All posts by NY Times Bestselling author Lawrence McDonald

Larry McDonald; founder of THE BEAR TRAPS REPORT investment letter, is a political policy risk consultant to hedge funds, family offices, asset managers and high net worth investors. As former Managing Director, Head US Macro Strategy at Societe Generale, he's a frequent guest contributor on Bloomberg TV, CNBC, Fox Business, and the BBC. Larry is a NY Times bestselling author, his book "Colossal Failure of Common Sense" is now translated into 12 languages. He ran a $500 million proprietary trading book at Lehman Brothers, made over $75 million betting against the subprime mortgage crisis and was consistently one of the most profitable traders in the firm. His "Bear Traps" letter is one of the most highly regarded on Wall St. He's participated in 3 major financial crisis documentaries: Sony Pictures, Academy Award winning documentary the "Inside Job," BBC‘s "The Love of Money" and CBC‘s "House of Cards." He's delivered over 72 keynote speeches in 17 different countries, at Banks, Investment Firms, Conferences, Law Firms, Insurance Companies and Universities.

China vs. USA – The Big Tech Great Divergence, What is Underneath the Surface?

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Breaking July 9:

Biden Administration to Give Technology Mergers Greater Scrutiny

Many of the large platforms’ business models have depended on the accumulation of extraordinary amounts of sensitive personal information and related data.

In the Order, the President:

Encourages the FTC to establish rules on surveillance and the accumulation of data.

Big Tech platforms unfairly competing with small businesses: The large platforms’ power gives them unfair opportunities to get a leg up on the small businesses that rely on them to reach customers. For example, companies that run dominant online retail marketplaces can see how small businesses’ products sell and then use the data to launch their own competing products. Because they run the platform, they can also display their own copycat products more prominently than the small businesses’ products. BN

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Thank you. LGM.

An Important Message from Jason Hsu and Larry McDonald

30% off sale – “Didi Extends Drop to Fresh Lows as China Weighs Rule Changes – Ride-hailing company has lost $17 billion in value this week – China plans changes to block firms from listing overseas” – Bloomberg

The future of Chinese Tech and ADRs: What can we learn from DiDi and Ant?

Much has happened this week in the Chinese tech and ADR space. Below are our thoughts in response to some of the questions I’ve been receiving from investors and others.

“The US IPO conveyor belt needs to slow down. US banks MUST do more due diligence. With 30 more China-based IPOs in the pipeline, look for the SEC to put the breaks on any day now.”

Larry McDonald, Founder of the Bear Traps Report

China Internet KWEB vs. Nasdaq 100 NDX
Equity markets have been pricing in pain for weeks in China big tech.

Is DiDi Ant Financial redux?

On July 6th, DiDi plunged 20% following the news of (1) a formal investigation by the Chinese Cyber Security Administration and (2) a temporary removal of its app from all app stores in China. Many western investors viewed this the same as Ant Financial’s scuttled IPO last year. Their analysis started and ended with, “What did DiDi say to piss off Beijing?!”

This is far from the correct interpretation; Didi is not Ant Financial Redux. Let us explain why these two are not even close.

“The SEC should rescind the DIDI offering and protect US investors from China’s shenanigans. It’s time to protect US investors from Xi Jingping. Yet another example as to why China’s companies should BE FORCED TO ADHERE to the same standards as US companies.”

Kyle Bass, CIO Hayman Capital Management

An obvious indicator of the difference between these two is that the Chinese regulator halted the Ant Financial IPO in its tracks. By contrast, it politely waited until one week after the DiDi IPO before announcing a formal investigation. If the Chinese regulator believed DiDi’s deficiencies could not be resolved to its satisfaction or would jeopardize DiDi’s operations in mainland China, it would have asked DiDi to pull its U.S. IPO – and DiDi would have complied. The fact that it allowed DiDi’s IPO to proceed is significant.

Some have suggested Beijing has exercised enforcement unevenly against DiDi and Ant Financial, unfairly targeting Jack Ma for harsher treatment. Again, this is not the correct interpretation. For starters, Ant and DiDi are both incredibly plugged-in and aided by the most connected powerbrokers in China. Rounds of informal but deliberate conversations will have occurred and agreements reached in both cases before anything formal is announced in the press. The key difference is that for Ant Financial, the regulatory deficiency was too great to be remedied under the existing model. To the extent there is reasonable dissatisfaction with Beijing’s handling of Ant Financial, it is that the regulator waited too long to act.

Didi’s IPO was allowed to proceed precisely because, unlike Ant Financial, Beijing believed the company’s deficiencies can be remedied. The concerns regarding data privacy are easily addressable and the punishment—temporary removal of the DiDi hailing app from app stores—insignificant in the long-term. DiDi’s hailing app is, after all, already on every smartphone in China through WeChat.

There is no doubt that Beijing intended to make a point with by announcing the formal investigation. Sending a signal to other industry players is often a primary objective when there are public sanctions against the clear industry leader for industry-wide infractions. However, the issue at hand is relatively minor. The regulator was apathetic enough to be willing to agree to a delay in the formal investigation until after the IPO, and that tells you everything you need to know about the difference between DiDi and Ant Financial.

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Is Beijing going after Chinese tech firms listed in the U.S.?

Some of the issues the China regulator is investigating regarding DiDi are industry-wide, which means the government action has broader implications. This was on display when major indexes tracking Chinese tech ADRs took a major nosedive on July 6 – even though most of them had not yet added DiDi!

This is One, Unsustainable – Yet Impressive Divergence
In the USA, close to 92% of corporate profits sit in the hands of the largest 100 companies, up from 57% in the 1990s, per the Wall St. Journal. Monopoly power is on the rise as Washington is on the sidelines, for now.

Clearly, the market is reading something much bigger into DiDi’s cybersecurity investigation. Investors are now concerned about all tech firms that store massive amounts of data and perform analyses on Chinese citizens and businesses. The Chinese government, like the U.S. government, does not want those servers to run on foreign hardware and software, which could make them vulnerable to foreign spyware. Tech firms are squarely in the regulator’s bullseye.

Meanwhile, the government’s claim against many of the same tech giants for anti-competitive business practices also looms large. The Ant Financial action served to signal zero-tolerance for innovations the regulator feels may circumvent financial stability regulations. This has caused tech players to abandon one of their core business strategies—taking a slice of the massive Chinese consumer finance market while avoiding the high compliance cost of distributing financial products. This was a valuable business. So yes, it appears a revaluation might indeed be warranted for all Chinese consumer tech giants. But that is hardly due to Beijing turning anti-tech or even anti-capitalism— it is just Beijing discharging its duty as the steward of China, Inc.

It may appear to some outsiders that China is targeting the firms that have chosen to list in the U.S.. After all, many of the most highly scrutinized firms –like Alibaba, JD.Com, Meitun and now DiDi – are widely held ADRs. But this is far from the truth, and it is a matter of correlation rather than causation. Stated differently, these firms are not being targeted because they are listed in the U.S.

Most of the U.S.-listed consumer-tech firms pursued listing in the U.S. not because they were “defecting” from China in pursuit of a better venue. These Chinese firms listed in the U.S. because they could not receive approval for listing back home. Alibaba, for example, could not gain approval for listing in mainland China or Hong Kong because of its corporate governance deficiencies, where Jack Ma as a small shareholder could always out-vote everyone. DiDi also actively explored listing on the mainland exchanges in addition to HKEX before it decided those paths were nearly impossible due to their various unresolved compliance issues related to China’s labor laws and tax codes (think Uber in the U.S.). The growing concern around DiDi’s ability to generate positive cashflow and reach profitability also made local regulators queasy about approving the company for listing, especially given the recent froth in tech shares. For DiDi, the quickest path to unlock liquidity for its founding core and its PE backers before the global tech euphoria recedes was to dash for the U.S. From filing to listing, DiDi took only 20 days, and priced at the top of the range. Heck, if Lyft can list successfully while stating in its prospectus that it has no business model toward eventual profitability, then surely DiDi can make a fine listed company on the NYSE.

When you consider that many firms listed in the U.S. are tech firms that listed here precisely because there were facing domestic regulatory concerns, it should be no surprise to find that a disproportionate number of the firms facing investigation are those listed in the U.S.

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Understanding Chinese Regulators

Those seeking to understand Ant Financial, DiDi, or other regulatory actions in China should start their analysis by understanding the differences between the U.S. and Chinese regulatory approaches.

Chinese regulators are interventionist. They so this, in part, because their financial markets are dominated by unsophisticated retail investors. Appealing to the wise invisible hand of an efficient market is a luxury that Beijing does not have. Thus Chinese regulators have to set P/E caps for IPO pricing to avoid irrational retail investors bidding prices to astronomical ranges during the subscription period. Thus Chinese regulators chose to take time to vet company financials and business model independently before approving listings. There is real personal career risk for the regulator who approves a firm that turns out to be a fraud or that craters in price due to its inability to execute on the promised business plan.

What Is An Investor To Do?

Foreign investors wishing to invest in Chinese firms must also accept a higher frequency of government intervention at the market, industry, and firm level. They should also understand that this intervention is not driven by senseless bureaucracy or a desire to punish success. The China’s regulator intervenes because it has a foundational (and sensible) lack of trust in its own inefficient capital markets. In China, the invisible hand wears a red glove.

About our Associate Jason Hsu

Jason Hsu is the founder and chairman of Rayliant Global Advisors. Throughout his accomplished career, Jason’s commitment to academic rigor and investor advocacy have led him to research, develop, and bring to market investment strategies that create significant value for investors. At Rayliant, Jason is continuing that commitment by educating investors and offering products to transform the investment ecosystem in Asia and beyond. Prior to his current role, Jason was the co-founder and vice chairman of Research Affiliates.

Jason is at the forefront of the smart beta revolution and is one the world’s most recognized thought leaders in that space. Building on his pioneering work on the RAFI™ Fundamental Index™ approach to investing with Rob Arnott in 2005, he has published numerous articles on the topic, notably his articles “A Survey of Alternative Equity Index Strategies,” which won a 2011 Graham and Dodd Scroll Award and the Readers’ Choice Award from CFA Institute; and “The Surprising Alpha from Malkiel’s Monkey and Upside-Down Strategies,” which won the 2013 Bernstein Fabozzi/Jacobs Levy Award for Outstanding Paper in the Journal of Portfolio Management. In 2015, Jason received the Bernstein Fabozzi/Jacobs Levy Outstanding Article Award for “A Study of Low-Volatility Portfolio Construction Methods” published in the Journal of Portfolio Management. He has twice received the William F. Sharpe Award for Best New Index Research (2005 and 2013), which is awarded by Institutional Investor Journals.

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One for the History Books, a New Control Regime in Oil

 

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Thank you. LGM.

One has to give pause when you think that the only news in markets that mattered today is OPEC+ and what is their next move. We live in a world with growing oil demand and shrinking supply – the stakes are sky high. ESG matters, climate change, inflation, Iran, etc, mean nothing today in the global crude market. All people want to know is – what is OPEC+ going to do next? So clearly, IT is an important issue for the market before we tackle anything else. The sticking point in the talks – the UAE (United Arab Emirates) want a higher baseline after large-scale CAPEX investments in recent years’ production capacity and wants to boost production by 700mbd. On the other hand, the Saudis do not want to offend the Russians and other players by adjusting the UAE baseline.

*BRENT CRUDE SURPASSES $77 PER BARREL FOR FIRST TIME SINCE 2018 – Bloomberg

See our full energy report here.

Gasoline, Summer Driving Season
After the U.S. handed far more control over the price of oil to the Saudis and Russians, consumers are paying the price. The White House wants this problem fixed by the time the 2022 midterm elections come around. Brent now up close to 116% since the eve of the 2020 U.S. Presidential election.

We are told OPEC+ is proud their “control of price” regime is back. A mere year ago, it was hard to grasp that they had any control after a 10-year hiatus as the dictator of pricing. We feel they canceled today’s planned meetíng just to save the pain of having to create more anxiety in the market when they admit OPEC+ could not land on a solution. Frankly, the agreement likely lies behind closed doors with a few parties and not the whole group. That is likely what is happening. But there are a bunch of people out there that say they have ‘inside contacts’ that likely know or think they know. “The deal we see is, no extension past April 2022, gives time for UAE to argue for a higher baseline, both are sides committed. Larry, there is a low probability of a destructive breakdown with a large boost in production, that´s not happening.” Energy Fund CIO in Canada, in our live Bear Traps, chat on the Bloomberg terminal.

The market hanging on the outcome of the weekend along with the meteoric rise of Saudi control of the market over the last year. All should be seen as a sign that they (OPEC+) don’t want to blow this opportunity. The March 2020 testosterone show inflicted a lot of pain on all sides, those scars are still healing. Oil price risk is to the upside. The likely UAE deal is a kick of the can to April 2022. The world is watching them again for signs of control or lack of it. OPEC lost control for 10 years when the Shale drilling spewed new non-OPEC supply into the market in ’09 and they don’t want to lose control like that again.

We are in a period of strong demand and weak supply. The UAE weekend proposal says no extension past April 2022, OPEC + wanted the extension for all of 2022. In recent months, years, the Saudis have worked many other members into contained quotas, baselines. A total breakdown is highly unlikely, “the oil market globally is in a sweet spot, there is too much money on the line for all the players. Demand globally is strong, we are looking at a deficit of 2.3 to 2.5mbd in June, the highest since last year coming out of covid” CIO, Pension Fund in Canada. If OPEC can’t make that perfect scenario work then it is sending a signal of significant weakness to the market. If they go down that disruptive road, volatility to pricing will be back. That is the last thing the Kingdom wants at this juncture. In other words, derivatives players will start controlling the price and we could see dramatic whipsaws in Brent – WTI as we did in the last decade prior to COVID rebalancing the market. While Saudi is in control, you won’t see the shorts show up. They have warned the speculators to stay away or be hurt. They listened for the most part but would show up again if this cartel were to start showing significant cracks. We just don’t think that OPEC+ is that unwise to let all of their great efforts go to waste over this quota issue. Demand surge is real, summer driving. Overall market dynamics best in decades, the risk to oil prices is to the upside. “All the emergency spare capacity is outside the USA now Larry.” Portfolio Manager in the U.S. Midwest. Spare capacity globally is mostly inside core OPEC, the ESG overdose has crushed US shale investments. “There is too much money in the hands of core OPEC, two years ago this was NOT the case with shale cranking” CIO, Macro Fund in NYC.

Further to that, there is an agreement that all parties are saying they are obligated to work with until Apr ’22. Even UAE says they are not trying to be a thorn or break up the cartel or even the agreement. So we think we can assume this agreement will be honored and we have relative stability until then. That is a lifetime in this market lately. Iran’s new supply risk is out in November in terms of getting oil to mkt, current shale new rigs coming online are not sufficient to impact prices near term. “Watch RIG equity as CAPEX investment start to come in, Q3. Very tight global market through year-end. One producer needs to produce 2.3mbd to get the mkt into a surplus, that is a high bar, not in anyone´s interest.” CIO Energy Fund in Canada.

US shale is not a threat as it is very high-cost production and requires higher prices or contango in the curve to see incremental supply enter the system. Also, the ESG (backfire) narrative still weighs heavy on their ability to grow. In this cycle, companies are being forced to return capital to shareholders. There is far less cowboy-up speculation, drilling. Frankly, this ‘noise’ around OPEC+ stability only shakes the ground under the US producer to remember how quickly prices could collapse again. After the colossal financial hit in Q1 – Q2 2020, shale speculators took their ball and went home.

The Curve is Telling
“It is time to think of the oil curve CL1 (front-month futures contract) is priced at $75.16 vs. CL36 (36 months out futures contract) down at $57.95. As you can see above the spread above is eye-opening looking back from 2005 to 2021. “Larry, the one-year backwardation roll is 11%, just wow” says a Veteran oil trader in our live chat. “Spikes in oil prices have triggered economic slowdowns historically. Remember, oil isn’t a forward-looking product. It is a ‘demand is here now’ product.. The curve shows it, CL36 at 2y highs vs. CL1 at 7y highs speaks volumes. WTI is saying this is a short-term supply and demand imbalance, Otherwise, PBR would be at $50/sh, its closer to $12.” Veteran Energy Sector portfolio manager, in Brazil.

Inventories are dropping and global demand is on the rise via economic re-opening, a massive increase in driving and massive unprecedented infrastructure spending around the world. We have yet to see the impact of global travel amongst countries via airlines which will add almost 3 mil b\d of demand. We don’t see any increase in OPEC+ production being considered as a threat to the current price. In this status quo market, we need more of their supply or we are going to see higher oil prices. The current situation is a very unique opportunity for OPEC to cash in. Non-OPEC – Ex USA production spare capacity around the world in decline. “We see strong demand (India, Europe) with real supply risk, it is not in OPEC´s interest to blow this opportunity.” CIO in London. Oil has a shot at $90 to $100 in, next 6 months.

We do not believe that a price-destructive “non-deal” is in the cards at this time. This is the strongest period OPEC+ has had in the market in decades and they don’t want to give that all up.

 

 

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Timeless Bitcoin

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In the Mayan empire, the cocoa bean was the unit of exchange.  The “Early Preclassic Maya” years walked through the late 1800s BC, while “Early Classic Maya” danced out to 600 AD. The Mayan kings of the city-states kept strict control over the cocoa bean supply. It was hard to grow. A supply growth under arrest, sound familiar? Cocoa crops failed all the time. And they had to be specially dried and fermented in a certain way to be valid legal tender. In other words, a cocoa bean required a lot of energy and was of limited supply. Like Bitcoin.

XBT Fails at the 200 Day
As the mad mob chases the brass ring, the drawdown brings a reality check. It took Google nearly 24 years to reach a $1T market cap, XBT just twelve years with the last $500B of gains this year. What does that mean? The beast inside the market is telling us there is a lot of capital that owns Bitcoin at MUCH higher prices. There is a substantial amount of weak hands in XBT that thirsts every minute of every day this week, “to get even and get out.”

Offered to the Kings

Keep in mind, there was a big difference. If you were caught growing cocoa beans illegally,  there was a good chance you’d find yourself on top of a pyramid with your living heart cut out of your body by a blood-encrusted priest (it was taboo to wash off victims’ blood) and have your still pumping heart offered up to the sun. The hot chocolate was the drink of kings. It was a special treat for the rest of the population. They literally drank money. Naturally, if a particularly expensive war came to a fruitless draw, the kings would release more of the cocoa beans than usual, i.e. they would debase their currency.  When a century-long drought came, the Mayans released so many cocoa beans they became all but worthless, the middle class was wiped out and that contributed to the Classic Mayan Collapse. Well, at least that is one hypothesis.  In any case, the real point is, the  Mayan kings watched their money supply like hawks. If someone had invented a virtual cocoa bean, he would have found his heartless body tumbling down a long flight of pyramid steps into a rapturous crowd.
And this brings us to Uncle Sam and Form 1040, which, after establishing your name, social security number, and contact information,  asked if you had traded any virtual currency during the past tax year. Then they asked about your deductions and normal income as per usual.  No government wants to see serious competition to its currency that it can’t control.  Sounds to us like the obsidian knives have been sharpened.
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AMC Credit vs. Equity, Telling

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Broken Markets, Beyond Silly

Now we have seen everything. AMC´s 5.25s due in 2025 closed down a quarter-point at 79.796 cents on the dollar vs. the AMC equity 95% higher at $62.55.

“After 30 years of trading stocks and bonds, 95% of the time I can assure you, credit leads equities. That´s a 12.25% yield to worst vs. 5 year Treasuries at 0.79%. Sell Mortimer, sell AMC equity.”

Larry McDonald, Creator of the Bear Traps Report.

Bonds are Telling You AMC Shares are Smoking in the Dynamite Shed
AMC 5.75% due 2025 are offered at 81 cents on the dollar. Meanwhile, the stock is trading at all-time highs.  Disconnect.  In the old days when capital structure arbitrage actually worked, you’d buy bonds and buy puts in the dollar amount of the next coupon payment if you thought bonds were worth par under a bankruptcy scenario.  The put expiry would be for the month the next coupon is paid. You’d play this game every six months until it worked. But markets are so screwed up who knows if it would work anymore. What we know for sure is that the bond and the stock disagree about the risks inherent in AMC’s future.  

AMC

November 2019

Bonds 96 cents
Stock $9.50

May 2021

Bonds 80 cents
Stock $40.04

Central Banks and Market Dysfunction

With today’s endless central back accommodation – Lehman Brothers NEVER would have failed, fact. That´s what “un-free markets” have become in a world where Adam Smith’s “invisible hand” has been tied behind his back. When the cleansing process of the business cycle is NOT allowed to function over longer and longer periods of time, the moral hazard buildup will trigger a transformation into another serpent, another beast. The next Lehman awaits, just a different flavor, dressed up in unrecognizable packaging.

The fundamental problem with aggressive accommodation from central banks comes down to a market foundation built on moral hazard. Each day, week, and month the Federal Reserve provides more juice, the leverage piles up in pockets all over the planet. Of course, central bankers often do not see the toxic leverage until it is far too late. We are led by academics, NOT proper risk managers. Herein lies the conundrum. While providing excessive accommodation (the Fed is currently making $120B of asset purchases monthly), when traditional shocks arrive – as they always have – the loose fiscal policy will be untenable and looser monetary policy, inconceivable. The market is ill-prepared today – far less so than under normal conditions historically.

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Shares Complete with Butter, Comedy

Beginning today, shareholders can sign up to receive special offers and investor updates by registering at amctheatres.com/stockholders.

“Investors who sign up starting today and in the coming weeks will be awarded with an initial free large popcorn usable this summer when attending a movie at an AMC theatre in the United States. The offer will be made available in their AMC Stubs rewards account.” AMC

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Bullies will be Bullies. Putin, Obama – Biden 2.0, the Conflict Cometh

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Over the last week – Russia’s Foreign Ministry has said that Ukraine’s accession to NATO would lead to a “large-scale escalation” of the war in Donbas & “irreversible consequences for Ukrainian statehood.” The Kremlin said – “the new situation in east Ukraine raises the possibility of full-scale military intervention.”

The fundamental problem with aggressive accommodation from central banks comes down to a market foundation built on moral hazard. Each day, week, and month the Federal Reserve provides more juice, the leverage piles up in pockets all over the planet. Of course, central bankers often don’t see the toxic leverage until it’s far too late. Here lies the conundrum. While providing excessive accommodation (the Fed is making $120B of asset purchases monthly), when traditional shocks arrive – as they always have – the market is ill-prepared. Far far less so than under normal conditions historically. Take Covid-19 for example. Many people forget the Fed embarked on additional quantitative easing in 2019. By Q1 2020, relative value hedge funds were running 20-1 leverage – yes, stepping in front of the steamroller to pick up $100 bills. One of the primary reasons why the Fed’s March 2020 bazooka was 5x larger than the weaponry used in the post-Lehman failure era (2008) – comes down to the enormous leverage in the fixed income market. The Fed literally had to put out a fire, 10x the size of Long Term Capital Management. In March 2020, at least ten hedge funds were on the brink of failure.

*A relative value fixed income hedge fund will go long vs. short either on the run (liquid) vs. off the run (illiquid) bonds or long cash government bonds vs. futures contracts. After all, a 1% annual return levered 20x magically becomes 20%, just insert the steamroller. These funds will PRINT fabulous returns year after year and then give it all back in a week – they NEVER learn.

The Relative Value Hedge Fund Blow Up
Central Banks are the GREAT enablers, they fuel leverage and turn traditional shocks into something far, far more dangerous.

The Coming Shocks

After President Obama was elected, there was the classic test from the bully that is Vladimir Putin, some say he disdained him. Russia’s move? He took Crimea and put Eastern Ukraine, converting the region into a permanent low-grade conflict. Putin realizes the best border that he can most easily exploit while giving Russia a geographic buffer against the West is a long-lasting, low-grade conflict in quasi-failed states within his sphere of influence. Hence Georgia. Hence Transnistria Romania. Hence Syria (love that Mediterranean port!). Today, adding insult to injury – he is militarizing the Arctic Circle. As our clients are pointing out in our live institutional chat on the Bloomberg terminal – before every invasion, the invader tries to first establish the moral justification for an invasion.  Russia has already started to build a “humanitarian” justification for direct action – a strong indicator of possible action. This is exactly what is going on now.

Ukraine, Impact on Risk Assets
So far there is some evidence of additional risk being priced into risk assets. The cost of credit default protection on Russian sovereign debt is underperforming vs. South Africa and other emerging market counties, but not Brazil. 

The Ukraine – Taiwan Risk Connectivity 

China did not make a move during Obama’s reign, nor Trump’s, and Xi may think that represents a missed opportunity. But the Chinese military really wasn’t up to snuff back then. On April 21, 2016, Xi became Commander-in-Chief of China’s Joint Operations Command Center of the People’s Liberation Army. To quote Ni Lexiong (lecturer at Shanghai University of Political Science and Law), Xi “not only controls the military, but does so in an absolute manner, and that in wartime, he is ready to command personally.” At some point, you have to walk the walk, not just talk the talk. China’s military has been built up, primed, and readied. Numerous senior officials in Biden’s DoD (Dept of Defense) are ringing alarm bells about potential Chinese aggression i.e. —  against Taiwan. As Niall Ferguson reminds us all, since the Communists’ triumph in the Chinese civil war in 1949, the island of Taiwan had been the last outpost of the nationalist Kuomintang. And since the Korean War, the U.S. had defended its autonomy. Taiwan is still treasured land for Xi and China.

Meanwhile, our own military brass has been complaining for decades about how it would be very difficult for the U.S. to fight three wars simultaneously. Think – Ukraine, Taiwan, and some sort of the Middle East/Central Asia/Iran mix.

RSX Russian Equities vs. Emerging Markets EEM
Clearly, some Ukraine – Russia conflict is being priced in here. Notice the recent under-performance of RSX Russian equities relative to the mothership EEM. 

Trump Biden – Putin Xi

Again, neither Putin nor Xi made a move during the Trump administration. Why? Why did they treat each meeting with Trump officials respectfully? Why did Chinese diplomats dump all over Biden’s team in Alaska, in over the top, disgracefully so fashion? Well, Putin, Xi, and Trump are all bullies, and above all unpredictable. Think back to a playground in grade school. Bullies don’t pick on bullies. Bullies pick on snowflakes. In Biden – Putin and Xi see a weak old man in decline, a figurehead for an Obama third term of a country that itself is in decline, laden with debt, riven by internal strife, and sick of war. Realistically, what would the U.S. do if Russia made a military move on Eastern Ukraine? Nothing. And if China saw that, Taiwan would be at serious risk.

The Life of a Super-Power in Decline

During the reign of Marcus Aurelius, emperor of Rome from 161 AD to 180 AD, the omnipotent stoic philosopher spent much of his time on military expeditions along the Danube, containing German incursions. In 387 AD the first German hordes crossed, never to leave. In 410 AD the city of Rome was sacked. In 487 AD the Western Roman Empire fell. Europe wouldn’t achieve its earlier economic prosperity for 1000 years. There are literally over 200 reasons listed by scholars for Rome’s fall, but certainly among the most important is that Rome had debased its currency to pay debts, and stretched its military too long beyond its limits. Meanwhile, farmers were cutting off their thumbs to evade the military draft. No thumbs: no spear throwing, no sword-wielding. Sure, the Roman West scrounged up a strong emperor from time to time (Aurelian, ruled 270 AD to 275 AD), but then a string of weak ones would follow hard thereupon. Meanwhile, the Germans were mastering Roman military tactics, and gaining wealth from trade with Rome. And always testing Rome for any military weakness. Finally, when Rome was at its weakest, the Germans faced incursions into their own eastern flank and poured into Western Europe. And now, here we are.

Russia Forex Ruble Under-Performance
At the Bear Traps Report, we are always looking for clues – across asset classes – to validate or invalidate the constant and often obnoxious stream of news in the daily – weekly cycle. Credit risk is all-important, but a glance in the direction of currency volatility – the price someone is willing to pay for a bet in one direction or another – is a key measuring stick to monitor. Notice above how much weaker the ruble has traded recently relative to the broad, Bloomberg Dollar Index.

Testing and Probing

Today, Russia and China are continually testing and probing the U.S. for weakness, just like the Germans did Rome. Occasionally, we vote in a bully. But half of our population finds that unbearable. So we vote in a doddering weakling in the name of normalcy and decency. And that’s fair. But Putin will push. For sure. Then Xi will push. For sure.

America will fail that double test, most likely. If America passes the two tests, there will be more tests. For sure. That’s just the nature of the game. The risk-reward is never perfect but looks pretty good right now from Putin’s and Xi’s points of view.

Some of our best relationships were in Kiev for the Orange Revolution. There was vast protesting on Independence Square in Kiev when Kiev’s Chief of Police walked on to the platform and proclaimed to the crowd that the Kiev Police Department had joined the revolution. He shouted, “We are with you!” The moment was electric. Everyone knew the tide had turned in favor of the Revolution. Cheers of joy waved through the crowd. An unbelievable moment of exhilaration.

The Dnieper River is Ukraine’s longest and Europe’s fourth, rising in Russia and spilling into the Black Sea. It is well known since ancient times: Herodotus describes it in his Histories. And it cuts Ukraine down the middle, effectively resulting in three Ukraine’s: the Crimean peninsula, Western Ukraine and Eastern Ukraine. It is well known that years before his annexation of Crimea, Putin approached Poland with the following proposal: you take Western Ukraine and I’ll take Eastern Ukraine. The Polish government was shocked, but this has given a lasting impression of Putin’s strategic goals in the region.

Eastern Ukraine is much more Russian. Western Ukraine is much more Ukrainian, far more European. It was Western Ukraine that drove the Orange Revolution. When the government wanted to strengthen its hold, our friends witnessed busloads of Eastern Ukrainian thugs, heads shaved and donning long black leather jackets everyone, dumped around the perimeter of Independence Square. They were scarier than the tanks that were already there. But in the event, they were bought off with vodka and weren’t much of a factor. The Eastern Ukrainians were skeptical and indifferent. The Western Ukrainians were enthusiastic, and Kiev, passionate. The Orange Revolution prevailed.

But then the new government became corrupt as many had predicted. And that did anger Western Ukrainians because they were left out of the action. So the new government fell to the old government. But that was unacceptable to the US. So the old government fell again leaving the current mess: Crimea gone, the East in low-grade conflict, and the West sullen and demoralized.

It is a pleasant coincidence for Putin and Xi that Hunter Biden has business “experience” in Ukraine and China.

In sum, Putin believes Eastern Ukraine is ripe for the plucking, but that Western Ukraine is closed to him. When should he take the East? Now or wait for the US to elect another bully, perhaps reelect Trump himself? Now is the time. Strike while the iron is hot.

Meanwhile, Xi views it as his manifest destiny to take Taiwan. Unlike Vietnam, which does have a minority Chinese population, Taiwan is really and truly Chinese. And it is hard to square a visionary goal of China being the single greatest dominant power on earth if it can’t even “take back” Taiwan. So if Xi sees Putin consolidate Eastern Ukraine, the pressure on Xi to consolidate Taiwan will prove irresistible.

Niall Ferguson and the Taiwan Relations Act

Ferguson’s depth and work on this subject is second to none. To Niall’s point, the act states that the U.S. will consider “any effort to determine the future of Taiwan by other than peaceful means, including by boycotts or embargoes, a threat to the peace and security of the Western Pacific area and of grave concern to the United States.” It also commits the U.S. government to “make available to Taiwan such defense articles and … services in such quantity as may be necessary to enable Taiwan to maintain a sufficient self-defense capacity,” as well as to “maintain the capacity of the United States to resist any resort to force or other forms of coercion that would jeopardize the security, or the social or economic system, of the people on Taiwan.”

And perhaps none of this would matter much to markets, a couple of 10% shakeouts, if we weren’t at highly levered all-time valuation highs, with call options being bought hand over fist as a result of forever money from the Fed.

And we notice cracks here and there in the market action even at fresh new highs: Nasdaq Biotech IBB ETF acts like death (nearly 16% off the Feb highs), ARKK Innovation ETF has $25B of new inflows now WAY underwater and the S&P 600 small-cap indices look very weak. These weak spots smell too high heaven, fewer and fewer stocks are holding up the market. The TRIN index remains cautious. The Archegos affair causing the margin to be reigned in. It’s an odd new high. Perhaps it will get better. Perhaps it will gain strength and come to look like a normal bull run. It happens.

But we have real geopolitical military risks right now that we haven’t seen since the eve of WWII. Ignore that risk at your peril. We won’t.

There is only one way to pay for war without conquest: inflation. And there is only one price to pay for running away from war: loss of power. Either scenario is bad for stock markets and good for gold.
Buy war insurance now.

We believe in the Fourth Turning. We believe our slate is about to be wiped clean. We believe in creative destruction. We believe the old order of today will fall to the new consensus of tomorrow.

But between now and then there is a crash or sequence of crashes so only one word matters: risk. And that risk is not currently being discounted by the markets.

 

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The Deal that Broke the Bank, Connect the Dots

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Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email tatiana@thebeartrapsreport.com – Thank you. LGM

As a former convertible bond trader, I have always found this unique corner of Wall St. extremely telling. Over the years we have witnessed countless clues and signals that come out of the interesting players on the field.

Robert M. Bakish is now a hall-of-fame stock seller, he’s also best known as the President and Chief Executive Officer of ViacomCBS. One of the world’s leading producers of media and entertainment content, driven by a global portfolio of powerful consumer brands, including CBS, Showtime, Nickelodeon, MTV, BET, Comedy Central, and Paramount Pictures. But, could Bob’s stock selling prowess help bring a Wall St. Bank to its knees?

This month Bakish noticed an unusual move higher in his stock price, at one point in 2021 the VIAC was 73% higher. Last week, Uncle Bob wisely approached Goldman Sachs and Morgan Stanley about selling some stock. In order to get the best price, Bob wanted to keep the sale quiet and do it quickly. He wisely stressed, “keep it, discreet boys.” On March 23, they priced close to $3B of equity and mandatory convertible securities, but the size and breadth of the sale caught some market participants off guard, some more than others indeed.

“Goldman dumps billions of dollars of stock causing losses at Nomura, then Goldman analysts downgrade Nomura because of the losses and poor risk management.”

Tom Braithwaite 

By now, everyone knows Archegos’ Bill Hwang was a protégé and one of the so-called tiger cubs of legendary hedge fund manager Julian Robertson. What people don’t fully understand is how just one firm can abuse and leverage the TRS (total return swap infrastructure) across the prime brokerage underbelly of Wall St.

Typically associated with the fixed income market (in bonds), a total return swap is a swap agreement in which one party makes payments based on a set rate, either fixed or variable, while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains. The plus side for Archegos is they could hide the size of their positions and very quickly turn the buying power of $1 into $5 or even $10. “Estimates of Archegos total positions are climbing–billions, then $50 billion, now some traders estimate $100 billion. ” Fox Biz, Charlie Gasparino notes. The thing about these guys (like Archegos) is, (and there are a lot of them out there), the only way to accumulate that kind of extreme wealth in a short period of time is through the most extreme, reckless hubris lens. Ultimately, it’s the same perspective that forges the insane riches, that will also be the catalyst behind colossal losses taking place in the blink of an eye.

Who’s Left Holding the Bag?

Credit Suisse CS CASH BOND MARKETS      +15/+20 from Fri close now (Bond – Credit Risk on the Rise)

CS 4.194 4/31   146/136 5×5  +7
CS 3.869 1/29   105/95  5×5  +7
CS 4.282 1/28   155/145 5×5  +7
CS 1.305 2/27   117/107 5×5  +8

Some parts of the fixed income market remain calm, but credit risk associated with Credit Suisse is on the rise.

Credit Leads Equities

Our index of 21 Lehman Systemic Risk indicators always has a section focused on credit risk.

Institutional Client in our Live Chat on Bloomberg: “These are your ‘for cause’ reasons to rip-up an ISDA and (Goldman, Morgan Stanley) start the liquidation process of the Archegos portfolio of levered-bets. How could I start a fund of that size and just tell every other major prime broker my collateral only has eyes for them – especially after AIG?!”

There is meaningful speculation that the DOJ reached out to Goldman Sachs and Morgan Stanley on Archegos’ business practices.  Rehypothecation is the age-old practice whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients. The lack of transparency in the formerly highly profitable total return swap arena, left banks dancing in the darkness, oblivious. There is intoxicating greed on both ends here, greed squared. First, you have the banks who have been reaching for profits in an era of flat yield curves. “Oh, why not roll-out total return swaps to prime broker equity clients, juicy margins, lets do it.” For years, total return swaps have been used on far less volatile bond instruments, BUT putting Archegos style leverage on highly volatile equities is insane. Then there is the greed on the client-side. Many clients we respect think, firms like Archegos embraced total return swaps on high-risk equities so they could attempt to manipulate stock prices to the moon (short squeeze weaponry), wipe out short-sellers in TOTAL secrecy (no disclosures). The whole debacle is just a nasty cocktail of extreme, reckless greed.

Some Street research estimates put the stated leverage (OTC/swap) in Archegos´ reputed use of equity TRS accounted for around half of the universe of OTC equity derivatives globally. Nuts!

Unfortunately for Bill Hwang and his pile of leverage, he’s never met an overnight, size seller like Bob Bakish. Last week’s colossal VIAC offering of shares pushed deal insiders into action. The legendary “Chinese Wall” across Wall St. banks has always been made with only the finest swiss cheese. We hear the bankers involved in the stock sale leaked the details to sales covering clients and very quickly Archegos was looking at a 15% loss when it surreptitiously controlled 10-20% of all the outstanding VIAC shares. At one point last week VIAC equity was worth $60B, this week she was lurking back near $25B. On March 23, Morgan Stanley priced the stock sale at $85 (it traded as high as $100 hours later), Bakish should announce a stock buyback tonight at $45 and burn the Street’s britches into the history books. The stuff legends are made of.

An Epic Unwind – Bear Traps Report from March 27, 2021
The epic sale of stock in the Archegos unwind (see above) will leave a dark stain on Wall St. for years to come.  The Credit Suisse mess is larger than what’s priced into the market. It’s NOT a Lehman size failure but they will be forced into asset sales (CSAM), and or a size rights offering. It’s beyond sinful in financial terms that PB (Prime Broker) risk across the street has such a disgusting lack of transparency. All of this will force a “come to Jesus” for the Street’s compliance departments and force a meaningful de-leveraging. Then come the regulators and House / Senate hearings. Keep in mind, this same problem went down in January with Robinhood, they could NOT properly and efficiently quantify counterparty risk during the trading-day and were forced into a capital raise. So, Q1 2021 will be forever marked by a period of reckless risk-taking breaking the system.

Last Week’s Events will Trigger Secular Change

Wall St. has always been an industry with thousands of silos sitting in the meadow. There are times when the investment bankers are sitting on a piece of information that can nearly destroy another part of the bank (Prime Brokerage TRS Total Return Swap business) – or for sure another bank’s business. It is the ultimate game of trading on inside information, some had it first, others just a few hours later, and that can make all the difference in the world.

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Greed Breaks Things

Don’t miss our next trade idea. Get on the Bear Traps Report Today, click here

Institutional investors can join our live chat on Bloomberg, a groundbreaking venue, just email tatiana@thebeartrapsreport.com – Thank you. LGM

Sorkin and McDonald Dig In
Our Larry McDonald, author of a “Colossal Failure of Common Sense”, and Andrew Ross Sorkin of “Too Big to Fail” fame – weigh in on bank credit risk. 

*CREDIT SUISSE FALLS 10% ON POTENTIAL LOSS FROM HEDGE FUND
*NOMURA CLOSES DOWN 16.3%, MOST ON RECORD, AFTER LOSS WARNING

Warren Buffett is found often quoting his partner Charlie Munger – “there are three ways to go broke: liquor, ladies, and leverage.”

The forced liquidation of more than $30 billion in holdings linked to Bill Hwang’s investment firm is shining much-needed light onto slimy financial instruments he used to build large stakes in companies.

Much of the leverage used by Hwang’s Archegos Capital Management was provided by banks including Nomura Holdings Inc. and Credit Suisse Group AG through swaps or so-called contracts-for-difference. We agree with Bloomberg here, it means Archegos may never actually have owned most of the underlying securities — if any at all.

The Great Deleveraging: If Nomura dropped $2 billion on the mismatch between trade execution on margin calls and/or remaining contractual risk then the knock-on effect is going to be on every Prime Broker credit desk. We will see them become far more stingy and likely tighten margin requirements. If you are making 1% and you are 10x levered that is 10% annualized, but 10% at 10x levered is 100% and so intoxicating in every cycle.

Watch Bank Credit
All the signs were there Friday. Banks with credit risk tied closest to hedge fund blow-ups dramatically underperformed.

Think of Andrew Ross Sorkin’s global bestseller, “Too Big to Fail” – the book was focused on the money center banks. That’s where the leverage was from 2005-2008.  Banks like Lehman would use phony facades like Repo-105 to juice leverage, massively. Regulators were blind, light-years behind the innovative games. Today, the leverage is now on the hedge fund side. Central banks and regulators are once again way behind. They are oblivious to many of the latest leverage weaponry, 21st-century games.

Why is this happening with equities at all-time highs?! Can you imagine the carnage if there was ever a shock to the system, an unexpected event like 9-11 would cause an extended crash, too much leverage.

TOXIC TRS

The key is that hedge funds (and family offices!) are using the banks’ cost of capital via TRS.

TRS: It appears that he (Bill Hwang) transacted exclusively in Total Return Swaps.  This enables him to avoid disclosure.  Some of the positions were held at multiple banks. The banks may not have known this. How to turn $15B AUM into $80B? The fun will really start when Senator Elizabeth Warren figures out this latest insult to risk management.

The most egregious holding is GSX Technidu.  This is a Chinese education company.  Muddy Waters and others have documented how this is almost certainly a fraud.

It appears ARCHEGOS had more than half the tradable shares in swap with multiple banks.  This appears to be an attempt to corner the market and create a manipulative squeeze.  Given that the stock went from $30 when Muddy Waters first published to $140, we’d say this WAS successful.

Our complete lack of securities regulation allows for this kind of manipulation.  We should not be calling Reddit posters to be in front of Congress.  Instead, it should be Securities Regulators, who permit this manipulation.

Four LTCM Style Events in 13 Months

A. March 2020: Relative Value hedge fund Blow-up

B. January 2021: Melvin Capital Blow up

C. March 2021: Archegos Blow up

D. March 2021: The Lex Greensill Fiasco

*When central bankers do NOT allow the business cycle to function over longer and longer lengths of time, capital will always matriculate into toxic places. A moral hazard overdose has arrived.

Four in 13, all Leverage

In thirteen months, we’ve witnessed three Long Term Capital Management (LTCM) type meltdowns with a fourth still gathering steam: 1) the March 2020 Relative Value hedge fund blow up; 2) January 2021, GME short squeeze Melvin Capital Management hit; 3) the March 2021 Archegos Capital Management total return swap unwind; 4) in Europe, the Lex Greensill credit crisis is picking up steam.

Credit Suisse Equity has been Telling Us Something
Friday’s volume was pointing to some real issues. In recent weeks as the Lex Greensill debacle sucked more oxygen out of the air, CS equity has been dramatically underperforming. Institutional clients in our live chat were asking this week if Nomura’s pain is $2-4B, doesn’t that put CS in the $6-8B range? Any capital issues for the bank? Do they have to start de-risking or seek to raise more capital? All at quarter-end? With $275B of risk-weighted assets by the end of 2020 and a 12.5 CET1 ratio, this equals $34.375B capital. Clients we trust see a high risk of impairments.

LTCM blew up in 1998, losing $4.6 billion in less than three months caused by high leverage exposure to arbitrage bets across related but different securities – which fell under pressure once the Russia crisis hit. Niall Ferguson is right when he points out that LTCM’s models only used five years of historical data, thereby not including the 1987 crash. The result? Mispriced risk parameters. So when a crisis hit, LTCM blew up.

Thirteen months ago a once in a 100-year crisis hit in the form of the Covid-19 pandemic that Relative Value hedge funds hadn’t modeled for. The result? Mispricing of risk parameters. So when lockdowns hit and the Fed surprised with an inter-meeting rate cut, Relative Value strategies were crushed.

In January of this year, hedge funds such as Melvin Capital were short various small to medium-sized firms as a big percentage of the float on a highly levered basis. However, no one foresaw that fiscal stimulus checks would be used by twenty-something stock market neophytes to organize short squeezes on social media. The result? Those levered short plays blew up.

And now we have Friday’s Archegos Capital’s blow up, a hedge fund that was levered long names like Farfetch, Discovery, GSX, Teschedu, Baidu, Tencent, Music Entertainment, Viacom, Vipshop, iQiyi Inc. et al, all hedged with S&P and QQQ index shorts. What was the leverage mechanism? Total Return Swaps. The leverage caught up with Archegos. The result? Rolling liquidations of the fund’s long line items during the day. Then at 3 pm the short index cover ramp up in SPX and QQQ, nearly 2% in a straight line into the close, in spite of month/quarter-end portfolio rebalancing going the other way.

Bill Hwang who runs Archegos took $200 million and turned it into $15 billion in seven years. He used big leverage. He hung on. And he hung on some more. And finally, he hung on too long. The leverage, and more importantly, the hubris, caught up with him. Time aged, classic tale. How did he create his leverage? Total Return Swaps (TRS).

The second problem is that Archegos had TRS with multiple institutions and, given the uncoordinated large-scale selling of the same line items, it looks like the banks weren’t aware of the similarities of their cross exposures. That’s the kind of thing that may lead to regulatory scrutiny. Not illegal. Just sloppy.

A swap agreement is set up between a bank and a hedge fund. The hedge fund pays a low interest on the swap, say 2%, and the bank pays out any appreciation to the hedge fund. If there are any losses, payments are due from the hedge fund to the bank. It’s a glorified margin loan. Equity put up by the hedge fund is usually around 25% to 30%. But it can be less. The reference asset can be an equity index, a basket of specific stocks, loans or bonds. If the hedge fund’s strategy is long/short — e.g. long specific names vs short an index — the TRS is considered low risk and thus doesn’t chew up the bank’s balance sheet. The TRS means the hedge fund has risk exposure without actually owning the asset. The bank has more control in a portfolio liquidation scenario because it is the actual owner of the reference securities. Hedge funds love TRS because they get risk exposure without a large cash outlay. Essentially the funding cost comes at a slight premium to the bank’s cost of capital but at a big discount to the hedge fund’s normal cost of capital. It’s like Greece getting close to Germany’s cost of capital for being a member of the EU. The bank gives up on interest vig in exchange for transaction fees. The EU reduces Greece’s cost of capital so Greece can buy more stuff from the EU. Same generic idea. Theoretically both win — until both lose. But the hedge fund (like Greece) runs the greater risk if things don’t work out. The TRS equity cushion is meant to protect the bank in the event of untoward price movements. Hence the wild Friday.

The world survived this crisis, apparently. However, we expect in a prolonged bear market (yes, they exist), there will be more TRS disasters and eventually, they will become the focus of regulatory reforms.

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