This Risky Behavior Is Threatening The Stock Market

Volatility in the news appears to be increasing.

Last week, a family office seemed to receive a margin call and brokers sold holdings to protect themselves.

A family office can mean many things. But in this case, it was a highly leveraged hedge fund. All the details are still not publicly available. From what we know, Archegos Capital Management seemed to have about $10 billion in assets. Investment banks seemed to sell at least $30 billion in assets last Friday when risks associated with the fund rose. That doesn’t seem to be all the fund’s holdings, so there could be more sales in the future.

One problem with Archegos is that there was excessive leverage. Another problem is that the fund’s brokers were unaware of how much leverage was being used.

The Wall Street Journal reported

“According to people familiar with the fund, the highly leveraged Archegos took big, concentrated positions in companies and held some positions via swaps. Those are contracts brokered by Wall Street banks that allow a user to take on the profits and losses of a portfolio of stocks or other assets in exchange for a fee.

The use of swaps allowed Mr. Hwang to maintain his anonymity, even as Archegos was estimated to have had exposure to the economics of more than 10% of multiple companies’ shares. Investors holding more than 10% of a company’s securities are deemed to be company insiders and are subject to additional regulations around disclosures and profits.”

This is a possible violation of securities regulations. It’s definitely a failure of the investment banks to fully understand the risks they accepted.

Why Should We Care?

Now, the question you may be asking is why should we as individual traders care? I touched on this news item a bit in my article yesterday, but here’s the main reason. There could be other funds like this out there.

There are also other problems for investment banks out there. Credit Suisse, one of the banks facing an estimated $3.2 billion in losses from Archegos, also suffered a loss of about $530 million from the collapse of Greensill, a start-up company.

According to The Wall Street Journal, Greensill “used Credit Suisse’s asset management arm as a form of off-balance-sheet financing. Credit Suisse sold the funds to investors, telling them they were relatively safe and based on short-term loans to companies.”

Greensill was allegedly buying receivables from companies at a discount and then collecting from the customers later. For example, Company A might have sold $100 million worth of goods to Company B, which agreed to pay in 30 days. Greensill could then buy the receivable from Company A for maybe $98 million and realize a gain when Company B paid the bill in full.

That’s a common business practice and it’s relatively safe. However, Greensill sometimes went beyond that and financed “prospective receivables” – receivables that have not yet been generated by Bluestone – from a list of “prospective buyers” that included “both existing customers … and other entities that were not and might not ever become customers…” according to Bloomberg.

Rather than discussing that business model, I want to highlight that Credit Suisse was refinancing Greensill’s loans, repackaging them and selling them to new investors. That process is familiar to anyone who understands collateralized debt obligations (or just saw the movie, “The Big Short”).

My concern is that investment banks aren’t catching family offices that use excessive leverage or companies practicing aggressive financing. Bankers seem to be missing things in due diligence, and that’s not a great sign for the health of the markets. That’s a long-term concern I’ll definitely be keeping an eye on.

How I’m Trading Right Now

In the short run, this doesn’t change how we should trade. The point is that there seems to be a lot of risk-taking going on in this market (don’t forget about those Robinhood traders, either). So while we still have opportunities to profit, we need to approach our trades with caution.

Among those opportunities is a recent trade we made in Williams-Sonoma, Inc. (NYSE: WSM).

WSM sells high-priced home goods, the kind of products that at least some consumers want right now as they cook at home more. Stimulus funds should add to the company’s sales as consumers who haven’t suffered from shutdowns use extra money to buy things like that set of pots they have wanted for some time. WSM also maintains exclusive relationships on some products so consumers have to buy those products from the store or website.

In addition to solid fundamentals, WSM is on an Income Trader Volatility (ITV) “buy” signal, as shown in the chart above.

As the stock breaks out to new highs, many traders might be tempted to buy the stock. That’s fine, but over at my premium Income Trader service, we have a better plan.

The trade we made allows us to get paid immediate income from WSM – without risking a lot of capital on the stock.

If you’d like to learn more about how to make trades like this, check out this report for more details.