The collapse of hedge fund, Archegos Capital Management, send a shockwave throughout the financial world. Founder and CEO was Mr Bill Hwang, a quiet billionaire with a strong track record in the hedge fund world. At his peak, he was worth a staggering $30 billion. At the time of collapse, most of his $20 billion net worth was lost in just 2 days.
Archegos Capital Management had built up a $100 billion portfolio and had become a darling of the banking world. Brokers had received an estimated $100 million in fees from Archegos and his accounts were generating huge returns. Credit Suisse made $17.5million in fees from Archegos in just one year. On Friday March 26 however, Archegos defaulted on its loans and within 2 days the company collapsed causing over $10 billion in losses hit to its lenders. The question is, how did such a huge operation collapse so swiftly and spectacularly?
What happened?
Archegos had been set up by Hwang as a family office following a tumultuous period in business. In 2008, his hedge fund, Tiger Asia, tanked 23% after he shorted European stocks which later soared. What further angered investors was that the fund was sold as Asian-focused fund. In 2012, Hwang settled a lawsuit against his hedge fund which was accused of insider trading and manipulation with regards to Chinese banks. He was slapped with a $60 million fine and was forced to close the fund. Next year, Hwang set up Archegos, using only his own money, seemingly to restore his reputation. This proved as successful as Hwang gained a reputation as someone who makes winning betters. Archegos was an early investor in Amazon, LinkedIn and Netflix. The company posted gains of 148% in 2020 and everything was going smoothly.
Archegos largely flew under the radar of most commentators and analysts despite effectively holding significant shares in blue-chip companies. This is because Hwang used swaps to place his bets. In a swap, two parties agree to begin a series of payments at periodic intervals where such payments are determined by an underlying asset. In this case, the banks would buy stock on behalf of Archegos and the holdings would appear in the bank’s name. The banks will then periodically receive their pre-determined rate of interest while Archegos makes profits or losses based on the change in the stock price. The use of swaps meant that even the banks had no idea how much leverage Archegos had racked up as its name never appeared anywhere. Credit Suisse, Morgan Stanley, Nomura and Goldman Sachs were all lending him money. Unfortunately for Goldman Sachs, they took Archegos on as a client just 3 months before the collapse after rejecting him for years over his chequered regulatory history.
The collapse of Archegos was however, fundamentally driven by over-leveraging. Archegos was betting on company stocks and then borrowing huge sums to increase the bets. This is called margin trading. Here, an investor seeks to buys stock, putting in a small portion themselves and receiving a loan from their broker to finance the rest. If the share price rose, the bank would pay out to Archegos but if it fell the bank would contact Archegos to put up more cash. This is known as a margin call. Archegos was borrowing a huge four times as much money as it was putting in. In Archegos’ case, this leverage ratio (or debt to equity ratio) was the driving force behind its collapse.
Archegos was a house of cards and two bad days brought the house crashing down. Hwang had invested heavily in a few stocks and began taking huge holdings in big media companies including ViacomCBS and Discovery. On March 23 and March 24 2021, ViacomCBS’ shares tanked 9% and 23% respectively. As per the swap & margin agreements, the banks came knocking for more cash. The sudden crash of ViacomCBS’s stock meant the $5 million buffer Archegos had would not cover it. Therefore, Hwang would have had to sell shares and close the swap contracts. This would have seen Archegos incur heavy losses and Hwang refused.
If the stock rebounded, everyone would get their money. But if just one bank closed the swap deal and sold its position it could send the price crashing. Morgan Stanley was the first to blink, and the share price did crash, meaning everyone lost out. Others including Goldman Sachs and Deutsche Bank quickly followed. Credit Suisse and Nomura were slower and incurred the heaviest losses. Archegos is now filing for insolvency and banks are left licking their wounds.
The fallout
The small positive from this saga is that Archegos was funded by Hwang himself, not by individual investors. Had Hwang been gambling with clients’ money, the regulatory response would be frantic. While regulators are exploring this collapse, the fallout is not a severe as it could have been. Furthermore, banks have sufficient cash reserves to comfortably withstand the multibillion-dollar losses caused by the collapse.
Market investors around the world however, are paying the price for Archegos’ failing. Ultimately, ViacomCBS’ share price tanked a whopping 51% in the week. Nomura and Credit Suisse also saw double digit declines as they suffered the heaviest losses from the collapse. Other Archegos holdings including Discovery and Baidu saw a 41% and 20% crash respectively.
As mentioned, investment banks collectively lost $10 billion and are now launching legal proceedings, seeking compensation. Credit Suisse lost $4.7 billion, Nomura faced a $2 billion loss, while Morgan Stanley recently revealed losses of $911 million. Two Credit Suisse executives lost their jobs while the bank cancelled bonuses of directors and cut shareholder dividends.
Was it preventable?
Yes. Although the decline in share price was huge, this should not have seen the collapse of a $100 billion fund. Hwang’s greed spurred these astronomical leverage ratios which could not withstand deep market crashes, which are quite common. Experienced investors like Hwang know how to effectively hedge market bets to ensure their businesses can weather market storms. In the pursuit of gains however, Hwang opted not to do this.
The banks cannot take as much of the blame as they were largely in the dark. The use of swaps means the banks would not have visibility on the total sum of Archegos’ debt. Banks that got burnt in this saga are beginning to take action. Nomura has already announced it will reduce its financing for hedge funds while other banks will no doubt take similar action.
After the Archegos’ collapse, the ball is now in the court of the regulators. While regulators have clamped down on the banking sector post-2008, hedge funds and family offices remain largely unchecked. There are no margin ratio limits for hedges as there are for individual investors. Family offices and hedge funds are typically not subject to regulation. Regulators could consider keeping a closer eye on funds and offices which pose a significant risk to financial markets. Whether they will take such action remains to be seen.
