It is important for us to take lessons from the collapse of Archegos Capital Management. There is the story we hear in the news, and the story we get from bankers in private conversations.
Way back in 2001, Sung Kook Hwang, better known as Bill Hwang, established Tiger Asia Management after Tiger Management, created by Julian Robertson, the legendary hedge fund manager, closed down. This makes him part of the Tiger alumni known as “Tiger Cubs”. Tiger Asia grew into a multi-billion-dollar hedge fund, and was one of the largest investors in the Asian Financial markets. He was a presence there before Asia really took off again with many Western funds.
In 2012, the Securities Exchange Commission charged Hwang and Tiger Asia Management with insider trading, and the manipulation of Chinese stocks. Hwang agreed to criminal and civil settlements of over US$60 million, but never admitted culpability. He then closed the fund. This sets a pattern of behaviour going back years.
One year later, Hwang converted Tiger Asia into a family office, and Archegos Capital Management was born. Hwang is a devout Protestant, the son of a preacher. The likely inspiration is from the New testament, from the Acts of the Apostles, and the Epistles of Paul. “ἀρχηγός, οῦ, ὁ”, “archegos” is mentioned four times in the New Testament. The connotations in certain Protestant circles is that it refers to leaders, or princes, “of Christ”. In Koine Greek, it simply means “leader” or “prime actor”.
By 2020, Archegos Capital Management had grown to become larger than many hedge funds, with a reported AUM is about US$10 to $15 billion. Archegos Capital Management had a very high leverage, estimated at around 6:1. That puts the total nominal exposure at about US$60 to $90 billion.
Archegos Capital Management was heavily leveraged through Credit Suisse Group AG, Deutsche Bank AG, Mitsubishi UFJ Financial Group, Morgan Stanley, Nomura Holdings, The Goldman Sachs Group, UBS Group AG, and Wells Fargo & Company. That is a diverse group of major banks: three American, one German, two Swiss, and two Japanese.
Archegos Capital Management’s derivative of choice was Total Return Swaps (TRS) or Certificates for Difference (CFD). In layman terms, when Archegos Capital Management wanted to bet, not invest, on a stock, they would go to one of the banks, and buy a derivative against them. As long as the price went up, the bank would pay them the difference. If the price dropped, Archegos Capital Management had to pay much more due to the leverage.
On the bank side, they would purchase the stock itself, in order to hedge their position, and balance their books. This made the bank the owner of the asset. All Archegos Capital Management had was a proverbial piece of paper, a derivative against the stock.
This was inherently risky. Archegos Capital Management then compounded that risk by doing the same thing, with the same stock, with several other banks. The flaw in the system here is that since Archegos Capital Management did not actually own any assets on their books, they were not obliged to make any regulatory disclosures. The investment arms of these banks were not likely to come together and share that information. Bankers are notoriously secretive and competitive. Archegos Capital Management used that against them. No one had any inkling as to how exposed Archegos Capital Management were to a single stock.
The problem with Archegos Capital Management’s exposure is compounded by the fact that they tended to trade with stocks in the media and technology space only. That was taking all their eggs, putting it in one basket, and balancing it on stilts walking on eggshells. These are what they considered to be momentum stocks. This strategy works if you can predict when the market turns, and exit. There is no algorithm that can predict the market with 100% accuracy, and this is what such a strategy needs.
Archegos Capital Management managed to build their exposure because they outperformed the market for a year, before the March 2021 meltdown. This was what lured all these banks in, because they wanted to part of this success, and make a lot of money as well. In 2021, several factors came into play. There was a change in presidency, Chinese pressure on technology giants at home, and fears of inflation before the Federal Reserve came out dovish. All this meant that yields on bonds went up, and this affected technology stocks the most. Another factor for a drop in their share price was profit taking as management in these companies prepared for a post-pandemic economy.
The problem became apparent with Viacom, one of the stocks on Archegos Capital Management had bet on. They had built up a US$10 billion exposure to Viacom. Viacom’s total market capitalisation was only US$30 billion. This meant that if Archegos Capital Management actually owned the stock, they would have owned a third of Viacom. Again, this is a system failure. When any person or entity owns more than 5% of a listed company, they have to disclose to the SEC. Archegos Capital Management only owned derivatives, not the underlying stock, so they were not required to make any disclosures, so the banks were not aware of how overleveraged they were.
On the 22nd March 2021, Viacom announced a US$3 billion share issuance. Along with the previously-mentioned macro-economic reality, the stock starts to go down, a market correction. Since the price is going down, Archegos Capital Management were hit with margin calls by the various prime brokers, at the banks. This was when the banks realised how bad the situation was.
During the week of the 22nd March, sometime on the 24th, representative of Archegos Capital Management’s major trading partners held a meeting with them to discuss an orderly exit from their troubled position to minimise market impact, and more importantly, the hit to their balance sheet. These banks had billions of dollars in exposure to increasingly volatile equity positions, and Archegos Capital Management were beginning to struggle with the margin calls. The meeting was inconclusive, and the banks could not agree on a joint action.
On Friday night, 26th March 2021, which was the start of the day in the US, the American banks forced margin calls on Archegos Capital Management, and began dumping affected shares, tanking the market. The Japanese bankers were probably asleep, and the Europeans had already left office. By the end of the day, in the US, which was the early morning of Saturday, 27th March 2021, the American banks had sold almost US$20 billion worth of shares via block trades. The Japanese and the Europeans had to stew over the weekend while the market crashed, and they were left holding the bag.
On Monday, 29th March 2021, Nomura announces losses of up to US$2 billion. And then Credit Suisse announced major impairments to their 1st quarter results, which lead to people on the management team being fired. Nomura’s shares dropped 15%, Credit Suisse is still falling after hitting the 15% mark, erasing all gains from the year.
The American banks still suffered losses of over US$100 million each, but the other banks have to absorb almost US$10 billion. Winners make ruthless strategic decisions. There are no friends in a crisis like this. The one out the door of the burning building gets the best seats to watch it burn.
There will likely be further margin calls on other hedge funds that are viewed as similarly exposed, and they would find it more difficult to convince banks to finance their risk. We will see losses all around, because of the 30% fall is share price. We may also see other hedge funds and family offices involved in similar level of trades fold.
Finally, I would be surprised if this does not lead to calls for a tightening of regulations and compliance. Banks needs to communicate more on counterparty risk management so they do not get caught out by something like this. While it was expensive, it is not big enough to tank the market. Shares that lost value will eventually regain their value since their fundamentals are largely sound, although it has also impacted earnings of funds and portfolios exposed to the technology sector.
There is a high level of systematic risk when global leverage across all funds and fund management sectors, banks and non-banks, on and off balance sheet, is very high. This is especially so for institutional investors who were looking for value in a market of depressed yields. They over-compensated.
For those who are invested in the long-term, they will see a drop
in the value of their investments for the short term, perhaps the next quarter,
as the market corrects, and recovers.
But if the underlying fundamentals are strong, and for those invested
through me, they are, the long-term investment horizon will show the eventual
value of the portfolio, and give a good return.
No comments:
Post a Comment
Thank you for taking the time to share our thoughts. Once approved, your comments will be poster.