You would think hedge funds and the banks that provide funding and services to them will have learned lessons from the past. One of the most impactful implosions of a hedge fund was the 1998 demise of Long Term Capital, now a notable chapter in financial-markets history. Books were written about its surprising collapse.
But too often the lessons from that time are forgotten. That episode (Long Term Capital) and its sudden exit, after it had attracted some of Wall Street's best traders and two Nobel Prize laureates, got immediate attention from the Federal Reserve. As a regulator of bank holding companies, the Federal Reserve Bank (New York) found a way to squeeze into of that late-summer, 1998, chaos to orchestrate a wind-down to avert systemic risks on markets. Finance historians explain the Federal Reserve's role, a pivotal moment for how it intervened in a segment of the financial system not clearly under its supervision.
What goes around seems to come around. In finance, history is often lost within a generation or so. Lessons are written. Bits and pieces of regulation are implemented. Since then, hedge funds are not regulated financial institutions, but those of a certain size must report their balance sheets and positions to bank supervisors. And after the financial crisis of 2008-09, big banks were forced to withdraw from this sector as traders and investors.
Years later, while still permitted to determine themselves how much leverage they desire or capital they must maintain, hedge funds still take on as much risk as they prefer. They remain glued to trading strategies that work well when designed in conference rooms with the help of models, computations, and napkin scribblings over lunch, until they don't work and they lead to losses measured by millions and then billions.
In some ways, if the Federal Reserve or the SEC doesn't formally regulate the hedge fund, then its bankers could. If the fund is too highly leveraged, has too much concentration in trading positions, or appears not to have ample amounts of capital cushion, then the bank (or broker/dealer or another fund) can choose not to do business with it. But of course, it loses the opportunity to make millions while supporting the fund's operations.
In 2021, a hedge fund few knew much about found its way to the front pages. Bill Hwang's Achegos was widely known in hedge-fund circles, partly because of his esteemed role at Tiger Management, run by hedge-fund legend Julian Robertson.
Like many funds, Archegos amassed huge positions, misunderstood or mis-calculated the risks in the postions, took sudden losses that wiped out much of its capital base and caused its funding and counterparty banks to take losses. Another chapter in hedge-fund history, but one where many participants involved might have ignored Long Term Capital lessons.
Compare Archegos to AIG, the giant insurance company. Back in 2008, it, too, had amassed substantial trading positions tied to a collapsing mortgage market. It had sold "credit default swaps" on mortgage securities and anticipated it would suck in the the CDS premiums indefinitely--a seemingly easy business to manage as long as there was no foreseable, formidable collapse in mortgage markets.
By late 2007, the unforeseable occurred. It accumulated losses in billions (marked-to-market trading losses) and owed the same to counterparties (including Goldman, UBS, JPMorgan, and others). But in this case, the U.S. Government intervened conveniently and recapitalized AIG and permitted the new structure to pay out counterparties. Shareholders were pummeled, management was escorted away, but a restructured AIG exists today.
Archegos was not big enough, important enough or critical enough to warrant Government supervisors to step in with bail-outs (something even less likely to occur in 2021, especially for non-banks). Its counterparties on the gigantic trades had to take losses exceeding hundreds of millions, topping a billion in one or two casses.
Banks hurt when hedge funds collapse because hedge funds rely on banks to support their trading activities in the way. They need banks for
(a) funding (secured loans) their positions,
(b) executing trades on their behalf (prime brokerage),
(c) custody for holding securities on their behalf,
(d) derivatives counterparties to help in hedging or using the same to gain a "synthetic" position,
(e) currency sales and trading, if trades involve foreign markets,
(f) futures and commodities brokerage if they seek positions in futures markets,
(g) securities lending, when they need to source securities to borrow to effect "short sales," and
(g) cash-management services if fund transfers are necessary. The list could be longer.
Long Term Capital even had syndicated bank revolving-credit facilities in place to ensure funding over an extended period of time. If overnight and short-term funding markets disappeared, it could tap into the committed bank credit line.
Since 1998, many banks regrouped and reassessed their strategies involving hedge funds as a client base, implemented strict risk policies, and required more safeguards. In that respect, banks "regulated" hedge funds and had become selective in choosing which funds to maintain relationships (or "onboard") and which funds to avoid.
The industry is still formallly unregulated (or at best, extremely lightly supervised), but important enough to banks because of the revenue opportunities. When banks engage in business with hedge funds, it becomes a risk-vs.reward analysis. The rewards can be mammoth, but the risks are too often hard to measure.
The industry continues to have hiccups intermittently since Long Term Capital--e.g., Amaranth, a natural gas trader. The 2008 Madoff scandal-collapse fits into this timeline somewhere, too. An electricity trader in Europe caused a temporary shut-down in 2018 at a derivatives clearinghouse at Nasdaq.
In 2021, the bold, brazen Archegos fund decided to accumulate positions in ViacomCBS stock (among other equities), but not at modest amounts. It sought positions by
(a) purchasing the stock outright in public markets and
(b) creating "synthetic" positions via derivatives markets.
In the case (b), that might mean purchasing call options or selling put options, but also might involve something called "total-return swaps," a derivative that is not new and permits funds to accrue gains without buying the underlying stock.
Whether Archegos sought positions via (a) or (b), it needed a counterparty and/or a willing bank.
The bank will be lured by hefty fees, but will have (or should have done) analysis and homework of the hedge fund itself (track record, earnings performance, trading expertise, balance-sheet leverage, capital adequacy, in-house risk management, etc.). The bank will have (or should have) analyzed the market risks related to the trading positions hedge funds are putting on. The bank might have required the fund to compute what is called the "VaR" of the trading position (or computed it itself) ("Value at Risk," a modelled computation of what the worst loss would be on the position with 95-99% confidence over a 1-10-day period.)
It appears Archegos (or Hwang, essentially) had overwhelming confidence that the price of ViacomCBS shares (and other names) would increase sharply over a defined period of time. That confidence might have been advanced by any number of factors: the media industry, company management, its adapting or evolving business model, certainty in future cash flows, expectations that it might combine with other media companies, etc.
Whatever the reason, the hedge fund wanted to capitalize on the likely prospects of future price appreciation. Just like many funds wedded to their notions or models, they chose not to take a modest or disciplined approach. They chose to bet the house and amplify returns via balance-sheet leverage: A 20% increase in the underlying stock could lead to a 40%-plus return for investors if it borrowed most of the funds to get into the positions.
Borrowing, of course, requires cooperating banks. And banks get comfortable by requiring the fund to pledge the underlying stock as collateral (with a reasonable, conservative cushion, or requiring the collateral to be, say, twice the amount of the loan outstandings).
Banks, too, would provide the funding at their discretion, meaning they offer the loan on an overnight or roll-over basis. The fund can borrow as long as there is sufficient collateral (ViacomCBS stock, in this case) or as long as banks are comfortable with the fund and exposure. Once they sense excessive risk or trouble (or see signs the fund's positions are spiraling out of control and resulting in mammoth losses), they can choose to call the loan. Often the request to call the loan and require payback is too late, history reminds us. The losses will have occurred as soon as the bank has valued the underlying collateral.
Along the way, banks, of course, earn an interest spread on the loan, which is a lesser reward than the risks attached to the exposure. But they gain all those other ancillary rewards from executing trades, acting as brokers and holding securities in custody on behalf of the fund (as described above).
Banks, however, individually and collectively, will have a limit in how much funding they are comfortable in providing. If a hedge fund like Archegos wants to increase its position (or gain more leverage in the position) and if banks have capped their tolerance for loan exposure, then the fund seeks other (synthetic) ways to achieve the position.
And that's where the "total return swap" comes in play.
In this case, Archegos enters into contracts with banks (or other funds) where it will pay counterparties an interest rate (say, quarterly) applied to a notional amount (say, $100 million). It will receive the percentage change in price of the underlying stock (reference asset) from the banks. If over six months, the stock rises by 12%, then Archegos pays the banks a rate pegged to Libor, and the banks pay Archegos 12% (times $100 million).
This permits Archegos to enjoy the gains of increases in ViacomCBS stock without owning it.
Always there's a hitch. If ViacomCBS stock falls in value, then Archegos must pay the Libor-pegged interest and the amount of the stock decline.
In its case, earlier this year, as the stock plummeted after it surged in late 2020. Earlier this year, the stock had reached $97/share; in recent days, it has been valued at $41/share (a 58% decline).
Each bank that engages with the fund (via lending or transacting via the derivative) won't necessarily know what other banks are doing. From day to day, banks can only guess at the total positions the fund has in one stock. From quarter to quarter, it may have leverage enough to require quarterly summaries and updates.
Banks and dealers that enter into the swap often have another counterparty on the other side. That means if they are receiving a Libor-based rate from Archego, they are paying something similar to another counterparty (in a dealer's role). It also means that if Archegos owes the banks the sum of Libor plus the amount of price depreciation, the banks owe something similar to the other side. Dealing banks must pay out what they receive from Archegos.
So as the price plummets, Archegos is losing significant amounts, enough to wipe out liquidity and capital on its balance sheet. The banks don't receive their cash payments from Archegos and must absorb the losses to make payments to the mirrored side of the trade. Unless a government steps in to bail out Archegos, which in 2021 won't happen.
The banks (including Credit Suisse, Morgan Stanley, Nomura, MUFG and others) had to absorb such losses from the trades and from loans they provided for Archegos, if they did do so.
As usual, not soon after, questions about apt risk management are hurled everywhere. How could Archegos have accumulated such positions?
Or better phrased, how was it permitted to accumulate such positions, because to do so required funding and trades with participating banks? How could both banks and the fund have under-estimated the volatility of the stock (and other equities, as well)?
It is likely the fund and bank risk models didn't account for the substantial increase in ViacomCBS stock volatility (sudden, sharp rise, followed by sudden, sudden fall). The fund and its counterparties might have presumed the so-called "VaR" of these positions (including ViacomCBS) was modest, predictable. Maximum losses were tolerable, acceptable. Up until mid-2020, that might have been the case. Share prices had not been too volatile the previous few years.
But even so, notwithstanding the surge in volatility, a bank counterparty would still have relied on the health, balance sheet, and capital adequacy of the fund to ensure its solvency in even the most volatile of markets. Hence, a strong, sturdy fund should be able to withstand losses from one issue or position of just about any amount, if it is not too highly leveraged, has sufficient liquidity (cash) on the balance sheet, and has a large capital cushion.
Archegos might have had a sterling track record and a known-among-funds reputation for its leader to do well. It, too, might have been a significant revenue-generator for banks involved. It may not have had, however, a strong balance sheet, stable earnings performance, lots of cash sitting on that balance sheet, and ample capital.
In such case, its stakeholders (including banks and counterparties) might have presumed too much that
(a) he who has had bountiful success and has shown competence in reaping big rewards while taking big risks would not allow his fund to risk its entire capital base,
(b) the worst cases imaginable as it relates to the stocks in the positions could happen, but won't happen, and
(c) if the models (and data reporting volatility and risks) say the probabiity of worst-case massive losses is close to infinitesimal, then proceed.
What history keeps telling us is that while operating beyond the grips of regulators, hedge fund managers know big losses have occurred (They read the headlines and histoy books) and might still occur (They run models and scrutinize volatility), but this time or the next time, it's always: "We've got this."
Tracy Williams
See also:
CFN: Market Volatility: Can You Stand It? 2011
CFN: Toning Down High-Frequency Traders, 2014
CFN: Dark Days at Knight Capital, 2012
CFN: JPMorgan's "London Whale" Losses, 2012
CFN: How Will Stephen Cohen's Saga End? 2013
CFN: Quant Funds Go Searching for the Truth, 2010
CFN: Is the Volcker Rule Hurting Market Liquidity? 2017
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