There was a cruel irony about Archegos Capital collapsing a week ahead of Good Friday. In Hebrew, Jesus Christ is referred to as the Archegos of Life. Archegos in Greek is used to refer to a person who shows the way and to top it all, Bill Hwang who ran Archegos Capital was a devout Christian. Just a few days ahead of Good Friday 2021, Archegos Capital sank under the weight of leveraged bets that went wrong.
In the process, Archegos Capital inflicted billions of dollars in losses to banks that funded its operations. Fund houses imploding due to excess risk is nothing new. It happened with Peregrine, LTCM, Bear Sterns, Refco, Man Financial and the list can go on. In all these cases, the reasons for the implosion were unbridled risk, misuse of derivatives, lax risk controls and lot of greed. Archegos Capital was no different.
Archegos Capital used an approach that is not still well understood outside very exclusive circles. To understand the reason for the implosion, let us look at 4 aspects of Archegos that led to this situation viz. Family Office, Total Return Swaps (TRS), Prime Brokers and Leverage.
Family Office: How the concept was misused
A family office is an institutional mechanism for managing wealth of rich families. Normally, family offices focus on preservation of wealth accumulated over time. However, with falling rates of return on fixed income investments, family offices are increasingly looking at higher risk instruments. While hedge funds manage $3.8 trillion globally, family offices manage around $6 trillion. In short, family offices are really huge.
Then there is the leniency in regulation. The Dodd Frank Act signed by Barrack Obama in the aftermath of the financial crisis, set stringent controls on the operation of hedge funds and investment funds, since they handle public money. However, family offices were exempted as they managed private money. It was this loophole that the Archegos founder, Bill Hwang, exploited to the hilt by doing high risk trades behind his family-office structure.
Prime Brokers: How they played a part in the fall of Archegos
Prime brokers are more common in the US where the broker not only executes but also funds the trade for a fee. Most of the funded trades are backed by securities but as clients become bigger, banks relax collateral rules. Also, funds like Archegos, use multiple prime brokers and get multiple rounds of funding, so overall risk is never known. That is when it is possible for prime brokers to get into trouble if the fund implodes.
The family office of Bill Hwang used Goldman Sachs, Morgan Stanley, Nomura and Credit Suisse as prime brokers. When the value of the notional holdings of Archegos started falling, prime brokers dumped positions in the market and exacerbated the fall. Over the next few days, Goldman Sachs and Morgan Stanley escaped with minor losses but Nomura and Credit Suisse could book losses of over $2 billion each. But where did prime brokers go wrong?
Total Return Swaps (TRS)
The crux of the problem was a product called Total Return Swap (TRS) used by the prime brokers and Archegos to take huge leveraged positions in the market. TRS is not an equity position, just a bet on stock price movement. TRS is a structured product and here is how it worked.
If the price of the stock is unchanged, the prime broker pays the dividends to the investor and the investor pays the fixed committed fee to the prime broker.
If the price goes up, the investor pays a fee to the prime broker. The prime broker pays the investor the dividends and a part of the price appreciation as reward.
If the price goes down, the prime broker pays the dividends to the investor but the investor pays the prime broker a fee and also compensates for stock price depreciation.
As you can see from the above 3 scenarios, the prime broker can never really lose money. It is not surprising that prime brokers earned $11 billion as fees last year from these Total Return Swaps. The only risk is if the investor implodes, which is exactly what happened at Archegos when the sharp fall in price led to huge losses on the TRS forcing the fire sale. But the real problem was of leverage.
Leverage on leverage can be awfully dangerous
Leverage is debt, but what is leverage on leverage? If you buy stock futures worth Rs10 lakh by paying Rs2 lakh as margin, that is 5-times leverage. If this margin money is funded by a bank up to 80%, then you actually put in Rs40,000 to take an effective position of Rs10 lakh. That is leverage on leverage and it is 25 times. Even a 1% negative movement can have a huge impact on your holding capacity.
Archegos had used TRS to bet on Viacom CBS, Discovery, Tencent Music, GSX Techudu and Baidu. When the prices fell and prime brokers started dumping shares, the leverage began to hurt and eventually pushed Archegos to the brink. In a way the family office model, the leniency of prime brokers and the TRS product exacerbated the crisis, but eventually it was crazy leverage that killed Archegos.