The Archegos

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If you follow the financial news, you may have heard about this controversy surrounding Archegos Capital.

In case you want to find out what this is all about, let’s dive right in

Background

Archegos Capital is the family office to manage the wealth of former New York hedge fund trader Bill Hwang. It currently is involved in the largest margin call involving a private client in history.

(The largest margin call would probably be AIG’s $100 billion top-up and mark-up in 2008)

To understand this, we need to first unpack a simple concept of how margin calls are triggered.

Margin calls arise when a bank gives a loan to a client to buy a financial asset, and the financial asset price falls below a pre-agreed threshold. The client must then post collateral, usually in the form of cash of government securities in order to bring the account “back to margin.”

The whole idea is that investing in financial assets is a risky business. Prices go up and down all the time and a bank, whose function is to make low risk bets, will find it difficult to justify giving a loan to a client to buy these financial assets. Margins solve this problem by ensuring that banks have a buffer which they can use to track how risky the loan is. The buffer ensures that even if the stock goes down in value, the bank is still protected and can sell the financial asset and make up any difference from the margin. So when a margin call is triggered, it is not that the bank has suffered any loss, but the client has suffered the loss and the banks will sell the financial asset and use the initial margin posted to keep themselves out of trouble.

In fact, margin lending is now so secure because of these provisions that banks rarely lose anything from their margin loan business, or called, securities lending in their parlance. To give you an idea, in 2016, Nomura sustained a $40 million loss in its trading arm and considered it so out of character that they called it due to an “incompetent trader.

Keep that figure in mind.

Now in Archegos case, they used this instrument called an ‘equity derivative’ instead of buying stocks. Think of it as a Contract For Difference, namely you only need to pay the difference between the current trading price and the price the contract has entered in.

Now the use of this contract is actually a key part of this controversy. This is because if you past a certain percentage ownership in a stock, you need to declare to the Security Exchange Commission as a substantial holder of the stock. Your name will also appear in the company’s annual report as one of the major shareholders of the company.

In the case of Archegos, the firm actually had beneficial interest well over the 15% threshold for certain stock counters, but he never declared to the SEC as being a substantial shareholder. This was because Archegos never owned a single share of the stock, only substantial contracts that were equity derivatives  referencing over a 15% of the company outstanding number of shares.

So what happened?

Beginning in February and leading into March, there was a sell-off in the tech world, concentrated in some China linked stocks and Media stocks. Unbeknown to the bankers, Bill Hwang’s true exposure to those stocks was much higher than previously thought of because he had multiple accounts with different banks, including Morgan Stanley, Goldman Sachs , Nomura and Credit Suisse. So each individual banker will probably think that their position was small compared to Bill Hwang’s wealth, put in reality, the total position was much higher than Bill Hwang’s total wealth. And the total position was correlated to these few stocks.

Early last week, some of these media companies took the opportunity of their elevated share price to do a secondary equity raise at a price substantially below their last traded price. This was the trigger for a sell-off and very quickly Bill Hwang’s position blew past the margin and the banks had to act fast.

Smart vs slow banks

The smart banks were Morgan Stanley and Goldman Sachs. They sold millions of shares used to risk manage Bill Hwang’s position way earlier than the other banks, namely Nomura and Credit Suisse. As a result Morgan Stanley and Goldman Sachs exited their position and suffered little losses, if any.

Slow banks

However not all banks were as smart as Goldman Sachs and Morgan Stanley, namely Nomura and Credit Suisse. They either did not have the systems or the management structure to understand clearly what was going on and did not exit their position. It could be that Bill Hwang was such an important client that no risk manager could do anything without the relationship manager’s okay!

As a result both entities have now publicly declared that they have suffered huge losses. Nomura has estimated the losses at US $2 billion, Credit Suisse estimates the loss at $1 billion, but people think it could be as high as $4 billion.

Moral of the story

  1. Bill Hwang is a risky client as he had already paid a fine of more than $40 million several years back to settle cases involving in insider transaction.

2. American banks have an information edge to European and Japanese banks when it came to US capital markets. They understood the situation earlier than others and made a quick decision to get out of the position in record time. In fact, the US bank traders were willing to sell millions  blocks of shares , which collapsed the share price to exit the position.

3. Risk management: Banks where risk management is important will not suffer loss. Those ruled by their front office, will suffer loss. Good luck.


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