The Collapse of Archegos Capital: Explained
Over the past month, all major global indices have been technically quite weak. Stock markets around the world are witnessing a fall as soon as there are rumors of negative cues. The fear of lockdowns amidst the exponential rise in Covid-19 cases and an increase in US Treasury Bond yield continues to create a state of panic. These factors have often led to major sell-offs in the market.
Last week, another crisis posed a threat to stock markets. Archegos Capital, a New York-based wealth management firm, has collapsed. Many prominent banks are facing heavy losses due to this incident. Let us understand the details surrounding this collapse and the impact it had on the stock market. There is a lot of financial jargon coming your way, and we will try to make it as clear as possible.
Brief Profile - Archegos Capital
Archegos Capital Management is a family office that primarily invests in the US, Chinese, and Japanese stock markets. A family office is a private entity that provides investment or wealth management services for ultra-high net worth investors. They serve very wealthy families, generally those with over $100 million (~Rs 735 crore) in investable assets.
Archegos Capital was founded by Bill Hwang, a former equity analyst at US-based Tiger Management (which no longer exists). In 2012, he was found guilty of insider trading and was charged by the Securities and Exchange Commission (SEC). Bill Hwang and the firms he managed had to pay $44 million to settle all charges. He was also forced to stay away from the investment advisory business. Thus, Hwang converted his firms into a family office. A point to be noted is that family offices are outside the regulatory scrutiny of the SEC. Most of their information or transactions are not available in the public domain.
The Collapse of Archegos Capital
Last week, Archegos Capital was forced into a fire sale of securities worth ~$20 billion (~Rs 1.46 lakh crore) after some of its portfolio stocks witnessed a significant fall. A fire sale refers to selling assets or securities at a very low price. Some of the prominent stocks in the firm's portfolio included ViacomCBS, Discovery Communications, Baidu Inc., GSX Techedu, and Tencent Holdings. The company had huge exposure to these particular stocks due to swaps.
What are Swaps and Leverage?
Swaps are a kind of derivative instrument that can be traded over-the-counter (OTC) amongst large institutional investors. Such trades do not have to be reported to the public. It allows investors to take huge positions in securities without having to pay large sums of money upfront. For investing in swaps, financial institutions often borrow millions of dollars from banks— known as leverage. So, the underlying securities were the publicly traded shares (ViacomCBS, GSX Techedu, etc) and swaps gave Archegos Capital the benefit of leverage. Bill Hwang had made huge bets on these stocks and was hoping they would perform well.
He used leverage, which is money borrowed from banks (or even brokers), for buying these shares. Prominent banks agreed to fund these transactions as they believed in Hwang’s expertise in managing money. Moreover, the lenders would also receive a lot of money through commissions.
When such transactions are conducted, a portion of stocks that a firm intends to buy are often pledged in the form of collateral with banks. More importantly, the investor has to immediately bring in additional money as collateral as soon as the stock prices begin to fall. This is because a decline in share prices leads to a fall in the value of margin with the broker/bank. This demand for additional money or collateral is referred to as margin calls, which are triggered when the value of shares falls below a certain requirement.
What Happened to Archegos?
Swaps often increase the size of investments in stocks by enabling investors to infuse only a limited amount of money. However, when the underlying investments show a decline in value, banks and brokers usually sell the shares they hold on behalf of their clients. If a client is unable to pay when a margin call is made, lenders begin to sell the shares to recover what is owed to them. If the stock prices continue to fall, these lenders would start to incur huge losses.
This is exactly what had happened to Archegos Capital and its lenders. There was a large-scale selling of ViacomCBS, Baidu, and Tencent shares— which led to the stock prices falling sharply. ViacomCBS fell 23% last Wednesday and another 30% on Thursday, as analysts downgraded the stock on account of being overvalued. The shares of other companies Hwang had bet on, such as GSX Techedu (a Chinese ed-tech company) and RLX Technologies, also started falling.
To cover their losses, Archegos Capital initiated a fire sale of the stocks in their portfolio. However, the firm was unable to meet its lenders’ calls for more collateral to secure equity swap trades they had partly financed. Most of the firm’s prime brokers such as Goldman Sachs and Morgan Stanley quickly offloaded the stock in all of Archego’s investments. As shares of the companies mentioned above were being sold or simply dumped, its stock price started falling heavily.
As per reports, two major lenders are likely to face severe losses due to their exposure to Archegos Capital. This is because the value of the collateral they were holding in the form of stocks was losing value very quickly. Japan’s largest investment bank, Nomura Holdings, is likely to face a loss of up to $2 billion. Switzerland-based Credit Suisse said a default on margin calls by Archegos could be “highly significant and material” to its first-quarter (Q1 CY21) results. As per sources, Credit Suisse’s losses are likely to cross $4 billion.
The stocks of all major banking and financial services firms that had exposure to Archego Capital saw a huge fall on Monday (March 29). Morgan Stanley shares fell 2.6% and Goldman Sachs Group took a hit of 1.7%. The shares of Nomura posted a record one-day decline of 16.3%. Credit Suisse shares dropped 14%, its biggest fall in a year.
Now you know how Bill Hwang and his firm, Archegos Capital Management, caused a mini-crash in the markets over the past week. It clearly shows the risk posed by large firms that are able to operate outside the purview of strong regulators. As mentioned before, family offices do not have to register with the Securities and Exchange Commission, nor do they have to disclose transactions. They continue to deal in securities worth billions based on rash decisions and greed. If such trades are left unchecked, it could lead to major systemic risks. The collapse of Archegos has made entities realise the importance of limits or strong regulations on swaps and leverages.