What’s your definition of a bad week? Join Jack Myers as he explores how poor risk management and excessive leverage cost Archegos Capital $20 billion in less than two days
When it Rains, it Pours: Leverage and the Collapse of Archegos Capital
We all have our bad days. Flat battery, burnt toast or a missed bus. How about losing US $20 billion in 48 hours? In late March this nightmare became reality for Bill Hwang’s Archegos Capital, as an unpopular announcement by ViacomCBS executives set off a chain of events that culminated in the liquidation of the fund’s portfolio.
Archegos had borrowed money from a number of banks to finance big bets on a handful of companies. When these bets went south, the fallout resulted in a race to the bottom and some eye-watering losses for those last out the door. This ordeal provides a spectacular reminder of the beguiling nature of excessive leverage, and how information asymmetry can cause devastating market failures.
Bill Hwang founded Archegos in 2013, and allegedly grew the fund’s assets under management from $200 million to an estimated $20 billion by 2020[i]. Prior to opening his family office, Hwang had worked for funds such as Tiger Management and Tiger Asia Management. He ran into trouble at the latter, where he faced insider trading charges for a number of trades involving Chinese bank stocks.
Archegos ran a simple yet risky strategy, holding a portfolio that was comprised of only a small number of stocks. This meant that its performance was highly contingent on these picks being right, and exposed the portfolio to large losses if they weren’t. Archegos also incorporated significant leverage into its’ strategy through the use of total return swaps, which added considerably to risk.
What is leverage?
Leverage is the act of borrowing money. In financial markets, it primarily refers to the use of debt to fund additional investment. Much like a lever helps you lift an object with less effort in the physical world, in markets it amplifies the return on an investment. As such, it is widely used by individuals and institutions.
While this sounds great, it is unfortunately a two-way street, meaning that any losses incurred are also magnified. If the price of an asset falls, so too does the ratio of the total investment (including borrowed capital) relative to the individuals initial investment. When trading securities, this triggers what is known as a margin call, where the trader needs to put up more money to maintain the leverage ratio and protect the brokerage if the investor is at some point unable to cover their losses. The more leverage used, the smaller the price decline needed to trigger a margin call. Before the collapse, Archegos had built up to a net leverage of around 5 times its’ investment.
Total Return Swaps
Archegos obtained its leverage through a financial instrument known as a total return swap. A total return swap has two parties: the Payer (Banks) and Receiver (Archegos). The receiver pays the payer a regular fee and interest to invest in assets on their behalf and in exchange the payer passes on the returns from these assets. The banks only require receivers to post margin, which is a small percentage of the total value of the investments they make. This allows them to take advantage of the aforementioned benefits of leverage[ii].
Where did it all go wrong?
The mechanics of total return swaps don’t lend themselves to an overly risky investment strategy. The real catalyst was the sheer volume of swaps used as a result of dealing through multiple brokers, and the information asymmetry that followed.
Information asymmetry occurs when one party in a transaction has access to more information than the others involved. Due to Archegos’ classification as a family office, they were not required to report their holdings to the US Securities and Exchange Commission. This meant that their lenders were unaware of the large and risky positions they held with other lenders, a key piece of information that likely would have stopped the banks from providing Archegos so much leverage.
The straw that broke the camel’s back occurred on the 22nd of March, when ViacomCBS announced that it was raising equity to build a streaming service. This move wasn’t popular with their shareholders, and triggered a sharp decline in the stock price. The fall was great enough to elicit a margin call from all of Archegos’ brokers. It became clear that Archegos had taken on too much leverage and was thus unable to service these calls, leaving brokers with no choice but to sell the positions they held on Archegos’ behalf, in what is commonly known as a fire sale. This increased selling pressure further pushed prices down, meaning the last banks to sell, including Credit Suisse and Nomura, realised large losses on their positions[iii].
Through the misfortune of Archegos, we have a great opportunity to understand what leverage is, why its attractive, and how that attraction can occasionally prove fatal. We also see how information asymmetry can cause market failure, in one of the most strikingly large examples in financial markets to date.