3065 Rosecrans Place #203
San Diego, CA 92110
None of the following is investment advice. Much of this is empirical conjecture, but the goal is to introduce concepts that could be important today and in the future. This memo took weeks to write. Enjoy.
What if everything you see in markets is a lie? What if a spike in the Nasdaq on a day of gloomy news is caused by a few traders pumping the entire market? What if prices are so inconsistently trustworthy that you can no longer believe them? What would you do?
In this memo, we analyze Bill Hwang’s rise and fall. We observe regulatory origins, a timeline of notable events, and the current state of regulation. Our guide through the events, from Long Term Capital Management’s blow up to a brutal short squeeze in 2021, will be Bill Hwang, who is currently in litigation with the SEC. Keep in mind throughout the memo how blind ordinary investors were to the giant moves… exactly the result regulators are supposed to defend against. And yet, nothing has ameliorated whatsoever, even over a year after his explosion.
230 years ago, the Buttonwood Agreement was signed by a handful of brokers that represented wealthy American investors (the “NYSE”). This agreement revolutionized trading in financial assets, from record keeping, brokerage practices, to regulation of all trades. Imagine arbitrary paper documents sold at random and you have the market before Buttonwood. Today, America has the most advanced financial asset markets of anywhere in the world, including ETFs that standardize participation and diversification.
France 1792 – Rouget de Lisle was asked to compose a song “that will rally French soldiers from all over to defend their homeland that is under threat”. La Marseillaise was penned only 3 weeks before Buttonwood, becoming France’s National Anthem only 3 years later. It brings tears to my eyes thinking that the revolutionary La Marseillaise was on the signers’ minds as they stood under the Buttonwood tree, due to striking parallels involved with both.
While Napoleon’s French Revolution roared across the pond, Alexander Hamilton fought an attempted coup (and America’s first financial panic) of his “Bank of the United States” which was the contemporary equivalent of today’s Federal Reserve Bank, though publicly traded. The original instigators of the coup were known as “The Six Percent Club” since shares in the Bank of the United States paid a 6% dividend. Their goal was to try and corner the market (using massive amounts of leverage) before the next distribution of shares in July 1792 and sell the shares to European investors at a profit. However, Thomas Jefferson aimed to cause a run on the bank at the same time by withdrawing more money than the bank had to give – a quasi ‘short squeeze’. The Six Percent Club went broke, and Thomas Jefferson would have prevailed, but Hamilton authorized the purchase of government bonds – a bail out.
On March 26, 1792, and with only Jefferson dissenting, the commission authorized $100,000 in open-market purchases of securities to offset the credit crunch that was occurring. After the collapse was over, the United States began its first official bull market, with stocks rising for the next 10 years until 1802. Two months after the open market purchases, the Buttonwood Agreement was drafted to regulate the trading environment and convince people it was safe to invest again.
Before Buttonwood, trades took place all over the city in auction houses, offices, and random coffeehouses. Deals often fell through and it was impossible to know if the person taking your money was a real broker or a con man. By pledging to trade only with each other, the NYSE founders created a network of trusted brokers who could be counted on to honor payments and offer legitimate investment opportunities. The deal was a win-win for investors and brokers and laid the foundations for our modern trading system. The public was much less blind to the risks of bad actors.
The outline of every financial panic that has happened over the past two hundred years occurred in the Panic of 1792: the wild speculation, the financial frenzy, the collapse that followed, the intervention of the government to keep the rot from spreading, and the eventual bail out. Importantly, though, the Panic demonstrated how the wealthy and powerful (Jefferson and Hamilton) use the financial system to joust, often leaving the less wealthy as casualties.
The point of this memo is not intended to be my historical erudition, but to ask, 230 years after Buttonwood, ‘Who is Bill Hwang?’
Bill Hwang represents an unknowable but probably highly influential segment of public markets. His 20 year+ trading history manifests both that little has changed in 230 years and that we should not expect change in the future. If you are or plan to be a value investor, Hwang must be an overweight segment of your curriculum. Whether friend or foe, his story is possibly the most important public account of a true ‘master of the universe’ hedge fund manager.
First of all, Hwang grew up in relative poverty in South Korea. His family emigrated to America, where his father died while Hwang was young. For years, Hwang did what he could to move up the ladder in the New York finance scene. At age 31, Hwang hobnobbed with Julian Robertson, earning his business for Peregrine, Hwang’s employer. Robertson hired Hwang in 1996, just as John Meriwether set up Long Term Capital Management (“LTCM”). By 1999, Hwang and every investor in the United States knew about LTCM, the firm that had equity of $4 Billion and swaps valued at some $1.5 trillion notional, equal to more than 5% of the entire global market at the time. LTCM exploded spectacularly.
August 17, 1998: Russia devalued the ruble and declared a moratorium on 281 billion rubles ($13.5 billion) of its Treasury debt, effectively defaulting. Ultimately, this results in a liquidity crisis of enormous proportions, dealing a severe blow to LTCM’s portfolio. NOTE: Russia could have printed money, but chose to default! This single event wiped out countless millionaires; this was a highly unlikely event, which was the primary reason the Fed bailed LTCM out – confidence needed to be restored.
September 22, 1998: LTCM’s equity has dropped to $600 million. Banks began to doubt the fund’s ability to meet its margin calls but could not move to liquidate for fear that a crisis would precipitate, causing huge losses among the fund’s counterparties and potentially lead to a systemic crisis. Banks extended more credit to LTCM to prevent such a crisis.
September 23, 1998 (the next day): The Fed, acting to prevent a potential systemic meltdown, organizes a rescue package under which a consortium of leading investment and commercial banks, including LTCM’s major creditors, inject $3.5-billion into the fund and take over its management, in exchange for 90% of LTCM’s equity.
Fourth quarter 1998: The damage from LTCM’s near-demise was widespread. Many banks took a substantial write-down on their investments. UBS took a charge of $700 million, Dresdner Bank AG – $145 million charge, and Credit Suisse – $55 million. Alan Greenspan cuts rates, calling the ordeal the greatest terror he had ever seen.
November, 1999 (one year later): John Meriwether opens a new hedge fund, JWM Partners, and raises $250 Million of outside capital.
*0.265%, or about 380 parts to 1.
From day 1, LTCM was responsible for 1 part of the total assets it managed, while the government was ultimately on the hook for the other 380 if a failure occurred. Effectively, there was no real risk, because LTCM was bailed out. Wall Street certainly took notice of this fortuitous circumstance – that a bigger failure resulted in a higher chance of a bail out. A bail out on a $4 B portfolio probably wouldn’t happen today, because banks are flush with roughly $4 trillion in reserves. Most losses that occur don’t make a scratch. However, had Hwang’s collapse happened in 1998, the world would have stopped. LTCM was the world’s largest hedge fund at the time. Today, Hwang was almost unknown.
What lessons could a precocious Bill Hwang, aged 33, glean from this experience?
2 years later, in 2001, after 5 years of employing Hwang, Robertson staked him with $25 Million of seed money. The firm, named “Tiger Asia”, would be an extension of Robertson’s “Tiger Management”, making Hwang a ‘Tiger Cub’. For about 11 years, things went smoothly upward; so high, in fact, that one of Julian’s other proteges said, “It was well known within Tiger that Bill was worth more than Julian. He had multiple 100% years.” Hwang’s success trading Asian markets lasted until he was indicted on insider trading and busted down to a family office. The SEC gave this description:
12/2012 “Hwang betrayed his duty of confidentiality by trading ahead of the private placements, and betrayed his fiduciary obligations when he defrauded his investors by collecting fees earned from his attempted manipulation scheme.” from December 2008 to January 2009, Hwang and his advisory firms participated in two private placements for Bank of China stock and one private placement for China Construction Bank stock. Before disclosing material nonpublic information about the offerings, the placement agents required wall-crossing agreements from [Hwang] and the firms to keep the information confidential and refrain from trading until the transaction took place. Despite agreeing to those terms, Hwang ordered [his head trader] to make short sales in each stock in the days prior to the private placement. Hwang and his firms illegally profited by $16.2 million by using the discounted private placement shares they received to cover the short sales they had entered into based on inside information about the placements.
The strategies Bill Hwang (and likely many participants) used running his hedge fund were and are obviously illegal, but only if he got caught. Hence, the questions:
Keep in mind that Hwang was managing other people’s money: about $8 Billion (Reuters). The trades were reportable with Hwang accountable under the Investment Advisor’s Act. As an investor of a hedge fund that knowingly breaks the law, you can only plead ignorance of the illegal activity once. If you sign up after that, and Hwang does it again, you are complicit. Thus, Hwang closed to outside investors and from 2013, he traded his own account: about $200 Million (Bloomberg). Family offices don’t need to report trades like investment managers that trade for others because there’s only one client to report to. Additionally, US position reporting regulation (i.e. 13F reporting) does not generally require foreign asset reporting, private asset reporting, some short positions, or some over-the-counter asset reporting like equity-linked swaps (“swaps”).
Swaps ultimately allow these traders to significantly front run everyone else. Which of these things is more probable – that individual investors all bought AMC’s stock at the same time, or a few of these hedge funds took billions of leveraged dollars long in AMC swaps? Unlike wealthy hedge funds, individuals cannot utilize swaps, which require subscription with the International Swaps and Derivatives Association (“ISDA”). Although swaps are not overseen by anything but a loose book of rules, and they are risky instruments to both system participants and the system itself, they continue to exist.
As discussed below, most of Bill Hwang’s investments were in swaps. So by indicting Hwang, the SEC implicitly is indicting themselves – for allowing Hwang to use swaps this way for so long. Because Hwang gets more leverage (and potential gains) with swaps than vanilla positions, swaps are inherently designed to entice people like Hwang – there’s really no other practical use for them. A way for gamblers to increase leverage. In Hwang’s case, the house extended credit, and the player lost, but how often does the house lose on such bets?
So a family office could corner the market in a public or private business using swaps and other family offices without the public knowing. This includes the SEC, who routinely audits hedge funds annually and occasionally will inspect offices of hedge funds, but family offices are exempt. One actor cornering a market in a publicly traded stock or commodity is much rarer than multiple actors, meaning that collusion is often a means to manipulate prices. An instance of a single family cornering a market can be found here. The Porsche family used options to skirt public reporting and, in October of 2008, announced the options position equivalent to about 32% of Volkswagen stock (position of 74% total). VW increased 5x in 2 trading days from a market cap of about $70 B to about $350 B. Adolf Merckle went from 94th richest person in the world to ending his life on the other side of the trade. $30 Billion was lost on margin calls, with Porsche selling a significant amount of stock in the next several days. German regulators inquired into Porsche, who said, “The ones responsible are those that speculated with huge sums of money on a falling VW share price.”
One of those responsible, according to Porsche, was none other than Bill Hwang’s Tiger Asia (here)! Back to the questions above:
Hwang got crushed by the Porsche Family (amount lost unknown), which made a 5 times gain on a $50 Billion + investment over a few months… and got away with it. Hwang saw Porsche kill a man, and get away with it. Not only did Porsche get away with it, but insulted those that lost! For Hwang, perhaps Porsche was right – perhaps people shouldn’t short stocks and if they are squeezed out of the position, they deserve it. Perhaps what is seemingly illegal is perfectly allowable by regulators given certain contexts. Perhaps the banks became more powerful than regulators: the banks were winners in both the LTCM blow up and the Porsche short squeeze. The house always wins.
The New Style:
Indeed, Hwang was generally in the right place at the right time by starting Archegos (his family office) in 2013. He bought big into Netflix and other tech stocks, riding them all the way until his dramatic collapse in 2021. His $200 Million eventually became nearly $10 Billion over an 8 year period, an annualized compound return of 64%. The leverage Hwang (probably) used over those 8 years to earn spectacular returns also caused his death in a span of a couple months. Ironically, his insider trading scandal of 2012 may have scared away investors, but banks were still free to supply him with loans without losing a shred of reputation. Due to his levels of leverage (5 times his money), one might think the banks encouraged his borrowing. All things considered, Hwang made much more money personally using that leverage and the added privacy that comes with family offices than he could have using investor money and being regulated, posing the question – was the family office the best thing that ever happened to him?
The playbooks that Hwang and many other hedge funds use today are very similar to that of LTCM in 1998. Step one – understand that LTCM caused a crisis because banks only had a collective $50 Billion in reserves in 1998. Today, banks have over $4 trillion to cushion any blows, meaning that 800 collective, juxtaposed LTCM blow ups would need to occur to collapse the banking system. Banks ‘evolved’ from being institutions of careful risk taking to a giveaway of credit by the government. A business losing money in 1998 would require shareholders to fund those losses, but today banks (i.e. the government) step in with cheap debt. Moonshot bets might pay off with windfall profits at a hedge fund or a tech company, but in failures, private owners just borrow money and recapitalize themselves with newly printed bank money. This is not a good thing or a bad thing, but just how things are.
Step two – research asset opportunities intensely and make a play in the public markets. On the equity side, LTCM would use roughly 25 times margin to buy stock in businesses (this article by Michael Lewis gives a great summary). This meant that given $1 Billion of equity, $25 Billion could be used to buy stock for LTCM’s collective portfolio. That $25 Billion would typically buy 4.9%* of a business’s outstanding shares and any purchases beyond that level would be bought using 50 to one leverage on that money. This meant that given $25 Billion of leverage, LTCM would be able to trade notional values in excess of $1.2 trillion.
Step three – offload the position onto unsuspecting, optimistic investors.
*Various contributions Hwang made to his foundation were of very highly appreciated stock instead of either cash or swaps, solidifying that he did own large blocks of individual stocks since at least 2006, when the foundation was formed.
LTCM would buy the 4.9% position in stock to get capital gains tax treatment, which has roughly half of the impact of ordinary gains tax treatment. The swaps allowed LTCM to deal directly with banks outside of exchanges, without clearing houses or regulators. Swaps are only allowable for highly sophisticated investors, meaning that the counterparties are roughly on their own. Additionally, swaps allow a firm to remove gains from the position every day and not affect either the position itself nor the tax treatment of the 4.9% position. The swaps, though negotiated contracts, provided incredible liquidity on correct bets. While swaps benefit large traders by allowing incredible margin, evasion of regulatory scrutiny, and great liquidity, the downside is that gains are subject to ordinary tax treatment. This, seemingly, is the only reason the swaps market only has $400 trillion in notional value. This figure is much higher than that of 1987, the year ISDA was created. Total swap value in 1987 was a relatively maudlin $1 Trillion.
Knowing the mechanics of the strategy, you might think there can’t be guaranteed malicious intent in this playbook: funds simply buy into businesses that they like. At 5% stock ownership, a fund has ‘influence’ in the operations of the business, reporting of the position changes, and regulators monitor thenceforth. Such a strategy is only useful for an activist fund that seeks to influence the business itself; any influence on the price of the shares is a second order effect. In fact, over 5% ownership of shares is a requirement to get influence in most cases, but such a requirement doesn’t exist for influence of the stock’s price. That is a different strategy altogether. By using swaps surreptitiously, a fund can have ‘influence’ on the price itself, arbitrarily allowing the price to fall significantly one day and forcing it to rise the next, without any catalyst. Thus, while an argument for no malicious intent could hold up in court, the influence to affect the price is inherently there. A bank robber might not intend to use the gun if the money is just given easily. Using this playbook, he’s almost sure to get the money either way.
More on Banks:
The banking relationships aren’t without controversy, though. First, Credit Suisse and Nomura lost a lot of money. Hwang’s swaps not only shielded the positions from regulator knowledge, but also from that of other banks. He effectively used the same collateral to enter multiple swaps, cornering the market of a few businesses. Viacom was a primary driver of his losses in March 2021. When it announced a share sale, the stock dropped precipitously and Hwang is reported to have had multiple margin calls on that same collateral. He was forced to close many of the positions out to satisfy the margin calls, which cratered the value of other swaps he held and led to even more margin calls, creating what is known as a ‘vicious cycle’. By the end of the week, Hwang had lost everything, totaling nearly $20 Billion, much of which he didn’t have to give. So Credit Suisse and Nomura took most of the losses, probed the poorly formed swaps, and finally kicked him out of Vegas.
The media (and regulators) covered this part of the story extensively. To the blind eye, Hwang illegally formed those swaps, over-levered and got pinched – an open and shut case. However uncommon his bets were, Hwang was seemingly already in trouble before Viacom announced the share sale, given his short bet against Futu. The position used swaps that were arguably destroyed by the counterparty of the swap: Morgan Stanley.
Lesser known in Hwang’s saga is this bet: his $4 Billion loss from a massive short squeeze on Futu, a wealth management firm in China. Reportedly, Hwang used swaps to effectively bet against the entire float of Futu, calling on the counterparty (Morgan Stanley) to close the position in full only months before Viacom dropped. The stock quickly increased 5 times. I believe this loss could have triggered Hwang’s other losses only a few weeks later. Hwang argues (at least) that the bank encouraged others to squeeze him and possibly was paid to do so.
Hwang will continue losing that argument. But shouldn’t we believe Bill Hwang? Bill Hwang, who saw everything from Julian Robertson in his prime to Adolf Merckle becoming a martyr for short selling. Bill Hwang, who has much less to lose than Morgan Stanley does should he win the case. Why should we believe anything else in the story isn’t routine in the business of mega traders? Of course, insider trading by Morgan Stanley is all but a guarantee. How can they close out Hwang’s position without canvasing the deal? Think about that – trying to offload a short position nearly the entire value of the company’s outstanding float… even an attempt to do so is technically insider trading – and Hwang should have realized it.
Morgan Stanley, on the other hand, could simply chalk it up to business as usual, meaning that closing out giant block trades is a systemic deficiency. Although the bank may not have profited itself, there probably was a profit made by using nonpublic, material information (i.e. Hwang’s Futu position). Had Hwang been betrayed by a natural person like this, clearly he would have a case. Banks are beyond reproach in such dealings, at once acting as an unbiased market maker for traders like Hwang and as a biased dealer of information to unknown third parties.
We should all understand that Hwang’s blow up could have been primarily driven by his blind trust in Morgan Stanley as a counterparty. A moral of the story – he is probably right that Morgan Stanley squeezed him, but he still loses. After all, Morgan Stanley will easily recall, “The ones responsible are those that speculated with huge sums of money on a falling Futu share price.” We must strive to learn from his mistaken conclusions that the banks are more powerful with each passing year and that what happened to Hwang will continue to happen well into the future, because banks likely profit the most on whales like him.
Ironically, Bill Hwang seems to be a casualty in the jousting contest between the banks. In this joust, Morgan Stanley won and Credit Suisse lost. Traders and investors interested in this story should also understand that the banks making those loans had and have relatively low risk. Although Credit Suisse lost $5.5 Billion;
Only a glance at this chart demonstrates that banks have capacity to lose trillions before anything significant shakes the system. Banks could theoretically have 500 blow ups identical to Hwang’s today without failing. Even if there were a failure, bail outs from the Federal Reserve (“the Fed”) will certainly shore the banks up. Perhaps banks still profited massively from Hwang even considering the Credit Suisse and Nomura losses.
Striking how similar all panics throughout history have been. All the mechanisms stay the same, only the actors change. Today, it would appear that we have less effective regulation. Banks are now the largest players in all markets, but they can get away with most anything and blame traders like Bill Hwang. Ironically, in 2009, we all believed that banks were above the law, having been rewarded massive bail outs for excessive risk-taking, but when short squeezes happen to Hwang, they aren’t blamed, even though Morgan Stanley, for instance, could have made billions in profit only on the crippling Futu squeeze. Banks are critical to the functioning of the system, so no matter how long the laundry list of misdeeds is, traders like Hwang will continue to be marginalized and blamed for what may have been a bank ‘mistake.’
Hence, the jousts of today have larger lances and faster steeds. And the jousts are solely among banks. So the only question an informed trader must ask is, ‘Who will get squeezed next?’ The Bill Hwang saga touched others that were likewise squeezed to the brink of death.
Importantly, all of these losers have not been indicted like Hwang. They can close down and pocket the fees from the good years or they can wait until the next bull market and do the same risky strategies again. Hwang could just as easily have been right beside them today.
To conclude, Bill Hwang’s indictment was an incredible gift to retail investors. We see the system for what it is and not what we have been taught in books and universities. We now can deduce that when the Fed eases financial conditions, wealthy investors take this as a sign that defaults will shift away from their own balance sheets and onto the governments’ balance sheets. So the wealthy lever up in ways that less wealthy investors cannot to take advantage of this ‘heads I win, tails you lose’ mentality, and we can’t really blame them: altogether, the American financial system is set up for exactly this process, and it always has been. It’s a system that I prefer over that of, say, Russia, which could have printed its way out of default in 1998 but chose not to. Our system might bless the wealthiest in good times and use taxpayer money to bail them out in bad times, but it beats all the others.
So, how much of the 13 year bull market was real and how much was swaps? How much of every single day’s trading is real and how much is swaps? If these are large percentages, we’d better hope there’s no crackdown on actors using Hwang’s playbook. We must learn to live with the fact that the majority of stock investing may not be done based on fundamental analysis, but on how much leverage is allowed. Understanding these things will make you a better investor, because the best investors are paranoid about the most remote risks.
All of this to say what a value investor must know: Prices can’t be trusted. Never. Research is the only thing that matters. Facts determine if you have an undervalued or overvalued asset. Price says nothing. Value is facts and research. Patience is everything. uncertainties will always exist – where will treasury prices go? Will stocks go up in China? And then there are risks – What is the risk of a short squeeze hitting me on a hedge? Will the whole market be hit with a short squeeze, resulting in a panic?
Panics have always happened with only a few small details changing – we generally should not expect anything to change, since 230 years on, regulation has barely changed depending on your perspective. Paying attention to panics and consequential regulation (or lack thereof) allowed Bill Hwang to earn a 64% average annual return for 8 years straight during a bull market, which is incredible under any circumstances. He pieced his playbook together from over 2 decades working with and for the greatest financiers the world has ever seen. We should applaud his hard work, if not simply for his ingenuity and cunning.
Our goal should not be to speculate whether Hwang is guilty or innocent, but to learn from him and to deduce how he got there. If all panics are the same with different actors, studying the winners will help make you a winner, too. Would you rather be the 6 Percent Club, Thomas Jefferson, or Alexander Hamilton? Would you rather be Adolf Merckle, Volkswagen, or Porsche? Would you rather be UBS, John Meriwether, or Alan Greenspan? Would you rather be Bill Hwang, Morgan Stanley, or Credit Suisse?
It’s your choice.
“Waiting helps you as an investor and a lot of people just can’t stand to wait. If you didn’t get the deferred-gratification gene, you’ve got to work very hard to overcome that.” ~Charlie Munger.
I’d like to mention how important it is to keep a straight head in times like these. Nobody likes waking up to bad news every day, and nerves are increasingly more raw with every passing day. Being patient in all aspects of life is more challenging now than maybe ever before. Tell your loved ones that you love them. Work on developing your skills to be the best you can be. Try to avoid uncertainty and only accept relatively low risk bets. Prepare mentally for a worst case scenario. Waiting years with cash to invest is very hard.
As far as the Fed. While I have made clear that I believe an $8 Billion loss is nothing to the system as it is capitalized today, I make no assertion that anything else whatsoever might be known for sure about quantitative tightening, which began this month. We know the Fed can do it, but nothing else is known. Therefore, we believe there are still more uncertainties than certainties in most global asset markets.
3065 Rosecrans Place #203
San Diego, CA 92110