Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: a mammoth margin call, the banks on the hook, and a look back at the failure of Long-Term Capital Management. To sign up for the Capital Note, follow this link.
A Spectacular Hedge-Fund Collapse
Wall Street is taking stock of the fallout from the rapid collapse of Archegos Capital Management, a $10 billion family office run by former Tiger Global fund manager Bill Hwang. The numbers so far are astounding: an estimated $3.2 billion in losses for Credit Suisse, at least $2 billion for Nomura.
Hwang’s family office took large, leveraged positions in a concentrated portfolio of stocks including ViacomCBS and Discovery Inc., both through outright share purchases and derivatives contracts called equity swaps. Prime brokers at investment banks lent large amounts of money to the firm on margin, perhaps mismeasuring the fund’s risk because of the opacity around derivatives. Unlike holdings of shares, which require investors to report ownership above 5 percent in a single stock, over-the-counter equity swaps offer exposure to stocks without the SEC reporting requirements of shareholdings.
Hwang’s purchases of nine U.S. and Chinese tech stocks drove a steady increase in their share prices, but those positions moved against Archegos when Viacom, one of its holdings, announced an equity offering that would dilute its shareholders. Hwang, by most indications a talented investor, suddenly faced a multibillion-dollar margin call that he could not meet. In a replay of the WallStreetBets saga, when Robinhood halted buying of GameStop and other “meme stocks” as its margin exposure grew unsustainably high, Archegos’ lenders rushed to unwind the fund’s positions in block trades. The fire-sale sent shares of ViacomCBS, Discovery, and GSX Techedu, among others, plummeting.
After an unsuccessful attempt to coordinate a smooth unwinding of Hwang’s positions, brokers rushed to sell shares and derivatives at a discount. The fire-sale magnified losses for Hwang and his lenders. Archegos held an estimated $50–$100 billion in equity exposure on $10 billion of underlying capital. That magnitude of leverage means a 20 percent decline would wipe out all the fund’s capital. Thus did an otherwise unremarkable decline in a handful of stocks spur at least $20 billion in block sales in a single day.
While commentators are likening the episode to the collapse of Long-Term Capital Management in 1998, there is as yet no sign that the unwinding of the trades is causing any collateral damages in markets at large. While LTCM was a liquidity provider to the financial system, with positions spanning geographies and asset classes, Hwang’s portfolio was concentrated in a handful of stocks, minimizing the collateral damage from the margin call. Prime brokers may rethink their risk protocols around equity derivatives, but the swaps purchased by Hwang occupy a small corner of the market. The gross value of equity swaps and forwards totals less than $300 billion, dwarfed by the multitrillion-dollar markets for derivatives linked to currencies and interest rates.
And while some worry that the episode could restrict the amount of margin lending available to hedge funds and thereby cause a reduction of overall exposure, the current dynamics of markets make it unlikely that a sudden “degrossing” will depress stock prices. The combination of a volatile start to the year driven by the GameStop saga and a cyclical rotation away from tech has already led hedge funds to reduce their positions in crowded trades.
Rather than an indication of unappreciated systemic risks, the collapse of Archegos is a classic case of a levered bet gone wrong. As long as Wall Street is in the business of making money, this kind of thing will happen.
Around the Web
“It was like a game of chicken,” reports the Financial Times
Before the troubles at the family office burst into public view at the end of the week, representatives from its trading partners Goldman Sachs, Morgan Stanley, Credit Suisse, UBS and Nomura held a meeting with Archegos to discuss an orderly wind-down of troubled trades. The banks had each allowed Archegos to take on billions of dollars of exposure to volatile equities through swaps contracts, and Hwang was struggling to deal with margin calls triggered by a plunge in ViacomCBS shares. An orderly wind-down would minimise the market impact and the hit to their own balance sheets as they worked to sell down stakes in companies that Archegos had amassed through the derivatives instruments.
Credit Suisse on the hook for two recent financial failures
Credit Suisse hasn’t said exactly what size of a loss it is likely to take from liquidating positions at the fund, run by former Tiger Asia manager Bill Hwang. It is expected to say more this week, according to a person familiar with the matter. In a profit warning Monday, it said the losses could be “highly significant and material” to its first-quarter results…. Berenberg analysts put Credit Suisse’s Archegos losses at around $3.2 billion and estimated another $531 million in losses at the bank from the collapse of Greensill, which Credit Suisse lent money to and partnered with for a $10 billion set of investment funds.
In an interview with Bloomberg, legendary investor Julian Robertson vouches for his former colleague
Julian Robertson: I’m just very sad about it. I’m a great fan of Bill, and it could probably happen to anyone. But I’m sorry it happened to Bill. . . . He’s actually a marvelous person. And it’s tragic that this particular thing is probably going to have bad effects on his life. . . . He’s a devoted Christian. He works with a lot of young people and all of that. You can say all this, but he’s a very fine guy.
Here’s my favorite exchange:
MA: There were more than $20 billion of block trades on Friday. What do you think when you hear that?
JR: I think that’s an awful lot of money.
While Archegos is smaller and less systemically important than Long-Term Capital Management was, the similarities between the two margin calls are unmistakable. A bit on the collapse of LTCM, recounted in colorful detail in Roger Lowenstein’s When Genius Failed:
Long-Term . . . began to make more directional bets, abandoning (for a fraction of its portfolio) the cautious hedging strategy that had been its trademark. Scholes was deeply upset by such trades, particularly its big position in Norwegian kroner. He argued that Long-Term should stick to its models; it did not have any “informational advantage” in Norway. A year or so before, Haghani had exploded at the suggestion that Long-Term invest in Greece. “How can you trust this economy?” he had demanded. But when challenged himself, he cast such quibbles aside. Haghani felt he could never lose; he pushed and pushed his partners until he got his way.
The fund went deeper into equities, too. Knowing that many high-tech companies issued puts (options) cheaply to manage their employee stock-option programs, Long-Term bought heaps of these puts, issued by companies such as Microsoft and Dell, and hedged them by selling puts on the S&P 500.
As LTCM took more risk, its lenders looked the other way:
Wall Street knew nothing of these internal tensions; indeed, the banks continued to give the fund a free ride. Merrill Lynch happily financed the fund in Brazil — a risky market — on the slimmest of haircuts. Becoming anxious, people on Merrill’s repo desk squawked to Robert McDonough, the Merrill credit officer responsible for hedge funds, about Long-Term’s exposure in emerging markets. McDonough just laughed. “We’re in bed with these guys,” he noted. “If they go down, we go down!”
Few possibilities could have seemed more remote. Indeed, so strong was Merrill’s confidence in Greenwich that on April 1, 123 starry-eyed Merrill executives purchased (in individual, separate stakes) most of Merrill’s investment in Long-Term for the executives’ personal deferred compensation plans. Komansky, who had succeeded Tully as Merrill’s chairman, put in $800,000; in total, the executives invested $22 million. Ironically, Merrill, Long-Term’s midwife, got out closer to the top than anyone else, leaving its own executives to take the downhill ride.
When the Russian sovereign default sent markets spiraling, LTCM lost half of its capital in a matter of weeks:
In Greenwich, on that golden late-August Friday, Long-Term’s office was largely deserted. Most of the senior partners were on vacation; it was a sultry morning, and the staff was moving slowly. Jim McEntee, the colorful “sheik” whose doleful warnings had been ignored, was minding the store. Bill Krasker, the partner who had constructed many of the firm’s models, was anxiously monitoring markets, clicking from one phosphorescent page to the next. Krasker clicked from governments to mortgages to foreign debt, the entire atlas of credit. When he saw the quotation for U.S. swap spreads, he stared at his screen in disbelief. On an active day, Krasker knew, U.S. swap spreads might change by as much as a point. But on this morning, swap spreads were wildly oscillating over a range of 20 points . . .
Long-Term, which had calculated with such mathematical certainty that it was unlikely to lose more than $35 million on any single day, had just dropped $553 million — 15 percent of its capital — on that one Friday in August. It had started the year with $4.67 billion. Suddenly, it was down to $2.9 billion. Since the end of April, it had lost more than a third of its equity.
The story ends, as always, with a multibillion-dollar bailout, extended by the fund’s creditors and facilitated by the Federal Reserve Bank of New York.
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