Awareness of a Leveraged Situation

The name was quite appropriate.  The situation at Situational Awareness (SA) brought plenty of awareness to the pros and cons of leveraged investing.  Today’s situation involves dealing with the aftereffects of yesterday’s aftermath.

As we noted yesterday, we saw a substantial relief rally after media reports stated that a single hedge fund, later reported to be Citadel, took over SA’s positions in a deal with that fund and its prime brokers.  The rally was quite understandable.  A forced seller was removed from the market, immediately improving the supply/demand characteristics of a cadre of key stocks.  That’s undoubtedly good news.  Whether the market was appropriately exuberant, or irrationally so, remains to be seen.

The key to that prior paragraph is that the prime brokers, reported to include Bank of America (BAC), Goldman Sachs (GS), and JPMorgan Chase (JPM), agreed to the deal.  It is important to understand the role of prime brokers when securities are traded on margin.  They are the ones lending money to their customers and holding those customers’ securities as collateral for those loans.  If the value of those securities goes up, that means that the collateral is more valuable and the customer can thus borrow even more against them.  In the case of a hedge fund that grew from $3 billion to as much as $45 billion in mere months, some thanks to inflows of as much as $20 billion, but much of it from stellar performance, there was plenty of opportunity for SA to continue adding to profitable leveraged investments.  Its prime brokers were undoubtedly quite willing to facilitate that growth.

But there is an important feature underlying that relationship.  It’s profitable for everyone involved when the stocks are going up but nasty when they’re not. 

When stocks are rising, the fund is of course making money from its investments, and its prime brokers are profiting from lending money and charging fees to an improving customer.

When stocks are falling, the value of the collateral underlying those loans is decreasing.  If the market value of that collateral falls below the amount required to backstop the loans, the nature of the relationship between the prime broker and the fund changes.  Rather than being the relatively passive financiers and executing brokers that they are during good times, the prime brokers now find themselves at risk.  To be blunt, they were always at risk, but they didn’t need to do much about it.  Now, they need to take action to protect themselves. 

That action can be undertaken in a few ways.  The brokers can of course ask the fund to pony up some more assets to backstop the loans, but a fund that is already fully levered probably doesn’t have much free cash available.  The other recourse is to sell shares to raise cash.  Some firms, including one that you are likely to be familiar with, don’t wait around for the first option – they liquidate positions when collateral becomes insufficient.  Unfortunately, this measure becomes problematic when the fund’s positions are so large and concentrated that the act of liquidating them further weakens the collateral backing the remaining loans.  A particularly nasty feedback loop can ensue, and that appeared to be the case at SA.

Therefore, it was quite a relief for investors in SA’s biggest positions to see that feedback loop broken.  And yes, that sort of relief should have been greeted with a substantial rally.  Was that rally too much too soon?  I’ll argue that Citadel doesn’t think so.  Ken Griffin owes a big thank-you to the investors who paraded into SA’s beaten-down holdings, thus giving his fund a likely double-digit percentage gain on that trade in less than one day.  (I wouldn’t hold my breath waiting for one.)   

Should that rally continue today?  Investors have fallen back into love with the Mag 7, thanks to the recent cloud-driven earnings reports of Microsoft (MSFT) and Amazon (AMZN) which have also boosted Alphabet (GOOG, GOOGL) today (and allowing them to largely ignore Apple’s big drop). 

More stocks are down today than up, oil futures and bond yields are higher, but the combination of “the correct” stocks being higher and potential month-end window dressing is keeping the S&P 500 (SPX) and Nasdaq 100 (NDX) in positive territory.  But to demonstrate the market mindset, I got some questions about why we were down during the brief period that those indexes were lower this morning.  None arose about why we were up over the past few days.  The preferred narrative remains in place, even if some key factors underlying it have become wobblier.