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Financial Fictions: The Old Ones

In recent months, we have seen financial meltdowns from Archegos Capital and Greensill Capital. Marxist economist Michael Roberts dives into the fictitious capital behind these events.

Michael Roberts

April 13, 2021
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Photo: Bloomberg Daybreak

Originally published in The Next Recession.

I must declare an interest. In days of old, many moons ago, I worked for an investment consultancy that advised Bill Hwang, the owner of Archegos, the ‘family office’ hedge fund that recently collapsed, leaving $20bn owed to two big banks, Credit Suisse and Nomura.

Hwang was then a ‘Tiger cub’, someone that veteran hedge fund manager, Julian Robertson of the pioneering Tiger hedge fund showed favour on with ‘seed’ investment capital. After leaving Tiger, Hwang struck out on his own back in 2001 to great success. But then there was the first scandal when in 2013 Hwang was barred from the US investment business. Authorities alleged that, as part of an insider-trading scheme, his Tiger Asia Management hedge fund had violated promises it made to some of the world’s most powerful investment banks.

But no matter. Hwang, a pastor’s son and deeply religious, soon re-invented himself to do God’s work’ in financial speculation. Hwang has credited his faith with helping him get through the difficult times. After Tiger Asia’s demise, he said that he had listened to recordings of the Bible for hours.

On getting God’s word, he set up what is called a ‘family office’, Archegos Capital Management, and eventually built up its trading positions running into the tens of billions of dollars with Wall Street banks, including some of the ones his old firm was accused of cheating. Hwang’s downfall came last week when he was unable to meet margin calls on derivatives trades, known as equity swaps, that he had struck with several investment banks. These instruments gave speculators the option to gain from stock positions without having to own the underlying shares himself. As Marx put it some 150 years ago in Capital, “Profit can be made purely from trading in a variety of financial claims existing only on paper…. Indeed, profit can be made by using only borrowed capital to engage in (speculative) trade, not backed up by any tangible asset.”

Infographic showing the anatomy of return swaps

It seems that Hwang had borrowed billions of swaps from different banks to maximise his ‘leverage’ in betting on the stock market, without telling each bank how much he had borrowed. The Archegos Capital debacle has exposed the hidden risks of the lucrative but opaque equity derivatives business through which banks empower hedge funds to make outsize bets on stocks and related assets. “We have a fundamental problem in the reporting of holdings of synthetic equity that is not secret and is not new,” said Tyler Gellasch, a former SEC official and executive director of Healthy Markets, an advocacy group. “If there are five different banks providing financing to a single client, each bank may not know it, and may instead think it can sell its exposure to another bank if they run into trouble — but they can’t, because those banks are already exposed.”

When Archegos’ bets went south, Hwang could not meet his commitments to these banks and several were left holding the baby. As Marx said in Capital, “In every stock-jobbing swindle everyone knows that some time or other the crash must come, but everyone hopes that it may fall on the head of his neighbour, after he himself has caught the shower of gold and placed it in safety.” In this case, Goldman Sachs and Morgan Stanley got out of Whang first and Credit Suisse and Nomura did not.

You might be interested in: Covid and Fictitious Capital

The Archegos story is an old-style financial meltdown. Yes, the financial instrument involved, equity swap derivatives, is a new form of financial asset (or what Marx called ‘fictitious capital’), invented in the last 25 years. And the setting up of a ‘family office’, which is not subject to the same financial regulations (such as they are) for modern hedge funds, has become a new way of avoiding scrutiny. Hedge funds are speculative financial vehicles basically for betting (with mostly borrowed money) on the movement in the prices of stocks, bonds, commodities, and on the ‘derivatives’ of these ad infinitum. Betting companies when advertising on TV must keep saying ‘please bet responsibly’, as the regulators demand (with little effect, of course). But with ‘family offices’, usually funded by mega-rich global family fortunes, it’s even worse. There are no controls or warnings at all.

In a report issued a year ago, business school Insead noted that the number of single family offices had grown by 38 per cent between 2017 and 2019, to reach more than 7,000. Assets under management stood at some $5.9tn in 2019, the report estimated. That compares with $3.6tn in the global hedge fund industry, according to HFR. These ‘family offices’ can do what they want with their assets, without regulation. Rich families place a growing share of their wealth in these types of structures. On average, they control assets worth $1.6bn apiece, according to another 2020 study by UBS, and a handful can stretch into hundreds of billions of dollars. Typically, each family office has two or three offices, often in hubs like Singapore, Luxembourg and London. Chief executives are paid something in the order of $335,000 a year, according to the Insead report.

In the Archegos example, it seems that only the mega investment banks have suffered and not the man and woman in the street. So we may have no sympathy for them. But indirectly, we all get hit because banks are using funds, also often borrowed, to speculate in this way rather than providing a proper banking service for people. Banks lend with strict conditions on mortgages or loans to small businesses, but it seems with no control at all to the likes of Archegos, where banks can make big money if all goes well. But as one equity derivatives trader put it, equity total return swaps are “a classic case of picking up nickels in front of a steamroller… You can pick up those nickels all day. That steamroller moves pretty slowly. But if you trip, boy, do you get run over.”

In the case of the Woodford financial scandal in the UK, there has been a direct hit to people in the ‘real world’. It is more than 18 months since the implosion of Neil Woodford’s investment fund business sparked the biggest British investment scandal for a decade. More than 300,000 individuals who entrusted their hard-earned savings to the famed ‘stock picker’ are still waiting to recoup the money. Many have had to delay retirement after nursing tens of thousands of pounds of losses. The UK’s Financial Conduct Authority, the supposed financial regulator, failed miserably to spot the Woodford crash. Woodford was once lauded as “the man who can’t stop making money” and “Britain’s Warren Buffett”. But great stock speculator was forced to suspend trading in his £3.7bn flagship Equity Income fund after failing to cope with a surge of investors reclaiming their cash. Investors stand to lose up to £1bn — more than a quarter of the fund’s value at suspension.

Then there is Greensill. This was a ‘fintech’ bank set up by former Morgan Stanley and Citibank executive, Lex Greensill. It specialised in ‘supply-chain financing”, ie ‘reverse factoring’ where the buyer chooses invoices that the financing ‘factor’ (Greensill) will pay for them early – that’s the opposite of factoring where the supplier chooses the invoices that it wants paid early by the factor. Supply chain financing speeds up transactions in a fast moving global market. But ti puts the burden of payment on the factor. Lex Greensill’s revolutionary innovation was to go one step realise and package these invoices into investment funds to be sold to banks — much as the big investment banks turned subprime mortgages into securities before the 2008 financial crisis.

Greensill also took deposits to invest in its apparently lucrative operation from companies and local councils, offering high rates and finding funds and loans for clients when big banks would not lend. It sprouted fast and took on exposure in loans worth $143bn by 2019 with ten million customers. In particular, it provided funding for metals magnate Sanjeev Gupta, who owns the third biggest steel company in the UK.

But Greenshill went bust because it could no longer find sufficient financing for its ever-expanding loan commitments and high deposit rates. Gupta’s steel workers could now lose their jobs and German local councils could take a $500m hit.

The scandal is still unfolding as it seems Greensill never had sufficient funding to take on the huge liabilities (debts) that the likes of Gupta’s steel companies had. Worse, it also seems that Gupta’s companies were using invoices to raise loans from Greensill that were issued by other parts of the corporate complex – in other words, claiming potential receipts as collateral to Greensill that were really debts owed by other parts of the company! Meanwhile Gupta’s group company was receiving state-backed emergency Covid loans to tide its businesses over during the pandemic. Thus Gupta completed the purchase of a £42m London townhouse. Gupta is now believed to be in Dubai. The UK government under Boris Johnson may well be forced to ‘nationalise’ Gupta’s Liberty Steel to save the business. It has drawn up a contingency plan to run Liberty Steel using public money while searching for a buyer. So this financial meltdown will be resolved with the British public paying up, similar to how the Treasury supported British Steel in 2019 at a cost to taxpayers of nearly £600m.

So nothing has changed from when Marx wrote about “a new financial aristocracy, a new variety of parasites in the shape of promoters, speculators and simply nominal directors; a whole system of swindling and cheating by means of corporation promotion, stock issuance, and stock speculation.”

In the rise of finance, “All standards of measurement, all excuses more or less still justified under capitalist production, disappear. … since property here exists in the form of stock, its movement and transfer become purely a result of gambling on the stock exchange, where the little fish are swallowed by the sharks and the lambs by the stock-exchange wolves.”

What is new are the forms of these swindles. There has been a huge rise in what is called ‘shadow banking’, ie lending and funding by non-banks (NBFI), which has expanded hugely since the end of the GFC and is now nearly half of all financial ‘assets’. Our new financial moralist, former Bank of England governor, Mark Carney, warns that : “more than £20 trillion of assets are held in funds that promise daily liquidity to investors despite investing in potentially illiquid underlying assets.” Carney reckons that funds like those run by the disgraced manager Neil Woodford “are built on a lie and could pose a threat to the global economy. These funds are holding assets that are hard to sell in a hurry – while allowing investors to take their money out on demand – are a mounting risk to the financial system.”

Back to Marx here. “The two characteristics immanent in the credit system are, on the one hand, to develop the incentive of capitalist production, from enrichment through exploitation of the labour of others, to the purest and most colossal form of gambling and swindling.” So the finance sector carries on just as before, engaging in speculation and regulators cannot and do not stop them.

As global stock markets hit new all-time highs and central banks continue to provide almost unlimited supplies of credit money into the financial sector, in the second part of this discussion of financial meltdowns, I shall review some new financial fictions and their inevitable meltdowns.

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