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After the implosion of a little-known investment firm that bewitched banks around the world with billions of dollars in losses last week, a big question arises all over Wall Street: How did they let this happen?
The answer may come from how the company, Archegos Capital Management, with the abundant help of at least half a dozen banks, made bets on the stocks without owning them.
Archegos used esoteric financial instruments known as swaps, which get their name from the way they exchange one stream of income for another. In this case, the Wall Street banks bought some stocks that Archegos wanted to bet on, and Archegos paid fees to the banks. Then the banks paid Archegos the returns on the shares.
These swaps amplified the purchasing power of the fund, but they also created a two-pronged problem. Archegos was able to exert a much greater influence on the share prices of a few companies, including ViacomCBS and Discovery, than it could afford on its own. And since there are few regulations on these types of trades, it was not subject to any disclosure obligation.
When those bets deteriorated last week after the shares of some of the companies in question fell, it sparked a miniature crisis: the banks that had let Archegos amass such large holdings furiously sold the shares to protect their own balance sheets, and the flood of cheap stocks caused stock prices to fall even further. And Archegos himself imploded.
The blow from the blind side sent the financial system shuddering and blocked banks with losses that some analysts say could be as high as $ 10 billion. And, for a while, Wall Street feared the problems would spill over.
“The disclosure system doesn’t cover any of that,” said Dennis Kelleher, chief executive of Better Markets, a Wall Street watchdog group. “These derivatives are designed for synthetic exposure which de facto conceals ownership interests.”
As banks track their losses and their shareholders are smart about the impact on their portfolios, the tactics employed by Archegos will attract the attention of regulators and renew calls for further regulation of swaps and similar financial products, called derivatives.
The Securities and Exchange Commission said it was monitoring the situation, and Senator Elizabeth Warren, Democrat of Massachusetts, said the Archegos collapse had “the makings of a dangerous situation.”
“We need transparency and rigorous oversight to make sure that the next hedge fund explosion does not hamper the economy with it,” she said in an emailed statement.
Archegos was actually a family office, set up to manage around $ 10 billion by Bill Hwang, who previously ran a hedge fund involved in an insider trading case under his leadership. But he used leverage – essentially, trading with borrowed money to amplify his purchasing power – perhaps up to eight times his own capital, some Wall Street analysts have calculated.
In this case, the leverage manifested itself in the form of swap contracts. In exchange for a fee, the bank agrees to pay the investor what the investor would have obtained by actually holding a stock over a certain period of time. If the price of a share increases, the bank pays the investor. If it falls, the investor pays the bank.
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Archegos has concentrated its bets on the stock prices of a relatively small number of companies. They included ViacomCBS, the parent company of the country’s most watched network; the media company Discovery; and a handful of Chinese tech companies. The banks used to buy swaps held millions of shares in ViacomCBS alone.
Normally, large institutional investors are required by the SEC to publicly disclose their equity holdings at the end of each quarter. This means that investors, lenders and regulators will know when a single entity has a significant stake in a company.
But the SEC’s disclosure rules generally don’t cover swaps, so Archegos didn’t have to report its large holdings. And none of the banks – at least seven that are known to have had dealings with Archegos – saw the full picture of the risk the fund was taking, analysts said.
The use of equity-linked derivatives has increased significantly in recent years. The amount of equity derivatives outstanding – including swaps and a related instrument known as a forward – on stocks listed in the United States has more than doubled from $ 50 billion at the end of 2015 to more than $ 110 billion. billion dollars in the first half of 2020, the most recent data available, according to the Bank for International Settlements, an international consortium of central banks.
The use of swaps and other types of leverage can oversize the gains when investments pay off. But when such bets go wrong, it can quickly wipe out an investor.
This is what happened last week. Several stocks that Mr. Hwang’s company had bet on began to fall and the banks demanded that he put in additional money or other assets. Known as the “margin,” this is a cushion of liquidity meant to ensure that the bank does not lose money if stocks fall. When he couldn’t, the banks threw away millions of shares they had bought.
The effect on stock prices has been profound: ViacomCBS fell 51% last week and Discovery fell 46%. The shareholders of these companies have seen the value of their assets plunge; over $ 45 billion in shareholder value has been wiped out of those two stocks alone. And the banks lost money on all the stocks that had fallen in value. Kian Abouhossein, an analyst with JP Morgan, estimated that banks have lost between $ 5 billion and $ 10 billion in their dealings with Mr. Hwang.
Credit Suisse may have lost $ 3-4 billion, said Abouhossein. Japanese bank Nomura Securities said it was exposed to losses of up to $ 2 billion. Morgan Stanley and Goldman Sachs have said they expect minimal losses – which means it won’t seriously affect their bottom line – but for such large entities it could still mean millions of dollars. Mitsubishi UFJ Securities Holdings Company, a unit of the Japanese financial conglomerate, reported a potential loss of around $ 270 million.
Analysts say the damage has been relatively contained and while the losses have been significant for some players, they are not large enough to pose a threat to the financial system as a whole.
But this episode will most likely reinvigorate a push to expand derivatives regulation, which has been associated with many high profile financial explosions. During the 2008 crisis, insurance giant AIG nearly collapsed under the weight of the unregulated swap contracts it issued.
The cascade of problems that began with Archegos was just the latest example of the ability of derivatives to increase unseen risk.
“During the 2008 financial crisis, one of the biggest problems was that many banks weren’t sure who owed what to whom,” said Tyler Gellasch, a former SEC attorney who heads the Healthy Markets Association, a group who is pushing for market reforms. “And it looks like it happened here again.”
Matthew goldstein contribution to reports.
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