It’s tough to know how much leverage is in the market until everyone needs liquidity at the same time.
As the 2008 financial crisis and the recent Archaegos blow-up demonstrated, leverage can quietly gather in odd corners of the market.
I mean, who would have thought a bunch of media stocks like Viacom or Discovery would be at the forefront of a liquidity event?
Before we move on, let’s roughly define leverage, because it means different things in say, the software world, than it means in financial markets.
In this piece we’re going to analyze the level of leverage currently present in markets through transparent data sources, as well as try to estimate where the hidden leverage lies.
The Dangers of Leverage
The dangers of leverage brings us back to the most basic practices in finance: lending. Banks lend and customers borrow.
Unsecured loans are based solely on creditworthiness. If the borrower defaults, the bank is out of luck. Secured loans lend against collateral, meaning that in the event of a default, the bank has some assets tied to the loan that they can seize to reap some of their losses. This is how mortgages work.
When things go bad, like they did in 2008, the value of customer collateral declines. So banks need more collateral so they don’t lose a bunch of money in the event of a default.
When banks demand more collateral from borrowers, borrowers have to either default on the loan or raise cash in some other way.
They typically raise cash by selling other liquid assets they have. When everyone is selling their liquid assets at the same time, it puts further downward pressure on prices across the board, contributing to a recession.
Borrowers are tapped out and either sold their assets at bargain bin prices just to satisfy lending requirements, or they defaulted on their loan and are now broke. Banks lose a ton of money because a bunch of their loans go bad.
So you can see, how if we turned up the volume on this mechanism, and people borrowed a lot more than they can afford to, and banks wrote the loans, how that negative feedback loop could even nastier.
There are plenty of elegant explanations about how the 2008 financial crisis occurred, but at its most basic level, it was a problem of too much leverage in the financial system.
Today, we’re going over sources of dangerous and potentially hidden leverage in today’s financial system.
No, we’re not making 2008 references to say that today’s financial system is in a similar situation, instead, we’re just using it to illustrate the dangers of leverage.
To start, we will review some publicly available data on margin debt from FINRA.
Margin Debt Balances at an All-Time High
One figure we do have transparent access to is the aggregate quantity of margin debt at FINRA-registered broker dealers. FINRA is the self-regulatory agency that regulates the security industry, among their mandates is to regulate registered broker-dealers.
FINRA makes these registered broker-dealers report certain data about their customers to ensure compliance with regulations, and one of those pieces of data is the level of margin their customers are utilizing.
This data essentially shows us how much debt investors are into their brokers via margin debt. It answers the question of: how much capital are customers using that isn’t their own? This number has been steadily growing since FINRA started collecting the data in the late 1990s.
Below is a chart we made with a logarithmic scale of the aggregate debit balances in FINRA broker-dealer customer margin accounts going back to 1997.
As you can see, the level of margin debt oscillates with the market itself, but on the whole, the number has been steadily marching up over time and is currently at all-time highs.
Interestingly, since the 2020 stock market crash, we’ve seen margin debt accelerating at levels not seen since the dotcom bubble. The chart is going parabolic, indicating people really ramped up their use of margin after the coronavirus crash.
A decent portion of this ‘new’ margin debt accumulated in the system is likely a result of the new breed of retail investors who started trading in 2020. Their trading strategies are very aggressive, frequently utilizing maximum margin and concentrating their capital into one position.
Up until fairly recently, financial pundits suggested that retail’s influence on the market is overstated, and that their capital base is too small to move the market. But time after time, retail has proven otherwise.
In the same way that a market index like the S&P 500 can tell us a lot about how the average stock is performing, we can think of this FINRA margin debt data in the same way. If clients are borrowing a lot of “vanilla” margin from their brokers, then you can bet there’s increased risk taking throughout the financial system.
Which takes us to the next dangerous source of leverage in the markets: securities lending.
The Underbelly of Wall Street: Securities-Based Lending
Securities-based lending is an opaque business with little public disclosure.
A key distinction.
There is securities-based lending, and there’s securities lending. Securities-based lending is when an investor borrows cash against shares of stock that they own. Securities lending is when an investor borrows shares of stock in order to sell it short. They’re two distinct parts of a bank.
The basic way a securities-based loan works is that a long-term investor has a large position in a stock, let’s say $10 million worth of shares.
This investor wants to buy a $2 million yacht but doesn’t want to sell his shares (which would trigger capital gains taxes) and doesn’t have the cash on hand. So he calls a bank and organizes a securities-based loan.
The bank will lend the investor a certain percentage of the value of the shares, with the shares serving as collateral in the event of a default.
The percentage depends on the creditworthiness of the borrower as well as the quality of the collateral. A bank is going to be comfortable loaning a higher percentage of the collateral against a large holding in the SPY ETF, then, say, a random OTC penny stock.
The investor (borrower) pays interest on that loan as you would on any loan like a mortgage, the collateral is just securities instead of real estate.
As mentioned, there is little public disclosure required for securities-based lending. Whereas when an insider of a publicly traded company must disclose when they buy or sell their own stock, there is virtually no required public disclosure for borrowing against those shares. Insiders
Let’s be clear, we’re not talking about securities lending for the purpose of short-selling, which is the situation where the investor borrows the shares to sell them short. In securities-based lending, it is the opposite.
The investor borrows money and pledges their shares. And it’s likely that the banks lend these shares out to short sellers to tap another source of revenue from the loan, but we’re talking about investors borrowing cash against their own shares.
The Role of the Retail Investor
The post-2020 retail investor is dramatically different from the retail investors that came before. Before the coronavirus crash, the average retail investor had more than $100,000 in their account and was mostly invested in index funds and other passive vehicles.
But then the market crash happened and everyone was locked in their homes for months on end with nothing to do. As Bloomberg’s Matt Levine would say, “instead of going to bars and parties, people traded stocks and options to pass the time.”
According to JMP Securities, the average Robinhood account was worth between $1,000 and $5,000 in 2019.
Compare this to the average Charles Schwab account, which has about $267,000 worth of assets. And because a 10% annual return on a few thousand dollars is boring, this new breed of retail investors prefer to take significant risk with the hope of multiplying their money quickly.
The primary strategy employed by this new breed of retail investors is buying out-of-the-money calls in speculative names like GameStop (GME) and AMC Entertainment (AMC).
While the buyer of these OTM calls doesn’t incur any margin debt because you can’t buy options on margin, additional leverage is added to the system when traders buy these options enmasse because options dealers have to take the other side of their trades.
The Gamma Squeeze
Options market structure experts like Brent Kochuba infer that most of the crazy moves in the “Reddit stocks” like GameStop (GME), AMC Entertainment (AMC), and Clover Health (CLOV), are a result of this phenomenon playing out in the options market, rather than purely the result of increased buying pressure in the underlying shares.
It’s a case of “the tail wagging the dog,” where the derivatives of a stock drive moves in the underlying stock rather than the opposite, which is the norm.
Fully explaining the influences of the options market in these stocks is beyond the scope of this article, but the basic explanation is that every action creates an equal and opposite reaction.
When investors cluster together and buy a bunch of out-of-the-money calls in, say, GameStop, the market makers who sold them those calls, must go hedge their sales in the underlying shares, creating upward buying pressure.
Then, as the price moves, they must adjust their hedges as those options they sold get closer to being in-the-money. A feedback loop is created.
This is the “Gamma Squeeze” that you frequently hear about on Twitter, Reddit, and even CNBC nowadays. It’s a situation where options market makers are forced to continually buy shares of a specific stock.
Are these market dislocations a source of leverage? Not directly.
After all, market makers’ positions are hedged, even if they’re losing lots of money on those hedges. And the option buyers (Redditors) are buying outright options which don’t require borrowing on margin. However, it’s a level of increased risk taking from a new population of investors, which probably creates leverage somewhere along the chain.
Hidden Leverage in the Derivatives Market
Back in May, a family office managed by a former Tiger Cub called Archaegos went belly-up. It was reported that they borrowed billions from their prime brokers to establish highly leveraged positions in media stocks like Viacom (VIAC), Discovery (DISCA), and Tencent (TME).
Instead of buying a bunch of shares, Archegos entered into total-return swaps (also known as contracts-for-difference) with their prime brokers. These are OTC derivative contracts that their broker structures, which allows them to have exposure to the reference security without actually owning the shares.
Put simply, it worked like this: imagine you want to buy $1,000 worth of Viacom (VIAC) stock while only putting up a small fraction of that in margin, let’s say $200.
You put up $200, which your broker holds as collateral. Your broker then buys $1,000 worth of VIAC and holds it on their own balance sheet. Why would brokers do this? Because they’re paid fees, and to keep a good relationship with the client.
Archegoes essentially controlled multiples times their assets in stock through these derivatives. The precise figure is unknown, but HedgeWeek reported that they were able to get extended leverage from six different prime brokers, against the same collateral.
And then one day, on March 22, 2021, ViacomCBS announced a secondary issue of their stock.
Now, investors really don’t like secondary offerings because it dilutes their ownership in the company. Stocks tend to fall after the announcement, but, if the offerings are done intelligently with minimal dilution, the price decline is typically recovered quickly.
However, this secondary offering caused massive unexpected knock-on effects.
We don’t know exactly what happened, but it looks like the drop in Viacom’s stock triggered a margin call against Archegos, forcing them to liquidate their holdings in other stocks to raise the cash in other stocks.
The liquidations in their other holdings caused a cascading effect that caused their entire portfolio to tank in value. See the chart of Archegos’ portfolio below; Bloomberg estimates it dropped 46% in value in a few days’ time.
So these derivatives supplied this extremely aggressive hedge fund an enormous source of leverage that nobody but the prime brokers knew was so concentrated in such a small number of stocks. And even the prime brokers reportedly didn’t know that the fund sourced leverage from several different prime brokers using the same collateral.
This hedge fund being a family office without outside capital, it’s very unlikely that this is an isolated situation. It’s almost certain that other hedge funds have access to this level of leverage.
For the last few decades, the global economy has been experiencing a consistent boom and bust cycle in which the economy is very strong for roughly eight years, then crashes aggressively, only to recover within a couple of years to repeat the cycle again.
Even before the coronavirus crash, it’s safe to say that many investors were looking over their shoulder, as the recent cycle suggests a crash is “due.” Now that the economy is roaring back after a long period of lockdowns, you can’t be blamed for looking for the piano to drop on your head.
So while we’re not making a prediction or forecast here, we’re just compiling some of the most dangerous accumulations of risk right now. These are a few key factors to keep your eye on should cracks start appearing in the financial system.
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