Streetwise Professor

It’s a story as old as time. An allegedly genius investor has a winning streak, which burnishes his genius image even more. He starts to believe it. Levers up. Then the wave he was riding crests and falls, the iron logic of leverage exerts itself. He becomes illiquid-if not insolvent-and either goes bust or gets bought out. And he’s no longer a genius, but an excuse maker.

One particularly famous example of this is Long Term Capital Management. LTCM had bona fide geniuses, Nobel Prize winners Myron Scholes and Robert Merton. Their genius apparently paid off for quite a while, with LTCM showing stellar risk-adjusted returns. Then, you know, stuff happens. Stuff like Russia effectively defaulting on its debt. Then your supposedly uncorrelated trades become suddenly correlated, and all start going in the wrong direction.

All that leverage that amped your returns now turns on you with a vengeance, and amps your losses. What’s more, your success has allowed you to grow to the point where you effectively are the market, which (a) moves the markets strongly against you when you try to liquidate some positions to meet margin calls and/or reduce leverage, and (b) pushes up the correlations even more.

Then, you are transformed from Golden Child to Systemic Problem Child. In LTCM’s case, it was so large that the Fed had to intervene to coordinate a liquidation of its positions into the tender loving care of the likes of Goldman.

Fast forward 28 years. The Golden Child and putative genius is Leopold Aschenbrenner, head of the oh-so-ironically named Situational Awareness hedge fund. The soi disant “Nostradamus of AI” implemented the picks-and-provisions strategy in the AI space, investing heavily in stocks of companies that provide the inputs to data centers and other AI-related activities. (SA also has private investments in AI firms like Anthropic).

He did time his entry right, and rode prices upwards. He (sound familiar?) amped his returns through extensive leverage (reputedly 4x). But-and there’s usually a but-the market peaked, and began to drop. And as has happened time and time again (it wasn’t just LTCM) the iron logic of leverage took over. Wrong way market moves beget margin calls on leveraged positions. Margin calls mean cash. Mark-to-market paper gains aren’t cash. So the imperiled fund was forced to sell positions to raise money-which only exacerbated the price declines.

Worse, the financial distress of a big position holder can’t be kept a secret. Evidently many others were apparently more situationally aware than Situational Awareness, and started to unload positions in stocks in which it was heavily invested. This front running exacerbated the price declines, and hence severely leveraged SA’s distress.

It happened so fast!, Aschenbrenner is no doubt thinking.

Sure did, (ex) Golden Child. Leverage comes at you fast.

And so do sharks. Jane Street, Millennium, and Citadel circled. In a single night, the last of these negotiated a deal to acquire all of SA’s publicly traded holdings at a discount estimated to be 10 percent.

The markets breathed a collective sigh of relief when news of Citadel’s purchase eliminated fears of a dumping of SA’s shares on the market: tech stocks rallied on the news.

Though no doubt his motives were purely self-interested, and are not as public spirited as J. P. Morgan’s intervention in the Panic of 1907, Citadel’s Ken Griffin did the markets a big favor. It is not from the benevolence of the butcher, the brewer, or the baker–or the hedge fund mogul–etc. (NB: I am not a reflexive Ken Griffin fan, as this old post demonstrates).

But as the saying goes, no good deed goes unpunished. Many-mostly Leopold fanboyz apparently-have argued that Griffin plotted SA’s demise (a reprise of CZ and SBF, maybe) by releasing a note predicted a Fed rate increase some time before the last Fed meeting. When the Fed did meet, and held rates steady-not raise them, mind you-the markets dropped, delivering the coup de grace to SA’s strategy that was already bleeding profusely. So per the fanboyz: See! Citadel caused this and then swooped in to take advantage!

Er, no. SA was already teetering. Citadel’s prediction-wrong, in the event-did not cause the final, fatal sell off. The Fed did.

For his own part, in a letter to investors Aschenbrenner rounded up the usual suspect-short sellers! It’s kind of pathetic. I have more respect for the natural gas fund operator who gave a blubbering, cringing apology when his widow maker strategy imploded.

If you are looking for other culprits here-beyond Aschenbrenner-look at SA’s prime brokers. Why did they supply so much leverage to back a poorly diversified strategy focused on a sector where sentiment had started to turn prior to the initial declines?

And if you want to do an It’s a Wonderful Life homage and wonder what would have happened if Ken Griffin/Citadel hadn’t been born, look at the disastrous unwind of another highly leveraged hedge fund-Archegos. Another example of an undiversified, highly leveraged fund caught in a doom loop when the markets turned against it.

In that instance, its prime brokers got together and agreed to assume the fund’s positions, and undertake a controlled liquidation. So far, so good. But one of them-Morgan Stanley-played “defect” in the prisoners’ dilemma facing the PBs, and sold $5 billion of Archegos’ holdings. Then the others jumped in and a full-scale fire sale occurred, leaving all the PBs badly singed. With Morgan Stanley (a la Margin Call) coming out best by getting out first (and not telling its counterparties what it knew about Archegos’ impending demise).

One firm-Citadel in this instance-didn’t face a prisoner’s dilemma. It-with the support of SA’s prime brokers-took the whole portfolio. Fire sale averted-to the markets’ relief (as noted above).

In sum, the Situational Awareness story is news, but not news. It is a story that has been repeated many times in many places. Leverage makes you look like a genius when the markets move your way. But with probability bounded away from zero, it will kill you when the market turns.