Over the past week or so there has been some unusual volatility in a handful of stocks, both US and Chinese. Media reports have attributed the volatility to forced selling associated with a large family office called Archegos. Archegos was started by Bill Hwang, who is a disciple of the legendary investor Julian Robertson. Julian Robertson started Tiger Management – a hedge fund – in 1980 and made a gazillion dollars for himself and his partners over the ensuing 20 years. According to Wikipedia, Tiger Management’s assets under management had grown to a massive $22 billion by 1998, making it the one of the largest hedge funds in the world at the time. Not long after that in 2000, Tiger Management effectively wound down its operations as a result of some heavy investment losses. However, Robertson’s legacy endured as many of his former disciples, known as “Tiger Cubs”, went on to start their own hedge funds or family offices. Bill Hwang was one such individual.
Following his stint at Tiger Management in the 1990s, Bill Hwang founded his own hedge fund, Tiger Asia Management, in 2001. In 2012, Hwang pled guilty on behalf of Tiger Asia (the firm was charged, not him personally) of insider trading in Chinese stocks. As part a settlement, Hwang was forced to pay a fine and was banned from managing outside money and trading in Hong Kong for a few years. As a result of this plea deal, Tiger Asia (then with assets around $5 billion) was reorganized from a hedge fund to a family office called Archegos.
Hwang’s Archegos family office, in turn, ran into a big problem a few days ago. The root cause of the problem this time was – you guessed it – leverage. Though Hwang had a massive amount of his own personal wealth to invest, he and his colleagues chose to magnify that investment power through the use of leverage. The leverage was made possible by three primary factors. First, the major investment banks were more than willing to extend credit to Hwang in an effort to generate more revenue from their relationships with him. The banks offered access to esoteric investment strategies involving derivatives, which allowed Hwang to leverage his estimated $5-$10 billion in capital to reportedly make investments totaling as much as $50 billion. Second, the use of derivatives to magnify Archegos’ equity holdings meant that the family office was not required to disclose large effective ownership positions, even in cases where ownership grew to represent 10% or more of a given company’s stock. This allowed Hwang to hide his exposure from the investing public as well as from his various bankers, who may have been unaware of his total exposure to individual stocks. And finally, family offices have greater flexibility than hedge funds. According to an article in the Wall Street Journal, “Family offices don’t have a fiduciary duty to keep their trading limited, and don’t have nervous investors to deal with. This can add to firms’ comfort with risk, say some who work with family offices.”
Archegos’ problems began with its large concentrated positions in US media companies ViacomCBS and Discovery, as well as several Chinese tech companies. By working primarily with five investment banks – Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura, and Credit Suisse – Archegos was able to maximize its exposure to these individual stocks and accumulate very large effective ownership percentages. When the stocks sold off and Archegos was unable to meet the collateral requirements for the derivative agreements, the banks started to liquidate positions. And once one of Archegos’ banks started selling (reportedly Goldman Sachs was first), the others followed suit. As the banks scrambled to reduce their exposure, the result was a massive drop in prices in a very short period of time. And due to the leverage created by the derivative positions, Archegos net assets fell negative as three huge positions collapsed in value.
It doesn’t appear that any of the banks doing business with Hwang was in significant risk of collapse, much less of triggering a broader financial collapse. Goldman Sachs, one of the first movers as the crisis evolved, has said the impact on their books was “immaterial.” By contrast Credit Suisse finished 2020 with a 12.9% capital buffer reserve, somewhat above their target of 12.5%. The estimated damage to Credit Suisse will drop their buffer to slightly below 12% — enough to cause pain, but far from an existential crisis.
Capital and liquidity requirements were made more onerous following the Financial Crisis to protect against systemic risks such as this. However, this mini-crisis is an example of the opacity still rampant within our global financial system. Warren Buffett famously said that you only find out who’s swimming naked when the tide goes out. The reality is that there are many more huge family offices and hedge funds out there with large concentrated positions, and there is no way to definitively say whether any of them is large enough to cause a systemic financial risis. Regulation, for all its improvements since the Financial Crisis, appears to have encouraged risk-taking by both the banks and family offices like Archegos in areas less visible to regulators and the investing public. And the magnitude of derivative exposure appears to be no better than before the Financial Crisis.
I would expect that as the regulatory post-mortem of Archegos is completed, there may be support for additional oversight of hedge funds, family offices and capital markets firms. But the reality is that these types of investment funds are huge money makers for Wall Street, and it may be hard to get legislation passed unless there is a far bigger crisis.