You Can Lever Up, or You Can Follow ‘Safe Money’ Strategies …

There’s a crucial boardroom scene in the 2011 movie “Margin Call” in which a junior mortgage analyst reveals to the investment bank’s CEO that they’re sitting on an enormous pile of toxic mortgage assets.

The analyst’s message? The music has stopped, the value of those assets is starting to plunge and if we don’t get out fast — before our competitors get wind of the crisis — the firm could fail.

The CEO, played by Jeremy Irons, responds as follows:

"There are three ways to make a living in this business: Be first; be smarter; or cheat. Now, I don't cheat. And although I like to think we have some pretty smart people in this building, it sure is a hell of a lot easier to just be first".

I thought about that scene this week after a multibillion-dollar “family office” firm managed to blow itself up. It did so with the help of funding from a wide range of U.S. and foreign firms.

And the saga of Archegos Capital Management offers lessons for investors of every stripe.

So, what happened?

Well, a family office is an investment firm that manages money for a small handful of very wealthy clients or even a single family.

In this case, Archegos Capital Management is run by Bill Hwang, a former analyst who left Tiger Management in 2013. He’s a protégé of Wall Street legend Julian Robertson.

Turns out Hwang, Robertson’s former “Tiger Cub,” made highly leveraged bets on a wide range of U.S. and Asian stocks, according to The Wall Street Journal.

It did so via outright stock purchases and through a form of derivative known as a “swap.” When the value of some of those stocks and swaps started to fall, that leverage kicked in — and losses rapidly piled up.

Archegos went to its trading counterparties — a who’s who of firms based in multiple financial centers around the world, including The Goldman Sachs Group, Inc. (NYSE: GS), Morgan Stanley (NYSE: MS), Credit Suisse Group AG (NYSE: CS), Deutsche Bank Aktiengesellschaft (NYSE: DB), Nomura Holdings, Inc. (NYSE: NMR) and UBS Group AG (NYSE: UBS) — to negotiate a way out.

The firm wanted the banks to agree to an orderly wind-down of risk that wouldn’t roil the markets.

But, like the fictional investment bank in “Margin Call,” a handful of those banks decided that it was better to “be first.” They decided to beat their competitors to the selling punch in order to minimize their losses.

Goldman and Morgan reportedly dumped a whopping $19 billion in stock in big-block trades last Friday alone, according to the Financial Times.

Here’s what one banker said: “The reality is in a fire sale: if you’re not first out the door, you’re going to get burned ... There’s no honor among banks, [it’s a] question of who blinks first.”

It’s not hard to find examples of the Archegos affair’s collateral damage. Punch up charts of ViacomCBS Inc. (Nasdaq: VIAC) or Tencent Music Entertainment Group (NYSE: TME) to see a couple of them. Shares of VIAC lost 61% in less than two weeks.

Are there broader lessons to be learned here? What does the behavior of this firm, or the Wall Street banks that funded its aggressive bets, say about markets?

For one thing, this isn’t the kind of stuff you tend to see early in a bull market. It’s the kind of thing you see after stocks have had a huge run, investors are feeling giddy and they’re willing to layer risk on top of risk to maximize returns.

For another, you don’t typically see these kinds of wildly aggressive bets being made on “Safe Money”-style stocks.

In fact, if you’re a Safe Money Report subscriber, you know your model portfolio investments didn’t get swept up in this mess.

Finally, this is yet another illustration of the danger of elevated leverage.

If it’s to be used at all, it must be used in prudent moderation rather than excess speculation. That applies to every investor, from multibillion-dollar hedge funds to “family offices” to individual investors.

In other words, stick with “Safe Money” strategies, and you’ll be much better for it.

Until next time,

Mike Larson