The Archegos Capital fiasco: Leverage gone wrong

Archegos Capital is making headlines, not for good reasons, though! But what's the matter exactly? Why is everyone talking about this? No idea? Well, read on to know.

As the title speaks, the entire story derives its root from these eight letters' word - 'LEVERAGE'. So, let's make sense of what leverage is.

Borrowed money, in market parlance, is termed as leverage. So, basically, leveraging means limiting one's personal funds' exposure and borrowing more instead in order to enhance potential returns. You see, you can't have all the funds to finance a billion dollars project. But there are banks and lenders out there to help you still be able to pull it off by putting just a small portion of your capital upfront (and the balance with debts). However, here's the catch… no bank will lend you for nothing; you will be required to provide collaterals as security against those loans ('no free lunches', you know'). And that's where the pain point emerges.

Well, let's explore.

Archegos and its leverage strategy

Archegos Capital Management is a family office run by a former hedge fund manager, Bill Hwang. Most of its operations were based on something called 'Total Return Swap'. Well, don't go by the complexity of the term; it's actually easy stuff. Here's our explanation.

Say, you're Bill. And you're planning to invest in a big lot of shares of companies. But that would mean emptying your pocket entirely, which obviously you don't want to. So, you set aside a small portion of the required funds out of your pocket and put it on the table. Then, you visit the banks, pitch your idea and ask the bankers to lend you the majority of the required funds, which you then use to proceed with the investments. And no, banks won't lend you money simply. You'll have to pledge some form of collateral. And when the assets you're gonna manage are shares of companies, why not pledge those shares? Hence, these underlying shares will then be held by those banks as securities, so they can sell them off to recover their money in case you default. And with this, your mini crash course on 'Total Returns Swap' is complete ;-)

Simply put, that's leveraging with a little masala, isn't it? Anyway, this must-have occurred to you... the deal seems to be quite risky for those lending banks. Then why would they lend the money, you ask? Well, that's where the proficiency and repute of the fund manager comes into play. If you're good at managing money, the banks can bet on your potential as they also stand to gain a lot in the form of commission and other fees. And being one of Wall Street's renowned fund managers, Bill Hwang didn't find it difficult to entice the bankers and pull off the arrangement.

So, many investment banks, the likes of Goldman Sachs, Morgan Stanley, Credit Suisse, Nomura and Deutsche Bank, etc. had lended funds to Archegos in the Total Return Swap arrangement. These funds were then deployed by Archegos in investments in the shares of companies. You'd be shocked to know that reports say Archegos Capital had a position of over $50 Billion with its assets of around $10 Billion only. That's like borrowing four dollars for each dollar of your own funds!

Anyway, What did go wrong then?

What went wrong with Archegos?

You see, leverage is a double-edged sword. It can, no doubt, turn 'rags to riches'. But if the risk is mis-handled, the 'riches to rags' case won't be far behind. And Archegos Capital has been a quintessential case of over-leveraging without adequate risk management. Let's understand.

The stock market is irrational. You can't predict things. Prices can swing like anything simply on the grounds of market emotions. That is the reason why you have to be very careful when you provide shares as collateral security to obtain loans. It's all good as long as the prices of those pledged shares keep marching up, but wait, what if they turn southwards? Think from the point of view of the lending bank. If the price of those pledged shares drop, it essentially means that those shares will now fetch lesser money than required. Meaning, in case you, the borrower, default in repaying the loans, the bank can't be able to recover its funds as the shares won't be worth as much. And obviously, the banks won't stand still.

Once such a thing happens, the banks will require you to put up more money by way of pledging additional shares. And that's what market folks refer to as 'Margin Call' (there's a movie as well).

Anyway, that's exactly what happened with Archegos. Some of the shares of companies that it had pledged with the banks started trembling, namely RLX technology, GSX Techedu, ViacomCBS, Discovery, etc. The prices of the shares of these companies started dropping, and each had a reason of its own. But as we said, the banks weren't gonna watch the security of their capital erode in front of their eyes. They wanted protection, and thus, they issued margin calls on Archegos. Ouch!

To this, Archegos refused to comply. Probably, they had nothing else to pledge as additional security. And the bankers, somewhere in the back of their mind, understood this. So, now what?

Well, your prudent mind would have suggested that the banks should rather sell all those already pledged shares asap, and just get away with whatever they can fetch. But here's the thing... in this case, the collateral are shares. It will take some time for the banks to get rid of those shares, and as they keep selling the shares, their prices will keep falling further! Meaning, selling of the pledged shares would make the banks further hurt the capital recovery. So, this wasn't a viable option for the banks, unlike you feel.

They couldn't sit and watch either. Because there were a number of banks, who were into this mess. So if not bank A, bank B would dispose of those shares, and bank A will have to bear the brunt (of further price crash) without any offence. Ultimately, when the banks found out that Archegos was anyway gonna default on its obligations, they could not resist but sell off those collaterals.

Goldman Sachs, Morgan Stanley and Deutsche bank were the first (and the less unlucky) ones to exit the deal proactively. This sale further exerted downward pressure on the prices of those pledged shares. And to their utter misfortune, Credit Suisse and Nomura came out worst. All the banks might collectively lose out over $6 billion, besides the crash in their own share prices. You'd be flabbergasted to know that there was a fire sale (sale of shares at dirt cheap price) of over $20 billion! And that's really, really huge.

Now you'll ask how could such a huge mess go unnoticed. Well, as we said earlier, Archegos Capital Management is a family office, meaning it was run by Mr. Bill Hwang and was managing Hwang's personal wealth. And now you know why it didn't catch regulators' eyes (family offices are generally an unregulated lot). And because it was kind of a swap arrangement and not a direct equity investment, it could keep regulators at bay. So, there you are.

'Archegos', in Greek, means 'one who leads the way'. It seems.. Archegos led the wrong way, though!

What does it bring for the Indian markets?

Listen to experts, and they'll say that this event won't have much of an impact on Indian markets. And probably they're right. Unlike the Lehman Brothers' scene, here, the pain point is in one hedge fund and not an entire asset class. So, if there's any impact at all (not evident as of date), that might be seen in some thematic funds (like those of the entertainment sector, where the shares saw a price crash in this case). India has learnt a lot from the Lehman Brothers' case, and such a ruckus is highly unlikely to repeat (as they say, 'History doesn't repeat itself, but it rhymes').

What's more is that Indian regulators are particularly very strict with regards to margin requirements, and thus such kind of arrangement aren't very popular here. However, there isn't much of regulatory supervision over family offices, and that could be a concern going forward.

The learning part

Greed destroys! Yes, and it's quite evident from this case as well. But well, I leave it to the great philosophers to mould you on this bit. Let's talk of the finance part.

And we couldn't agree more with Mr. Warren Buffet when he said, and we quote --

"Having a large amount of leverage is like driving a car with a dagger on the steering wheel pointed at your heart. If you do that, you will be a better driver. There will be fewer accidents, but when they happen, they will be fatal."

What say? Write to us in the comments below.