital was not regulated as it was categorised as a ‘family office’.

• This family office was able to use relatively well known derivative instruments(CFDs and Total Return Swaps) to massively increase its bets.

• The estimated notional value of Archegos’s portfolio was as high as $100 billion, backed by just $15 billion of its own capital. The rest was borrowed. And here’s the worrying thing.

• The banks who provided up to $80 billion of combined funding to Archegos seemed to have no idea that the same $15 billion of capital was being used multiple times as collateral with each bank. Imagine a house being mortgaged 5-6 times except, unlike a house, this portfolio was yo-yoing in value by 5-10% on a daily basis.

So perhaps, the new twist in this tale of banking greed(versus risk curiosity) and leverage was the category of borrower and its almost total anonymity. Regulators will be particularly unnerved that a virtual “nobody” was swinging a $100 billion bat on Wall Street. The fact that pension funds who own shares in the loss making banks and the battered portfolio stocks(Viacom, GSX etc) have suffered loss will also focus regulatory minds. How many more of these secretive offices are massively leveraged?

There are believed to be more than 100 family offices world-wide who manage significant capital. My own view is that there are way more below-the-radar pools of capital out there than is currently thought. And this story has one further detail which adds a modern twist to the traditional leverage torture tale.

Archegos Capital operated out of a New York office. However, the source of its capital was Asian and the majority of the stocks in its highly concentrated portfolio were Chinese (eg GSX, Baidu, Tencent). These stocks were listed on US stock exchanges but, because derivatives were used, the brokers/ intermediaries of these instruments appeared as owners. So, in the middle of last week investors and regulators would have thought regular Wall Street players like Morgan Stanley, Nomura, Goldman Sachs, Citigroup and Credit Suisse held positions in these stocks. By Monday, the whole world and the chronically incurious lending banks discovered one Asian investment counterparty was the ultimate owner/beneficiary of huge positions in a small number of companies. Knowing me, knowing who… A-Ha!

Get ready for more leverage implosions. The story will still be the same but the cast of characters has become far more global and disguised. Think money laundering too. Leverage…loss…rinse….repeat. Hmmmmm…….

Zoom, Teams, Google and cloud technology have connected us during lockdown to the people in our professional life in a hugely effective manner. But, one aspect of this remote work flow is often overlooked. We usually know the other person or people in the interaction. Throw in audio visual technology and pre-pandemic communication via phone or email almost feels sensory deprived. Superior connectivity is a positive fact of business communication, but what about knowledge? Specifically, who are you dealing with?

Now think about those using or working in financial services. Know Your Customer(KYC) requirements are a fundamental step in conducting any regulated financial transaction. Yes, the process can sometimes be frustrating and time-consuming, but this week’s newsflow had a striking cluster of stories highlighting the serious risks when KYC processes fall down. There also might be a very current twist to these KYC failures. Let’s take a look at the headlines.

German regulator takes oversight of Greensill Capital as crisis deepens – The Guardian

The huge Wirecard scandal seems to have prompted the normally somnolent German regulator, BaFin, to adopt a more proactive approach in this complex story. Greensill Capital and its banking entity in Germany were a very big player in a niche banking activity known as supply chain finance. It’s a $1.3 trillion market, and Greensill was the innovation leader, providing $150 billion of funding to millions of customers since its inception in 2011. Greensill now faces collapse in multiple jurisdictions from Australia to the UK. And the cast of characters in the story is fascinating; the likes of Credit Suisse, David Cameron, BaFin, the UK government and Softbank are the headline names but the critical counterparty is less well known.

It appears Greensill Capital had an outsized, over-exposed, financing relationship with the Gupta Family Group(GFC). The Gupta business portfolio includes the huge Liberty steel group and Wyelands Bank, with the former a hungry recipient of funding from Greensill. The German regulators were not comfortable with the concentration of Greensill’s risk/exposure to one group(GFC) and froze payments in and out of its German banking subsidiary. The picture emerging is that counterparties who thought they were dealing with Greensill were actually funding GFC. Credit Suisse have taken fright and suspended their $10 billion fund JV with Greensill. Tokio Marine acted even earlier pulling insurance policies on Greensill assets. These policies expired on March 1st and dramatically accelerated events.

Greensill is currently hurtling towards insolvency with Softbank writing off their entire $1.5 billion investment in the group. When the litigation teams pick over the carcass of Greensill there will be two key questions. Did counterparties really know Greensill (and its GFC relationship) and should they have known? In Ireland the regulators are answering this question rather emphatically in a very different case of misidentification.

Davy’s CEO steps down after bond deal revelations – The Financial Times

The choice of an international press headline is deliberate. For Irish readers, another tale of financial chicanery won’t exactly stun a nation previously skewered by apparent greed in financial services. However, the story will resonate with international readers on two levels. First, this story emerged from another private deal in the debt markets. Second, there’s a new global sheriff in town.

For transaction context, private debt deals, unlike shares trading on exchanges, are more difficult to monitor and prone to poor visibility/discovery of “fair” prices. So, there are occasions when prices found for clients can subsequently be perceived as unfair, and lead to dispute. Sure enough, a client of Ireland’s pre-eminent stockbroker, J&E Davy, wasn’t happy with a price he received for Anglo-Irish debt instruments he sold back in 2014. The twist here was that the counterparty who made a significant profit at the client’s expense was his paid advisor, the firm itself, J&E Davy. More specifically, a consortium of Davy employees, turned out to be the purchasing counterparty but was never identified as so to the client.

For those that think it would be pretty common for clients not to know the identity of their counterparty they would be almost correct. In this case, the status of the consortium, as advisor to the client, opens up a huge can of worms regarding a potential conflict of interest. Potential, but not actual, the accused firm might have argued. But no. Unfortunately, the J&E Davy compliance department were kept in the KYC dark for 4 long months. If all was tickety-boo, compliance would have known the true counterparty ID on the day of the deal. Now, back to the sheriff.

The titular regulatory sheriff in Ireland is the Central Bank who brought an enforcement action and slapped a €4.13 million fine on the miscreant firm. Seasoned local observers were expecting the ample-necked Dublin outfit to make the usual do-better-next-time PR noises and move on. Not so this time. There’s another sheriff, a bigger one. All governments, banks and companies are signing up to do better in the areas of Environmental, Social and Governance compliance (ESG) at the behest of regulators and asset managers. The big stick being used is international capital flows.

As much as $70 trillion of investment funds now claim to be paying significant attention to ESG compliance. So, Davy’s pretty awful first step in “no heads” PR repair was quickly overtaken by much bigger player concerns. The Irish state’s financing arm and key sovereign bond client counterparty, the NTMA, issued a statement with an accusation of a “breach of trust”. Big corporates, including Bank of Ireland, expressed similar concerns in public and private. And heads are now finally rolling down Dawson Street. The new reality is that states and corporates across the globe have to make real efforts to ensure their commercial eco-system is adhering to similar ESG frameworks. ESG is a game-changer which is increasingly occupying the minds of board directors and executives. Arguably, knowing your client (KYC) is one of many relationship hurdles which have become much more complicated. And if that’s complicated try this….

ARK funds fall into bear market – The Wall Street Journal

This writer first came across the ARK group of funds and its leader, Cathie Wood, in early 2020. At the time this US investment team was taking big bets on innovation darlings like Tesla, Zoom, Shopify, Teladoc and Roku. Total funds being managed by Wood’s team were a little over $13 billion. Fast forward to last month and the fund family was managing more than $50 billion! This was the hottest fund family with the hottest stocks. However, the number of stocks in the portfolio didn’t grow as fast as the fund flows so positions in some stocks have become very heavy e.g as much as 10% of Tesla. That’s not too bad in a rising market as lots of buyers chase up a limited number of available shares. The reverse is not so pretty.

A weaker NASDAQ and jittery bond markets has prompted a vicious 23% fall in the underlying value of the ARK fund holdings. Lots of sellers, right? But there’s more, as in more sellers than you think. Did buyers/clients of the ARK funds know there were other funds mimicking(under licence from ARK) the trading strategy and portfolio? We are now hearing that Japanese fund giant, Nikko, has billions of client funds copying the ARK strategy. So, there are now certain individual stocks in the ARK portfoio where Nikko and ARK combined own up to 25% of the entire share capital. Some of these stocks are illiquid and recent memories of the Woodward debacle in the UK should focus regulatory minds. In simplified terms, investors may ultimately take the view that they should have been told the ARK investment strategy was really an ARK + Nikko strategy. Knowing me, knowing who…..is important.

Technology, financial complexity, ESG, connectivity and regulation continue to move forward. Probably not human behavioural failings and conflicts of interest but they remain critical franchise risks if KYC processes do not keep pace. The good news is Irish companies like Fenergo, ID-Pal and UBO Services are leading the race to upgrade KYC processes. Now it is incumbent on senior executives and board directors to show more tech curiosity in solving KYC issues. The upcoming ‘Senior Executive Accountability Regime’ is a significant step by the regulators in holding individuals to account. And remember that $70 trillion ESG stick too. A post-factum “A-Ha” from a responsible individual won’t cut it. The commercial world will just cut you.

In the London office of KPMG they might tell you to “stop moaning”. Perhaps we should. Vaccinations are coming, efficacy rates are great, schools are opening up again and spring is in the warmer brighter air. And yet, frustration is growing with a perceived lack of government urgency in returning the country to a more normal level of social and economic activity. I never thought I’d write this but my sense is a major driver of governmental sclerosis is money. No surprise there. But what if I said it was easy access to money rather than the lack of money? First, let us confirm the perception as a data reality in the following graphic (Source: Oxford Coronovirus Government Tracker) showing Ireland topping the European charts in the number of days in lockdown:

Lockdowns cost money, lots of it. Last week we mentioned that high-risk companies were raising debt (junk bonds) at all-time low interest rates. Governments, thanks to central bank support, are even luckier with borrowing costs close to zero or better(negative rates). In fact, Ireland is doubly blessed as the only European country to actually achieve positive GDP growth in 2020. Very large multi-national tech and health sectors do help. Lucky us.

But, I’m not so sure of luck over the long run. This may sound odd, but one wonders would our government show a bit more urgency and innovation if funding was a little tighter? The government is tasked with dealing with both a public health and an economic crisis. Very difficult but in recent days I am reminded of those famous words of Ronald Reagan – “The nine most terrifying words in the English language are, ‘I’m from the government, and I’m here to help’. ” The following government actions or inactions could come back to haunt us.

1. The government has announced an extension of social and economic lockdown until April 5th but has assured us “the end is truly in sight”. There was specific mention of new virus variants as additional reason for caution but no mention of shutting airports and borders. Is it just easier to lock us up?

2. As we approach one year anniversaries of pandemic lockdowns recent reports suggest NPHET have told the government additional lockdown periods are necessary until hospitals begin to reduce record patient waiting lists. Despite a wall of debt funding available to government, it would seem the Department of Health and the HSE has failed to upgrade our hospital capacity or staffing levels. Back in October our “No Funding Limits As Lockdown Bites” article made pointed reference to the lack of HSE planning for a “consistent spike in non-Covid hospitalizations through the winter months…EVERY year”. Is the government calculation that business owners are more capable of shutting businesses than the HSE is capable of delivering a public health system which is fit for purpose?

3. The SME sector employs one million people. It is the crippled arm of our K-shaped economic recovery but the government seems incapable of articulating an effective capital support strategy for SMEs. There are lots of supportive words, even credit guarantee schemes, but the dogs in the empty streets know there is no real urgency to bring new thinking to the crisis. The draw down statistics on the SME Credit Guarantee Scheme are damning; in the last update, just over 10% of the €2.5 billion of “available” funding had been taken by SME companies. Where is the government curiosity on this disfunctional support scheme?

4. The government is a significant shareholder in two of our three pillar banks, AIB and PTSB. And a fourth big SME player, Ulster Bank, has just thrown in the towel. Competition is now a quaint concept for business customers. Recall those Reagan words and wonder why Irish mortgage rates are double the European average. It is even worse for SME customers. A Central Bank report in October showed Irish businesses were lumbered with borrowing costs more than two and a half times the euro area average (5.03% vs 1.90%). After Ulster finally says “NO” what price will businesses pay for a government-owned “Yes”?

The Ulster Bank exit also provides a window into the out-dated thinking being applied to business banking. Latest reports suggest government owned AIB will buy/take over the €4 billion Ulster Bank commercial lending portfolio. Think of a world embracing the efficiencies of digital platforms, artificial intelligence(AI), remote/cloud computing and data science. Now think about the number of staff it is suggested are needed to accompany that portfolio of loans to AIB……. 300. The mind boggles. Yes, government is scarred by the 2008 financial/banking crisis but it is possible to re-invent our banking sector. A fresh(no legacy loans) well-capitalised national digital business bank operated by the best tech-savvy banking experience would be a really good start in breaking our customer-crushing image. It can be done.

Check out France, the home of recently split dance duo, Daft Punk. Some might not even know they were French. Here’s a few other things we may have missed about France in recent years. For most of my financial services life French stocks have failed to excite most fund managers – 30 hour work weeks, state-intervention and tight relationships between the national champion firms are often cited. Sounds like Reagan’s most feared form of government help. But look again, as Bill Blain at Shard Capital has done, and you’ll find there are more top 500 global companies in France than any other country in Europe. Blain thinks fund managers are missing a trick; “France could be on a roll. It has reasons to be. There are over 1 million trained engineers, 13,000 AI researchers and almost 60,000 French PhDs – all of them as dedicated to beating les Rostbifs in business.”

France has a plan. We don’t and there’s a growing sense that difficult government decisions are being put on the long finger as a hope strategy. Hope is not a strategy. And there’s some cautionary signals coming from global debt markets. Government needs to move quickly as the “Get Lucky” period of low interest rates won’t last forever. The FT headline today highlights growing debt market concerns – ‘Bond investors suffer worst start to year since 2015”. Let’s hope bond markets this time inspire some constructive urgency rather than 2008 destruction. The government need to remove the pandemic helmets and apply modern solutions to our healthcare system and SME funding. Pandemic excuses and easy money will probably end. Public anger will not.