Money Stuff: Playing the Game of Infinite Leverage

BloombergOpinion Money Stuff

Matt Levine

Infinite leverage Robinhood Markets Inc. is a discount brokerage that allows customers to trade stocks and options, with zero commissions, on their phones. We have talked about Robinhood in the past when we discussed brokerage-y topics like zero commissions and payment for order flow. But you can also analyze Robinhood as a mobile gaming company. It makes an app that you can download to your phone, and then you can play a game on the app. As with many mobile games, there are in-app purchases, and you can end up spending a lot of money on the Robinhood game. The game is of course a stock-trading game. The purchases are stocks. You win by getting a lot of money. But there are other ways to play. Some people aren't interested in playing the game as its designers intended. They want to hack the game, to find weird glitches and exploits, to take the game apart and build their own weird levels, to stream the resulting monstrosities to entertain their friends. Many, many, many of my readers have emailed and tweeted about a Robinhood exploit that goes by the charming and accurate name "infinite leverage." Here's a Reddit user called ControlTheNarrative who claims to have gotten 25x leverage on his trading; that is, he put in $2,000 and turned it into about $50,000 worth of stock. Here's another Reddit user called MoonYachts who claims to have gotten 250x leverage, putting in $4,000 and turning it into a $1,000,000 stock position. You are not supposed to be able to do this; normal stock market games do not allow you to bet a million dollars by putting up only $4,000 of your own. ("We're aware of the isolated situations and communicating directly with customers," said a Robinhood spokesperson.) These people are posting screenshots and videos of their exploits. They are discussing ways to use the exploit for further, even more outrageous pranks. I do not exactly know what they are thinking. Presumably some part of what they are thinking is along the lines of "if I use $4,000 to buy a million dollars' worth of stock and it goes up then I will make a lot of money." But surely another big part of what they are thinking is "if I use $4,000 to buy a million dollars' worth of stock then my friends on Reddit will be amused." Judging by the Reddit threads, and by my email inbox, this was a correct analysis. I suppose it is not a conventional financial analysis, but you should not underestimate the importance, in trading generally, of impressing people with your wit and boldness. For what do we live, but to make sport for r/wallstreetbets, and laugh at it in our turn? Okay what is the trade? It might make more sense if I describe it in three ways. Version 1 is the simple economic description of the trade, which is easy to follow and, therefore, self-evidently ridiculous: Put $100 in your margin account. Buy $200 worth of stock on margin. (Brokers will generally lend you up to 50% of the value of the stock, so you can use your $100 to buy $200 of stock.) Sell the stock for $200 of cash. Use the $200 of cash to buy $400 of stock on margin. Sell that stock for $400 of cash. Use the $400 to buy $800 of stock on margin. Etc. That, to be clear, is not a thing. Your broker would notice, in step 3, that you sold the stock. It would probably ask you to repay the margin loan at that point. At the very least, it would notice that you still only had $100 of equity, and it wouldn't lend you more money on margin. But there is a variant on the trade that is economically more or less identical but that disguises what's going on a bit. Here is Version 2 in schematic form[1]: Put $100 into your margin account. Buy $200 worth of stock on margin. Sell deep-in-the-money covered call options on the stock for, say, $190. Simplistically, this means that someone pays you $190 today and in exchange you promise to sell them the $200 worth of stock for $10 at some specified date in the near future. You've sold $200 worth of stock for $200, but on a sort of installment plan where you get $190 now and $10 later.[2] Now you don't really own the stock anymore. Soon the options will be exercised, and you will deliver the shares. The option buyer really owns the stock; you're just holding on to it for her for a little while. But you still technically own the stock; the options haven't been exercised yet. And now you have $190 in cash to go along with the stock that you still technically own. Use the cash to buy another $380 worth of stock on margin Sell deep-in-the-money covered calls on that stock for, say, $361. Now you have another $361 in cash. Use that to buy another $722 worth of stock on margin. Etc. This is exactly as silly as the first version of the trade, but it is more confusing. "Sell deep-in-the-money covered calls on the stock" means almost the same thing as "sell the stock," but it doesn't sound the same. It has more words, and those words sound technical and options-y. And whereas selling the stock leaves you with no position (you had stock, you sold it, you have nothing), selling the option leaves you with two positions (you own stock and have sold options). Perhaps the computer software will not know how to combine those two positions. It should know how to combine them—this is pretty basic stuff, and you don't really have any more equity in your account after selling a covered call than you do after selling the stock—but it might not. It definitely would not let you get away with Version 1, but it might let you get away with Version 2.  It did! Here's Version 3, which is quoted from ControlTheNarrative's description on Reddit: With Robinhood Gold, you can use what's called Margin to trade with increased Buying Power. So I did an instant deposit of 2000 dollars (the minimum required to access Gold Trading), and then I bought 100 shares of AMD for 3,800 or so, with margin. Then I sold an AMD Call Contract with a 2 dollar price strike to get almost all my money back (it's important to find a stock that has Call Options with such low strike prices like Ford, GE, etc). Then I use that money to buy TWO hundred shares of AMD because remember, margin doubles my buying power, then I sell 2 Call Contracts with the same 2 dollar strike price to get almost all my money back, which is then doubled again thanks to Robinhood's Margin. I repeat this until I am sufficiently leveraged for my Personal Risk Tolerance. Right now, I am at 25x leverage because I had 2000 dollars in Instant Deposits.  Ah. Super. If you are reading this I hope I do not need to tell you that this is not investing advice. First of all it really shouldn't be allowed; you shouldn't be able to get infinite leverage this way, and I assume that Robinhood will close this loophole quickly. Second, even if you can do this, it's not … it's not like it's free money or anything. You get more leverage than you ought to, but why would you want infinite leverage? Leverage isn't an absolute good; it increases your potential return but also your risk. You probably shouldn't make hugely levered single-stock bets with your savings! I don't know, maybe it's fun for you. Certainly it's not investing. I write sometimes around here about weird derivatives and financial perpetual-motion machines, trades that exploit glitches in markets or regulation to produce economically strange results. This is not exactly that. This is not a glitch in the world, or in regulation, or in the structure of markets, that will take years of work and complex legislation to fix; it doesn't really demonstrate anything interesting or fundamental about the financial system. This is a glitch in one particular piece of software that can probably be fixed today by patching the software.  On the other hand, I mean, sure, this is the retail version of goofy financial engineering. ControlTheNarrative and friends would fit right in as investment-bank derivatives structurers or distressed credit-default-swap traders. The combination of attributes here—high risk tolerance, ethical flexibility, fanatical literalism, a sense of joy and play and pride in their creativity—is easily recognizable. This trade doesn't tell you anything fundamental about the financial system, but the attitude behind it might. So much of what is interesting and important in finance really is, deep down, about finding ways to hack the game. SoftBank Who gets to decide whether startup founders should be able to get super-voting stock? The obvious answer is "investors." Founders generally like dual-class stock structures in which they get more votes than everyone else. Investors generally don't like giving up control to founders forever, but they might agree to it if the terms of the investment are otherwise attractive. It's just one more term that can be negotiated. If investors mostly don't mind it, there will be a lot of dual-class stock; if investors deeply hate it, there won't be; and if investors dislike it but are willing to make tradeoffs, then some founders will make those tradeoffs and get super-voting stock and others won't. But there is a widespread belief that there's some sort of market failure here, that dual-class stock is bad for investors but they are somehow powerless to push back against it. Investors are dispersed, there's lots of capital and not so many hot tech companies, and investors have a hard time focusing on voting rights (which become important in bad times) when times are good. So there are lots of efforts to make someone else be in charge of super-voting rights. Many stock exchanges used to ban dual-class stock, and people who dislike it sometimes call for the exchanges to bring back those bans. The idea is that investors for some reason cannot get together to block dual-class stock on their own, but if the exchanges blocked it then that would be good for investors overall. Or there have been recent, often successful efforts to get dual-class companies excluded from stock indexes, on the theory that (1) index funds shouldn't be "forced" to buy dual-class stock and (2) companies really want to be in indexes and so this will deter them from using dual-class stock. (Theory 2 seems wrong, though, and companies keep going public with dual-class stock.) What about … SoftBank? SoftBank is tightening governance at companies it backs as the Japanese conglomerate and its $97bn investment powerhouse try to limit the outsized control of start-up founders and restore confidence in their bets following the near collapse of WeWork. The Tokyo-based group is expected to outline tougher governance standards and restrictions on dual-class share structures on Wednesday as it takes a multibillion-dollar writedown because of bad bets on investments such as the US-based office-sharing group, said people briefed on the plan. The new governance standards will apply to future investments made by SoftBank. Its Saudi Arabia-backed Vision Fund is in discussions about how it can adopt some or all of these measures. … For private companies, SoftBank will look to have at least one board seat, require at least one independent director, prohibit directors from owning supervoting shares and limit founders or management to less than half of the board seats. SoftBank will also introduce guidelines on how much a founder's or management stakes can be sold at the time of an IPO or other forms of exits.  We talked last month about SoftBank Group Corp.'s sharp change of heart about money-losing poorly governed startups. One possible outcome here is that SoftBank is the market, that its multiple hundred-billion-dollar funds and omnipresence in startup funding give it the sort of power to change norms that other investors don't have. If a big venture capital fund or institutional investor says "we don't like dual-class stock," founders can just go elsewhere; founders can play investors off against each other, exploit their fear of missing out, and raise money with dual-class stock anyway. But when SoftBank says "we don't like dual-class stock," there is not really any alternative to SoftBank. If you want to raise billions of dollars in ten minutes to fund the sort of blitzscaling that will obliterate your competitors and leave you in sole control of a massive market, there is basically one person you can call, so you need to set up your company to appeal to SoftBank. Maybe some founders will be willing to give up perpetual control for the promise of SoftBank riches. I mean, that's the optimistic view. SoftBank seems to be flipping all the switches at once: Not only does it want good governance now, but it also wants more control for itself, and it wants its companies to make money. Founders can't get the whole 2018-vintage SoftBank package just by giving up dual-class stock now; they also have to give up other things like, you know, rapid growth without making money. Perhaps the result will just be that the appeal of SoftBank money will decrease, and founders will go raise dual-class stock somewhere else. Oh speaking of governance, how do you like this? Some of SoftBank's gains have come by adding to its bets on companies at higher valuations. In one of the starkest examples, SoftBank and the Vision Fund have led more than $2 billion in funding rounds for fast-growing Indian hotel chain Oyo Hotels and Homes since 2015—pushing the valuation up to $10 billion from less than $1 billion just two years ago and booking paper gains for the fund along the way. In the latest round, announced in October, the Vision Fund led an $800 million investment that brought its stake in Oyo up to 48% from 45%. But SoftBank's chairman Masayoshi Son gave the company an additional boost by backing a loan to its 25-year-old founder, who used the money to invest $2 billion into Oyo, including buying stakes worth $1.3 billion from venture-capital investors including Sequoia Capital and Lightspeed Venture Partners, according to people familiar with the deal. We talked last month about the Oyo "selfie round," in which the founder, Ritesh Agarwal, borrowed money to double down on his stake in the company. "Why would you do this if you're Agarwal's lenders," I asked, and I didn't really have an answer. Now I do!  Lien counting A key fact about any debt instrument is its seniority. If a company doesn't have enough money to pay back all of its creditors, the more senior creditors get paid back before the less senior ones, so the more senior debt is safer and usually carries a lower interest rate. Some companies just have one sort of debt, but others like to slice things up, selling more-senior debt to one group of investors and less-senior debt to others, appealing differently to different types of investor and also creating opportunities for arbitrage and fun and mischief. There are all sorts of priority hierarchies, but among U.S. high-yield companies the biggest division tends to be between secured debt and unsecured debt.[3] The secured debt has a lien on most or all of the company's assets; if the company can't pay the debt, the secured creditors get to seize the assets, which makes them functionally ahead of the unsecured creditors. But you don't have to stop at two classes. You can slice things up further and have, like, very secured debt, which is ahead of somewhat secured debt, which is ahead of senior unsecured debt, which is ahead of junior unsecured debt. I made up those names. There are actually standard names. The top-ranking secured debt is normally called first-lien. Next is, sensibly, second-lien. The first-lien debt has the first claim on the company's assets; the second-lien debt has a secured claim on whatever is left over after satisfying the first-lien. Anything left over after satisfying them goes to the unsecured, which can also be divided up.[4]  What if you want even finer divisions among secured creditors? The somewhat funny norm in U.S. secured markets is to have a thing called 1.5-lien debt, which as its name implies is between the first-lien and the second-lien. The first-lien gets the first claim on the assets, the 1.5-lien gets the next claim, the second-lien gets the … third claim. The obvious Spinal Tap question is "why not just call the 1.5-lien the second-lien and the second-lien the third-lien," and fair enough, but usually the idea of 1.5-lien is that it is slotted in between existing first- and second-lien, so you can't just renumber things. Once you have issued second-lien debt, the second-lien investors expect to remain second-lien forever; you can't make them third. But you can surprise them with a fraction. Once you accept 1.5-lien debt then the next stage is 1.25-lien debt, which is behind the first-lien but ahead of the 1.5-lien. That exists. Also there is 1.125-lien debt. There's also 1.75-lien debt, which goes between the 1.5-lien and the second-lien. I suppose you could just slot like 1.3-lien debt between the 1 and the 1.5, and then 1.2 between the 1 and the 1.3, and then 1.1 between the 1 and the 1.2, and get to the same place while saving on decimal places, but financial engineers are very tidy-minded and like to operate in fractional powers of two. So the liens get sliced into eighths. I don't think there is any 1.0625-lien debt yet, but give it time. Hovnanian Enterprises Inc. is a homebuilder with Caa1/CCC+ credit ratings and a history of creative debt refinancing, and today it announced the commencement of its latest refinancing, which features 1.75-lien notes. This follows the announcement last week of the completion of another Hovnanian refinancing involving first-lien loans, 1.125-lien notes, 1.25-lien notes and 1.5-lien notes. There are also existing second-lien notes, and unsecured notes. The list is therefore (1) first-lien, (2) 1.125-lien, (3) 1.25, (4) 1.5, (5) 1.75, (6) second-lien and (7) unsecured. If you have second-lien notes, you are sixth in line. I don't even have a point here. Structural choices accrete over time and the result is sometimes just silly. Finance is great. Oh one other thing. Hovnanian has an affiliate called K. Hovnanian at Sunrise Trail III LLC. KHASTIII, as I will call it just to be annoying, owns $26 million worth of Hovnanian bonds. (Unsecured, as it happens.) Those bonds were scheduled to mature last Friday. Instead, on Friday, Hovnanian and KHASTIII agreed to extend the maturity until Nov. 1, 2027, "which enables K. Hovnanian to preserve certain debt refinancing capability under its outstanding indentures." If you have followed Hovnanian's story, you might remember these KHASTIII bonds. These were the bonds that Hovnanian bought (through KHASTIII) so that it could miss an interest payment on them and trigger its credit default swaps. The credit default swaps would pay out, CDS holders would make a big profit, and one of those holders—GSO Capital Partners—would use some of that profit to subsidize a cheap refinancing for Hovnanian. This was hugely controversial and great fun, and the pope sort of got involved, but ultimately it came to nothing, the CDS was never triggered, and the KHASTIII bonds … almost matured! Came within hours of maturing! And now they'll be outstanding for another eight years in case anyone gets any more clever ideas for ways to trigger CDS. Things happen Risky Mortgage Bonds Are Back and Delinquencies Are Piling Up. Saudi government to have one-year restriction on selling more Aramco shares after IPO. Xerox Ends 57-Year Venture With $2.3 Billion Sale to Fujifilm. Can Argentina Discriminate Against Bonds Issued Under Macri? Do six per cent of financial transactions sent via the Swift system really fail? Is There Too Much Disclosure? Popeyes Chicken Sandwich Sells Out Again and Even Turns Deadly. China Has a Glass-Bridge Bubble. The Men Who Still Love "Fight Club." Vince McMahon Upset With Saudi Arabian Prince Over Missing Money. If you'd like to get Money Stuff in handy email form, right in your inbox, please subscribe at this link. Or you can subscribe to Money Stuff and other great Bloomberg newsletters here. Thanks! [1] One of the many readers who emailed me about this story, Jack Yan, CFA, sent a schematic description of the trade using some of these numbers, which I have drawn on here. [2] The calls are *deep* in the money, so there is no real option value: The calls will be exercised, and you will sell the stock for $10, unless it drops by more than 95%, which is super unlikely. So you can think of it like a forward rather than an option, which means among other things (1) you can expect to definitely sell the stock (it's nearly "delta one") and (2) the premium for the option (the $190) and the strike price (the $10) should add up to pretty much the current stock price (plus maybe some small time-value-of-money component). So Bloomberg tells me that AMD January 2020 $2 calls closed at $34.30 yesterday, while the stock closed at $36.29; $2 plus $34.30 basically equals $36.29 plus a penny of time value. (This basic idea of doing a forward sale but documenting it as a call option shows up occasionally in institutional trading—mostly as a regulatory arbitrage—and investors will sometimes trade "penny-strike calls" or "zero-strike calls," in which the strike price is zero or a penny and the option premium is the full purchase price of the stock.) [3] Technically security is not the same thing as seniority but it's good enough for our purposes. Another big hierarchy in U.S. high-yield involves *structural* seniority; operating-company debt is generally "senior" to holding-company debt for most purposes.  [4] The best unsecured debt is normally called senior unsecured. Even if there's only one class of unsecured—even if there's only one class of debt—it will generally be called senior unsecured. The thing below that is usually called "subordinated," though you can tack on words to that. "Senior subordinated" is pretty popular, which of course means there is also "junior subordinated."

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