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Hello everyone, this is Kevin. We just heard about the complete collapse that started around Tuesday last week and continues to this day. This is due to hedge fund greed, margin, the post -margin call lending crash, and the complete crash in the hedge fund market, which is reverberating throughout the stock market.
Even today, we see that stocks not only sold off massively last week, but continue to fall today. People were asking, "Wait, what the hell is going on? Could what happened to that hedge fund happen again? Are other companies at risk? Should we just sell everything and run from this disaster? Is this really a margin call that happens once a decade?
Or is this just a nice way to calm us down until the real [ __ ] hits the fan?" In this video, I'll break down exactly what happened over the past week so you can fully understand the situation, why it happened, and whether we expect it to happen again. So, let's go. First of all, you need to know about this guy, Bill.
He founded a branch of a successful American fund called Tiger Fund, and set it up in Asia. Ultimately, he managed over $5 billion in this Tiger Fund affiliate. However, they were seriously hurt in 2008 during the Volkswagen short squeeze, and a few years later they decided: you know what, we'll close the Tiger Fund in Asia.
Bill Hwang was the head of Tiger Fund in Asia. It was like a GameStop short squeeze, but then it was Volkswagen. This seriously crippled them. So, in 2012, I'm really compressing the story, okay? Because it's not that important, but we'll deal with it. So, in 2012, they decided: you know what? We no longer want to be a regulated hedge fund.
Let's refund everyone who invested in our fund, and, you know, there are some allegations that we may have engaged in insider trading; Let's plead guilty, pay the $44 million fine, and take the company private so we don't have to deal with these damn regulators anymore because they're constantly pressuring us.
That's exactly what Bill did. it became private. And this has been a very common occurrence over the last decade. We have seen many hedge funds transform from hedge funds, which are much more heavily regulated by the Securities and Exchange Commission, to simply private family funds. You see, family foundations only work with assets directly belonging to the family.
So you really need to put together a kind of family tree and say, look, we're all connected in some way , all the people who are invested in this. And because we are all connected, we are all good. We don't need to reveal that much . That's one of the big advantages of a family foundation—you can hide a little more from regulators because the Securities and Exchange Commission does n't care whether what you're selling is good or not.
All they care about is that you are honest with the public about what you are selling. But if you sell to people within your own family, they don't care too much, because if you want to rob your own family, that's your business. And that's exactly what happened here. Except that Mr. Bill William decided to call this foundation Archegos.
And Archegos now had about $10 billion in assets under management , and that sounds like a family that I kind of want to be a part of, because I want a piece of that $10 billion, but I don't want to be part of shady dealings. And it is precisely about these dubious matters that we will talk here. I'm just saying, a family with 10 billion.
There's enough money for everyone when you have a family with 10 billion. Okay, that's a lot of money. But, in any case, here's what probably happened. So, Mr. Bill had about $10 billion in assets. That's pretty much what we know now. Honestly, there could have been much fewer of them. And Mr. Bill decided to use a very common hedge fund tool known as total income swaps.
By the way, they are sometimes also called total return rate swaps. And it will become clear in a moment, or cash- settled stock swaps. I personally think the easiest way to remember what these swaps are is to simply think of them as total rate of return swaps. This is very useful, and it will all become quite clear when we look at an example, because literally you are exchanging rates of return with someone.
And the reason I like the name " total rate of return swap" is because that's how I think about it. Let's say I agreed to pay someone 4% interest, but then they made 15% on a certain stock. Suppose I could take these interest rates and exchange them. I'm like: give me 15%, and you keep the interest rate.
And now the same thing works in reverse, which can also be dangerous. So we'll talk about this example, but a total return swap will help you understand this a little better , because it's a little bit confusing here, and you can see exactly what happened. Okay, the best thing to do now is just to go to an example and show how these things work.
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Okay, the commercial is over. So, here's how it works. Archegos says, “Hey, we have $10 billion in cash. We want to buy a swap from you.” And the cool thing about swaps— because we're a hedge fund and risk people, we want to use a lot of leverage. We want our $10 billion to actually control about $ 30 billion, because wow, if we get a 10% return on $30 billion, that's like making $3 billion in profit, whereas if we were just using our own money, we'd only have a billion dollars in profit.
Yes, leverage. Aha. Oh , but wait, leverage works both ways. So it's not always as simple and profitable as it seems. So what's happening here is exactly how a swap works. And remember how I talked about that total return swap? Okay, this is going to be very interesting. So what happens here is this: Archegos says, “Hey, you know what?
Why don't we pay you 3% interest on top of the value of your capital? What could be, let's say, LIBOR at 2.8%. These are standard indicators , you can look at what the one-year LIBOR is now. Okay, this is just a basic concept of cost of capital that banks use. Don't dwell on this. Essentially, Archegos is saying, "Hey, we'll pay you 3.28% interest." "And we want you to take our $10 billion as collateral and use it to buy $30 billion in stock in, say, Viacom, because we really believe in the growth of Viacom." And banks like Credit Suisse, Deutsche Bank, Goldman respond: "Okay, that sounds good." "We get our 3%." "And, if your stock goes down, you'll pay us." "If they grow up, no problem." Like, you pay anyway, that's the theory.
So the bank seems satisfied: cool, we're earning 3.28%. And the goal is that there is almost no risk, because if the value drops, we will simply call you and make a margin call. That's in theory. So the bank thinks: cool, we'll make money on interest, and Archegos: cool, we'll be able to increase our capital.
In fact, this is a very, very common phenomenon. It happens constantly. And it works something like this . Let's draw a line here. The easiest way to understand this is through a simple example. Let's take that $30 billion, and let's assume the market grew by 20%. Suddenly, that $30 billion yields a 20% return, which equals $6 billion in revenue.
Well, here you have this 3.28% interest. So, let's take $30 billion and multiply it by 3.28% interest. Let's say a year has passed . That's 984 million. And this is exactly 3.28%. So in this case it was a profitable swap because Archegos says, "Great, we have a swap contract." " So please, let's share these profits." "Bank, you get a payout of 3.28%." In other words, you get $984 million and we get $6 billion.
Thank you very much. So, we paid a commission for that $6 billion . We got our $6 billion . It cost us $984 million . Perfectly. Class. A very, very profitable deal. And that's exactly how these swaps work. But what if the opposite happens and the situation is even worse? So let's assume the opposite happens.
Now we have $30 billion in Viacom, but suddenly the stock is down 40%. Well, damn it. This is minus 12 billion. So technically, on the $30 billion here, interest payments, we still have $984 million, uh, but the banks say, " Okay, we need to do a swap." Let's do a swap. We get 984 million. You have to take $12 billion in losses because the stock went down.
And now we will make a swap for 12 billion. The bank gets $984 million." That's how it's supposed to work when things are going bad. But wait a minute. Wait a minute. Big problem. Archgo only has $10 billion. So they're "in the red." They get a margin call because the banks say, "Hey, your stock is going down ." You need to find capital.” Archgo says, “Yeah, we don’t have enough to cover how much they just dropped.” And Goldman, Deutsche Bank , Credit Suisse say, “Uh, okay.
Selling Viacom." And so they're just selling these stocks in batches or in bulk at a discount to get rid of them and protect themselves from further losses. Okay, but this is just an example, right? This is just a hypothetical example . Yes, that's true. This is just a hypothetical example. But guess what happened in the market over the last few weeks?
Stocks have been pretty volatile, especially certain Asian stocks like BU, or even other companies like NEO, have been feeling pretty tough as well. But, uh, this particular fund invested in companies like Tencent and BYU, which have also been feeling the pressure lately. Also, they invested in Viacom, a stock that's been up over 600% in the past year.
It was just incredible, until, of course, they decided to raise some money, sell some of the stock, which caused the price of the company, or the stock price, to plummet; and it suddenly fell 27.9% or so , on top of all the other, uh, the price drops that this fund faced. Which made the banks say, "Hey, you're running out of money." Margin call time, my friend." And then what happens?
They run out of money. The banks say that's it. We're going to sell these stocks, and they're going to go even lower. So this is an example that has come true. Archgo took about $10 billion in assets, leveraged them to $30 billion. When the swap went wrong, they didn't have enough money to cover it.
And there wasn't enough disclosure for the public or the SEC to even understand what was going on , because they're a family trust that, in effect, in the shadows, had taken over 10% stakes in some of these companies that were being sold off, because technically they didn't own the stock. Technically, the banks owned the stock.
And that's how they got into trouble. Now, what are the risk factors here? Because look, Credit Suisse just lost $2 billion. Well, Nomura, another fund, they're also losing a lot of money because they were involved on the other side of this swap. Goldman Sachs says their losses are insignificant, and Deutsche Bank liquidated the assets early.
By the way, another problem is that apparently several of these banks looked at the Archegos collateral and were like, " Oh, you have 10 billion? Sure. We'll lend you that much, essentially, in a swap." And they were all essentially referring to the same original 10 billion. So it's possible that that 10 billion was leveraged much more than usual, or it's possible that they actually had less than we thought and were able to leverage it much more than usual .
So there's a big transparency problem here. And in a way, it's like, how does the guy at Goldman know that this client also securitized the same cash collateral at another bank? It's hard to know because the system is n't really transparent, right? It's a disaster. Anyway, now we kind of know what happened.
Now we have to ask yourself, what is the risk of this happening again? Is this the beginning of the end, so to speak? Well, look, it could happen again. This kind of thing is perfectly normal. It's the same crap that happened, pretty much the same crap that happened in 2008, except in 2008 it was mortgage credit default swaps .
So when mortgage values collapsed, all those swaps were wiped out, because suddenly a $10 trillion mortgage market was leveraged not three times, like Archegos, but nine times, to a $90 trillion market. It was a huge balloon, a huge bubble that burst instantly. So what is the risk going forward? Well, I mean, the reality is that hedge funds are still what they are.
They are often reckless gamblers who over- leverage, over-compete and poorly regulated because of all these shady, toxic, and obscure products that exist with huge incentives for short-term profits. What that means is that when they lose, everyone else ends up being the fools and absorbing the consequences, because the hedge funds and all these players who are making huge short-term bets on huge leverage don't care about anything except wanting to hit the jackpot and be somebody when they get lucky one day.
But when it goes wrong, it goes downhill very quickly. That's why people like Warren Buffett say, "Don't get into too much debt." That's why I say, look, if you're going to use leverage, keep it below 20 %. 20%, folks. So for every dollar you have, maybe 10 or 20 cents, or better yet, zero . Then you don't have to worry at all.
Then you don't you'll lose sleep at night. But these guys have three or four dollars in loans for every dollar they have. It's just ridiculous. That's why when you suddenly turn on CNBC or something, the guys in suits say, "Yeah , we're moving into this sector." They do it because every dollar they can raise a stock is like three or four dollars in their pocket.
That's huge leverage. And it's no wonder these lousy hedge funds are constantly rebalancing and taking margin calls, because they're always on the edge, because money is so cheap. Everyone is borrowing more and more money, and it's really dangerous. Now, do we think that this is going to happen more often because of this?
Should we expect any repercussions or repercussions in the rest of the system because of this? Probably not. Probably not. If other dominoes were going to fall , they would have fallen a long time ago. Mainly because we already had Credit Suisse, and the banks say, "Look, we've absorbed the losses. That's it.
Let's move on." That doesn't mean there aren't other Archegos or Araos out there. It's possible that there are more of them out there . In fact, you can almost guarantee that there are, and that's just in the family hedge fund business, right? Or maybe not hedge funds at all, but family funds. Although hedge funds do this kind of thing regularly too.
Now they have to be a little more transparent, but so what? Even if they disclose their assets, that doesn't necessarily mean that anyone is going to really care until [ __ ] hits the fan. So, yes, markets are very, very vulnerable, and the reason for that vulnerability is often the use of leverage.
So take care of yourself. Try to have as little leverage as possible. Ideally, zero leverage on stocks. Ideally, no more than 65% leverage on income-producing real estate. You can just keep investing for the long term, watch all these panickers go crazy, and just buy the dips. Thanks everyone. Thanks for watching. If this was helpful, please share this video. See you guys in the next episode.
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