Homework – 3/10 Try Harder

Marketwatch never ceases to be fascinated by the lengths to which people will go to beat the market and earn that elusive extra dollar. Although we know that investing in anything carries a degree of risk, there always seem to be plenty of people around who are more than willing to throw caution to the winds.

This month, I am offering two cautionary tales of investment which went horribly wrong.

In the plush suburbs of Los Angeles, Zachary Horwitz was seen as a successful actor, even though no-one seemed to have heard of his films. To describe him as a D list actor may be a kindness. But Zachary lived in a US$6 million mansion and hobnobbed it with his wealthy neighbours. Being a bad actor, it seems, is no impediment to acquiring wealth. Or is it?

You see, our Zachary had a company called linMMCapital LLC. For over five years this company advertised itself as having licences and distribution agreements with both Netflix and HBO and other online platforms. Investors were offered returns as high as 40% pa.

When the first lot of dividends were due to investors, they received instead received copies of emails from Netflix and HBO explaining why the deals had been delayed. In total, investors put in US$227 million (about AUD$300 million).

And yes, you guessed it, the whole thing was a fake. All the documents which investors had seen were forged. Netflix and HBO had never heard of him, which says something about his acting career. Clearly no-one did their due diligence. If you include the dividends that should have been paid over the past few years creditors are owed US$690 million.

Jake is now in custody awaiting trial. He seems to be destined to wearing a fetching striped suit with arrows on it for several years. And investors can spend time contemplating why their hunt for better returns in a low return environment led them to take outsize risks.

Another individual, Bill Hwang, set up a company called Archegos Capital. Bill had previously led a hedge fund that became caught up in an insider trading case. He and his firms at the time paid US$44 million to settle the case.

Archegos was actually a family office, set up to manage roughly $10 billion. But it used leverage — essentially, trading with borrowed money to amplify its buying power — perhaps as much as eight times its own capital.

In this case, leverage showed up in the form of swap contracts. In return for a fee, the bank agrees to pay the investor what the investor would have received from actually owning a share over a certain period. If a stock rises in price, the bank pays the investor. If it falls, the investor pays the bank.

Archegos focused its bets on the share prices of a relatively small number of companies. They included ViacomCBS, the corporate parent of the country’s most-watched network; the media company Discovery; and a handful of Chinese technology firms. The banks it used to buy swaps held millions of shares in ViacomCBS alone.

Normally, big institutional investors are required by the S.E.C. to publicly disclose their holdings of stock at the end of each quarter. That means investors, lenders and regulators will know when a single entity holds a big ownership stake in a company.

But S.E.C. disclosure rules don’t usually cover swaps, so Archegos didn’t have to report its large holdings. And none of the banks, at least seven that are known to have had relationships with Archegos, saw the full picture of the risk the fund was taking. And Bill’s past was clearly not a factor.

That’s what happened last week. Several stocks that Bill’s firm had bet on started to fall, and the banks demanded that he put up additional money or other assets. Known as “margin,” this is a cushion of cash meant to ensure that the bank doesn’t lose money if the stocks fall. (You may recall we discussed margin lending as an investment tool recently.) When he was unable to do so, the banks dumped millions of shares of stock they had purchased to try and recoup their losses.

The effect on share prices was profound: ViacomCBS fell 51 percent in just one week and Discovery 46 percent. Shareholders in those companies saw the value of their holdings plunge; more than $45 billion in shareholder value was wiped out of those two stocks alone. And banks lost money on any shares whose value had fallen. One analyst estimated that banks lost up to $10 billion in their dealings with Mr. Hwang.

Credit Suisse, a large investment bank, has lost US$4.7 billion as a result of this. A couple of their most senior executives including their chief risk officer have left the company. The Japanese bank Nomura Securities has said it is exposed to losses of as much as $2 billion. Morgan Stanley and Goldman Sachs have said they expect minimal losses — meaning it won’t seriously affect their financial results — but for such large entities that could still mean millions of dollars. Mitsubishi UFJ Securities Holdings Company, a unit of the Japanese financial conglomerate, reported a potential loss of around $270 million.

Now honestly, these people are supposed to be experts and understand risk. Clearly they didn’t understand enough.

So there we have it. We may be looking for higher returns on our money as we strive to earn that bit more. But when you do, remember these stories and don’t rush in where you don’t fully understand the picture.

The season for a good red is almost upon us and Marketwatch thought he would get in early. It is good to see that winemakers are starting to use varieties other than cabernet, shiraz and merlot. Distinguished grapes such as Durif are appearing more often. And from South Eastern Australia comes a Durif Shiraz made by David Joeky. Called Dark Corner it is an impressively dark wine with a good flavour. I drank the 2017 which could go for a few more years. Reasonably priced, try it, you won’t be disappointed.

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