Archegos Capital: What went wrong?
The collapse of the family office/hedge fund Archegos Capital sent shockwaves throughout Wall Street, with shares sent crashing, and calls for increased oversight of the banking industry. But what actually led to Archegos’ demise, and could it have been prevented?
What was Archegos Capital?
Archegos Capital Management was the family office of multibillionaire hedge fund manager Bill Hwang. A family office functions similarly to a hedge fund in that it can take both long and short positions. In theory, a family office contains its own risk since it only manages the assets of a wealthy individual or a few families, however the problems at Archegos can mostly be found at one issue: undisclosed leverage.
The root issue was the large amounts of borrowing used to facilitate Hwang’s bets. Combined with the fact that family offices are exempt from many of the disclosures that normal hedge funds and investment firms are held to, and the use of opaque financial instruments, this was a recipe for disaster. The fund had around $10 billion in assets financing over $30 billion in debt, with some estimates sitting at over $50 billion, though the true value is unclear due to the nature of the derivatives held.
The Securities and Exchange Commission has let family offices decide for themselves whether they should be registered and file regular reports. A regular family office has a very low risk appetite and consequently in the peculiar event of a collapse, has minimal impacts on the wider financial markets. Despite this, since Hwang was using his office as a pseudo hedge fund, the exceptionally large leverage meant as soon as the tide turned against his bets, the ship sank.
What triggered the crisis?
When someone trades with borrowed money, known as trading on margin, lenders demand a certain amount of collateral as security. Collateral is the value of assets pledged by a borrower to be forfeited in the event of a default. If the value of a stock holding goes down, lenders will demand more collateral. Not having sufficient collateral triggers a margin call, where the lender can force a sell-off of the stock to bring the investor back into compliance with margin requirements.
Archegos Capital was a large investor in ViacomCBS, a mass media conglomerate, whose share price had increased over eightfold from a 5 year low in March 2020. Seeking to capitalise on this, it announced a $3 billion public offering to raise funds for “general corporate purposes”, as well as to invest more aggressively in streaming services.
The market thought the shares were vastly overpriced, with common shares offered at $85 on March 24, but closing at $70. The overvaluation due to concern amongst institutional investors about the competitive media landscape, as well as the sell pressure created by stock dilution resulted in a further fall to $66 as markets closed on March 25. This was the trigger for when the banks issued their margin calls. Archegos also had positions in the Chinese stocks Tencent Music and Baidu, both of which had faced sale pressure and contributed to the calls.
ViacomCBS share price
What was the collapse, and who is footing the bill?
Following the failure to meet the margin call, Archegos’ various banks – Goldman Sachs, Morgan Stanley, Credit Suisse, Nomura & UBS – held a meeting on March 25 to discuss an orderly wind-down of its exposure to minimise market impact. It is unclear whether an agreement was reached, but some banks had begun selling to stem their own losses, with Credit Suisse and Morgan Stanley both appearing to have unloaded small batches of shares after the meeting.
The morning of Friday, March 26 was when the dumping really began, with Goldman Sachs seizing collateral and pitching global investors on billions of dollars of Archegos-linked stocks. Morgan Stanley followed suit, and they sold roughly $19bn in large block trades of over 10,000 shares at a time. This was effectively a very expensive game of chicken between the banks, with billions of dollars on the line. Goldman and Morgan Stanley limited their losses by selling Archegos’ shares quickly, before the size of the sale brought on a larger fall in the stocks’ prices.
Some of the holdings that were sold represented 10% or more of the outstanding shares in the companies. SEC rules require investors who own more than 5% of a stock to report the stake, but the use of derivatives known as total return swaps meant Archegos may never actually have owned most of the underlying securities, if any at all. Investors using these swaps receive the total return of a stock from a dealer for an agreed fee, and those returns are typically amplified by leverage. Since these are transacted off exchanges, this allows managers like Hwang to amass exposure to publicly-traded companies without having to declare their holdings. Archegos’ huge concentration in single companies contributed to the magnitude of this particular collapse.
The majority of the opaque derivative market involves interest-rate and foreign exchange swaps, which are relatively benign compared to the far smaller markets of credit-default swaps and equity swaps. The fact that one firm quietly amassed large positions through the use of these derivatives has led to criticism against loosely regulated firms in this area that have the power to destabilise markets.
“Thousands of people, as well as several companies, took on huge losses not because they did anything wrong, but because a handful of huge banks decided to bet on one shady securities trader.”
- Alex Kirshner, Slate
In the subsequent stock sales, at least 8 stocks lost a combined $35 billion in market value. Of the banks, Nomura and Credit Suisse are reported to have held the brunt of the losses at $2bn and $4bn, causing 19.4% and 20.5% falls in their own respective share prices. Analysts at JP Morgan estimate losses across all banks from the crisis could hit $10bn, with Deutsche Bank, Wells Fargo & MUFJ also involved.
How did Archegos manage to borrow so much?
Many of the banks involved had ‘prime broker’ relationships with Archegos, which is a wider-ranging and more lucrative arrangement than what might be expected for a normal hedge fund client. Combined with the environment of near-zero and negative interest rates worldwide, banks are constantly looking for other sources of income, with the substantial fees paid by Archegos a very attractive proposition.
Whilst the SEC was in the dark about Archegos’ activities, analysts at all the respective banks’ credit departments, who have to approve all counterparties, had full insight into its capital position, stake sizes, risk management and other processes. The stock positions taken by Hwang in the form of swaps are on the banks’ books and are subject to its own risk management oversight. It was not for a lack of oversight or knowledge on the banks’ part that led to Archegos’ downfall, rather they were blinded by trading commissions in the hugely profitable prime brokerage business, which generated $30 billion of revenue in 2020.
Could it have been prevented?
This was not the first financial collapse of 2021 arising from cheap borrowing, with the situation akin to that of Melvin Capital. Its massively leveraged short positions in GameStop were exploited by an army of Reddit users, leading to a $2.8 billion bailout. In this instance, we are seeing similar results, except purely through market forces, and on the long rather than the short side.
Bill Hwang’s creditworthiness has also come into question, especially considering his suspended conviction in 2012 for wire fraud resulting in the forfeit of $16m of criminal proceeds. This is on top of a $44m settlement with the SEC over charges of insider trading. Following this scandal, Goldman Sachs actually stopped doing business with Hwang for some time, but later revived the relationship to serve as one of the lenders for Archegos.
Some of the storm was self-reinforcing – missed margin calls leading to selling, pushing prices lower, resulting in further selling. Considering Archegos’ risk level, the banks may have accepted inadequate margin, but this is a consequence of firms anxiety to grow business in a tough lending market. However, in both the Archegos and Melvin Capital cases, the impacts were relatively contained and did not spill over into the broader financial system. This can be attributed to the stricter regulatory changes since the financial crisis, with banks required to build large capital buffers to absorb losses.
At the end of the day, not every credit loss is a mistake or disaster. In this case, Hwang lost his bets, and he had no money left to play with. There is no systemic risk from Archegos’ collapse, but it has still prompted calls for greater oversight of the financial system. The most prominent of these calls came from US Senator Elizabeth Warren:
“Archegos’ meltdown had all the makings of a dangerous situation – largely unregulated hedge fund, opaque derivatives, trading in private dark pools, high leverage, and a trader who wriggled out of the SEC’s enforcement”
Both the US SEC and UK’s Financial Conduct Authority have opened investigations into the operations of the banks involved.