Margin Call: How Archegos Capital Management failed to go on 'do not disturb'
Prime brokers took a toll after putting their trust and lucrative lending in a volatile hedge fund, Archegos Capital Management, led by controversial fund manager Bill Hwang. The debacle soon revealed the number of risks hidden in profitable, but nonetheless opaque, equity derivatives, which are often chased after by hedge funds for their high returns. Banks involved included Credit Suisse, UBS and Nomura, which were most likely aware they were playing with fire when lending to the hedge fund, but unaware that that fire would soon cause billions to go up in smoke. When margin calls, is there enough capital to make it to the call?
Source; Scene from the film 'Margin Call'
Margins and synthetic financing
In investment terms, margin refers to the buying of stock or other securities with a combination of the investor’s own funds e.g. a hedge fund, and borrowed funds e.g. from a bank or broker. It is the difference between the total value of securities held in an investor’s account, and the loan amount from the lender. The bank or broker act as a lender, and the securities the investor buys are the collateral.
Hedge funds using margin for purchases usually pay interest in return for their loan, which earns banks steady income streams. The stock-price changes between the purchase and the sale create leverage for the investor, i.e. the investor’s percentage gain/loss is magnified compared to the percentage gain/loss had the investor purchased through wholly owned funds. In cases where the investor is expecting returns of a higher rate than the interest on the loan, margin investing is seen as advantageous.
To offset the exposure, the lender will usually either own the underlying assets, or buy a hedge from another financial institution. A total return swap (TRS) is a financial contract, namely a bet on the movement of a stock. Where the stock goes up, the bank reimburses the investor, as well as any dividends distributed as a result of holding the stock. If the stock falls instead, the investor makes payments to the bank, from a daily to a quarterly basis.
The high stakes involved in this scenario mean that the bank is at the risk of the investor’s default, especially if there is not sufficient capital at the hedge fund’s end. Looking at global rules on swaps, the Basel Committee on Banking Supervision and the International Organisation of Securities Commissions have set out rules on asset managers to cover their swaps deals through a restriction called the maintenance margin. This is the minimum account balance the investor must maintain, usually to cover 10 days of possible losses, based on the historic performance of the shares. If that is not maintained, the lender will attempt to force the investor to deposit more funds, or sell the stock to pay down the loan; this is called the margin call.
Derivatives lawyers have noted that post-financial crisis, capital rules helped insulate wider markets. When it comes to disclosures, banks are said to treat equity TRSs as collateralised loans for accounting purposes, and thus they do not make it to the derivative trading desk of the bank. This, in turn, means that they are not filed under the Basel III regulations on risk-weighted assets, leverage and credit risks – all global banks are required to make these .
Archegos Capital Management
Bill Hwang previously served as founder of Tiger Asia Management; a fund which pleaded guilty to use of inside information to trade Chinese stocks in 2012. Hwang was also banned from trading securities in Hong Kong in 2014 for 4 years. One year later, he emerged from the shadows to set up a new secretive ‘family office’, Archegos Capital Management. He was allegedly seen as a compelling prospective client by prime brokers, being called an “aggressive, moneymaking genius” by analysts at Goldman Sachs. Despite his unfavourable track record, he was successful in growing $200mn of assets to $10bn, just within 9 years of setting up Archegos.
Banks linked to Archegos include Wall Street lenders Goldman Sachs, Morgan Stanley and Wells Fargo, as well as Swiss UBS and Credit Suisse, and Japanese Nomura, which were all competing for its business when it was first set up – then seen as a source of great fee opportunities. The banks lent billions in credit to Archegos, to make “highly-leveraged bets” on US and Chinese stocks, including those of ViacomCBS, a US broadcaster.
Profits were made through total return swaps, which as explained above, are a type of “synthetic financing” allowing hedge funds to make large bets without buying shares or disclosing positions. Positions are not disclosed as equity TRSs are essentially contracts between two parties, and as a result do not have to be cleared and reported through an exchange. The opaqueness of TRSs means hedge funds, like Archegos, are able to enter similar swaps with several lenders, while the lenders remain unaware of the fund’s accumulating exposure.
Archegos was successful at flying under the radar until its bet on the ViacomCBS stock collapsed. After a number of Archegos' positions dissipated, a mass wave of selling off from the banks was set off, wiping $33bn from the companies involved. This was triggered as a result of Archegos defaulting on margin calls on positions on its high-flying stocks, and banks were left losing extreme amounts of money, and asking themselves whether lending to a highly leveraged hedge fund was worth it.
“If there are five different banks providing financing to a single client, each bank may not know it, and may instead think it can sell its exposure to another bank if they run into trouble – but they can’t, because those banks are already exposed”; Tyler Gellasch, former SEC official
In fact, the FT reported that crucial parts of the 2010 Dodd-Frank Act do not apply to hedge funds like Archegos, while the Act is responsible for improving accountability, transparency and financial stability in the US financial system. Reuters reports that when the Act came in force, it exempted “any company which provides investment advice about securities to family members, and is wholly-owned and exclusively controlled by family members or entities”. This meant that such companies, of whose structure Hwang adopted when setting up Archegos, would not have to: register with the SEC; provide quarterly public reports on equity holdings and derivative trades; disclose ownership structure, assets under management, or bank relationships. The adoption of proposed amendments to the Act were delayed by the US Securities and Exchange Commission (SEC), as a result of Covid.
A run through the losses: Nomura reported a $2.9bn loss, suffering its biggest quarterly loss since the 2008 global financial crisis and suspending its head of prime brokerage as a result; UBS losses reached $861m; Morgan Stanley took a dent of $911m; while Japanese MUFG and Mizuho reached a collective $390m.
Credit Suisse: the aftermath and compliance takeaways
The biggest loss, however, was suffered by Credit Suisse, as one of the several lenders to Archegos, and the leading European provider of prime services. While the bank made $17.5mn last year in revenue through Archegos fees, the loss amounted to $5.4bn, with the group opening two investigations by external parties into the events which led to the losses. Reportedly, the bank demanded a margin of only 10% (judging by industry standards), for the TRSs traded with Archegos, and allowed a 10-times leverage on transactions. Coupled with another recent loss suffered by the bank through Greensill Capital, alarm as to the bank’s risk management processes has been raised, with chair António Horta-Osório promising an urgent review of the bank’s risk management, strategy and culture.
The incident rightfully points to how essential risk management is in the banking and finance industries, and there are several compliance lessons to be learned. Both the SEC and the Commodity Futures Trading Commission have called for regulation of “family offices”, which was relatively lax under the Trump administration; exempting them from disclosures of previous disqualifications or from undergoing stringent KYC. The aftermath of this debacle serves as an impetus for risk functions within financial institutions to revisit their firms’ trading documents, strive for accurate and reliable pricing of the inventory, aggregate risk exposure and certify their rights in assets, to withstand any imminent stress events .
Interested in reading more: The future of bank risk management, McKinsey & Co