Don't Confuse Archegos Collapse With Contagion
(Bloomberg Opinion) -- A lot of overheated rhetoric is wafting around concerning the inability of Bill Hwang’s Archegos Capital Management to meet margin calls. But this is an everyday Wall Street story writ large, not a disaster that should worry regulators or anyone outside of Archegos and its lenders. The fund was not overly levered and its risk was not hidden. We may find out additional details, but from what we currently know there’s no reason to assume this was more than a losing trade by a very rich person.
One reason many seem to be over-reacting is because of reports that Archegos’ approximately $10 billion of capital (basically Hwang’s net worth) supported $50 billion to $100 billion of market positions. These figures, if accurate, are gross notional leverage, which adds together the notional value of the fund’s long and short positions. If Archegos borrowed $40 billion to buy $50 billion of one stock, that would be a lot of leverage. A 20% down move, not uncommon in individual stocks, could reduce the fund’s capital to zero and threaten its lenders with losses. But no prime broker would lend 80% of the purchase price of a single stock.
Hwang typically ran dollar-neutral portfolios, equal amounts long and short. A portfolio that is long $25 billion of stocks and short $25 billion can be much safer than one holding $10 billion of unlevered stock. Lending $40 billion against such a portfolio might be prudent. Although we don’t know for sure, reports and Hwang’s history suggest that his long positions were concentrated in about 10 stocks, while his shorts were more diversified, perhaps even among index hedges. In that case, the perfect storm would be that all his long positions have their largest down moves in history at the same time as the market as a whole goes up. Lenders that don’t lose money in perfect storms are taking zero risk, which is generally not the optimal business solution.
Granted some of this perfect storm was self-reinforcing, with missed margin calls leading to selling that pushed prices lower, leading to even more selling. But people are exaggerating the direct effect of the Archegos margin calls. Given the size and liquidity of the stocks relative to Archegos’ positions, there were likely fundamental forces at work, as well as other investors in the same position as Archegos and opportunists selling ahead of the selling they expect from others.
Another popular misunderstanding is that Archegos’ use of swaps hid the risks from creditors and regulators. There are two main ways hedge funds get leverage to buy stocks. The first is to buy the stocks in a prime brokerage account and borrow some of the purchase price from the broker. The second is to enter into a total return swap in which the broker buys the stock and the fund agrees to pay any losses on the position in return for receiving any gains. These are virtually identical economically, and pose the same risks to the prime broker. In fact, funds often buy stocks, and only later instruct the prime broker whether to hold the shares in the brokerage account or in a swap. In both cases, the broker is holding margin cash from the fund, as well as the shares. If the shares decline in value the fund must post more margin, or the broker will sell the shares and keep the margin to repay the loan.
It sometimes happens that shares fall so far and so fast in price that the prime broker loses money, and the fund lacks the cash to make good. That’s a risk of the hugely profitable ($30 billion of revenue in 2020) prime brokerage business. We are seeing reports that two prime brokers lost around $2 billion, which is an exceptional amount, but we don’t know the whole story. Some of those losses may be indirect, such as losses from the firms’ own positions. Perhaps the firms accepted inadequate margin for Archegos’ risk level, which happens sometimes when firms are anxious to grow business. But the capital rules here are quite strict, and any losses will be felt by bank shareholders. The financial system and bank creditors are not at risk. These are internal risk management issues for banks, and nothing to worry anyone who doesn’t own their stocks.
Although some banks may have made unfortunate decisions, it’s not true this risk was hidden or that there are not good systems to manage the risk. The first line of defense is the credit departments, which much approve all counterparties. These analysts had full insight into Archegos’ capital position, position sizes, risk management, processes, strategy and other factors. The credit department is not allowed to share this information with traders or prime brokerage staff, but it does examine this information carefully before approval and monitors it rigorously afterwards.
Next, the stock positions are on the banks’ books, and are subjected to extensive risk management oversight as part of the vast portfolio of long and short equity positions held. There are sophisticated quantitative models, stress tests and careful attention by the banks’ traders who know the price and liquidity situation for each name constantly. Mistakes are made, money is lost, but not for a lack of attention or knowledge.
Finally, regulators insist that large capital buffers are held to cover losses. However optimistic the prime brokerage managers were, and however aggressively they shaved margin requirements to win business, they had no control over the minimum capital needed to ensure that even in extreme events the losses were limited to bank shareholders and could not spill over to the broader financial system.
Not every credit loss is a mistake or a disaster. They are a natural part of the financial system. Other than the amounts involved, the Archegos collapse is nothing unusual. Hwang has a reason to be depressed, and some at the Wall Street banks may be looking at pink slips, but the rest of us can go about our business unconcerned.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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