After the implosion of a little-known investment firm that last week weighed billions in losses on banks around the world, a big question is being asked all over Wall Street: How did they let this happen?
The answer could be because Archegos Capital Management, with the full support of at least half a dozen banks, placed bets on stocks without actually owning them.
Archegos used esoteric financial instruments called swaps, which get their name from the way they exchange one stream of income for another. In this case, Wall Street banks bought certain stocks Archegos wanted to bet on and Archegos paid the banks a fee. Then the banks paid Archegos the stock returns.
These swaps increased the fund’s purchasing power, but also created a two-pronged problem. Archegos has been able to build a lot more leverage on the stock prices of a few companies, including ViacomCBS and Discovery, than it could afford on its own. And since there are few regulations governing this type of business, there have been no disclosure requirements.
When those bets got sour last week after the stocks of some of the companies in question fell, it sparked a miniature crisis: the banks that made Archegos amass such large holdings angrily sold the stocks to protect their own balance sheets and the tide of cheap ones Shares pushed share prices even further down. And Archegos himself imploded.
The blind-side hit shuddered the financial system, stuck banks at losses that some analysts say could hit $ 10 billion. And for a time Wall Street feared that problems might cascade.
“The disclosure system doesn’t cover any of this,” said Dennis Kelleher, executive director of Better Markets, a monitoring group on Wall Street. “These derivatives are designed for synthetic exposures that de facto hide ownership.”
If banks add up their losses and shareholders are wise about the impact on their portfolios, the tactics used 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 was “all set for a dangerous situation.”
“We need transparency and strong scrutiny to ensure that the next explosion in hedge funds does not affect the economy,” she said in a statement sent via email.
Recognition…Emile Wamsteker / Bloomberg News
Archegos was actually a family office set up by Bill Hwang, who previously ran a hedge fund that was involved in an insider trading case under his leadership. However, some Wall Street analysts calculated leverage – essentially trading borrowed money to increase their purchasing power – that was potentially eight times their own capital.
In this case, the leverage was shown in the form of swap contracts. In return for a fee, the bank undertakes to pay the investor what the investor would have received through the actual possession of a share over a certain period of time. When the price of a stock rises, the bank pays the investor. If it falls, the investor pays the bank.
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March 31, 2021, 6:27 p.m. ET
Archegos focused its bets on the share prices of a relatively small number of companies. These included ViacomCBS, the parent company of the country’s most watched network; the media company Discovery; and a handful of Chinese technology companies. The banks that bought swaps alone held millions of shares in ViacomCBS.
Typically, large institutional investors are required by the SEC to publicly disclose their holdings at the end of each quarter. This means that investors, lenders, and regulators know when a single company has a large stake in a company.
However, the SEC disclosure rules typically do not apply to swaps, so Archegos did not have to report its large holdings. And none of the banks – at least seven known to have had ties with Archegos – saw the full picture of the risk the fund was taking, analysts say.
The use of equity-related derivatives has increased significantly in recent years. The number of equity derivatives outstanding – including swaps and a related instrument known as a forward – for US-listed stocks more than doubled from $ 50 billion at the end of 2015 to more than $ 110 billion in the first half of 2020, according to current news 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 exceed profits when investments pay off. But when such bets go wrong, it can quickly wipe an investor out.
That happened last week. Several stocks that Mr. Hwang’s company had bet on began to fall, and banks demanded that he put up additional money or other assets. Known as “margin,” this is a cushion of cash that is designed to ensure that the bank does not lose money if stocks fall. When he was unable to do so, the banks tossed millions of stocks they had bought.
The impact on stock prices has been profound, with ViacomCBS down 51 percent and Discovery down 46 percent last week. The shareholders of these companies saw the value of their holdings decline. Those two stocks alone were wiped out with shareholder value of more than $ 45 billion. And banks lost money on stocks that had fallen in value. Kian Abouhossein, an analyst with JP Morgan, estimated that banks lost $ 5 billion to $ 10 billion in their dealings with Mr. Hwang.
Credit Suisse may have lost $ 3 to 4 billion, Abouhossein estimated. Japanese bank Nomura Securities has stated that it is exposed to losses of up to $ 2 billion. Morgan Stanley and Goldman Sachs have announced that they expect minimal losses – meaning it won’t seriously affect their financial results – but for such large companies that 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 minor, and while the losses have been large for some players, they are not large enough to pose a threat to the wider financial system.
But the episode will most likely revive a push to expand derivatives regulation that has been linked to many significant financial blows. During the 2008 crisis, insurance giant AIG nearly collapsed under the weight of the unregulated swap contracts it entered into.
The cascade of problems that began with Archegos was just the latest example of the ability of derivatives to increase invisible risk.
“During the 2008 financial crisis, one of the biggest problems was that many banks didn’t know who owed what to whom,” said Tyler Gellasch, a former SEC attorney who heads the Healthy Markets Association, a group advocating market reform. “And it seems this happened again.”
Matthew Goldstein contributed to the coverage.