Greed is not good: Hedge fund’s implosion hurts some of the world’s biggest banks

We’ve seen this movie before. A hedge fund uses massive derivative positions to take extremely leveraged bets and blows up, spreading billions of dollars of losses among Wall Street banks and threatening the financial system.

In this latest instance, thankfully, it doesn’t appear the financial system is at risk but the extraordinary fire sale of Archegos Capital’s positions has roiled markets and racked up billions of dollars of losses for some of the world’s largest and supposedly sophisticated banks.

Archegos is run by Bill Hwang, a former Tiger Management fund manager who pleaded guilty to insider trading in 2012 and paid $US44 million to settle the charges.Credit: Bloomberg

In 1998 it was Long Term Capital Management that blew up when the hedge fund was blindsided by the Asian financial crisis and the fund, with only $US5 billion ($6.6 billion) of capital but $US125 billion of debt – and more than $US1 trillion of off-balance-sheet derivative positions – was bailed out at a cost of about $US3.6 billion by a consortium of Wall Street banks orchestrated by the US Federal Reserve Board. It was subsequently liquidated.

This time there has been no rescue, only the dumping of $US20 billion-plus of shares, the collateral for Archegos’ derivative positions that could have been as much as $US50 billion in a “family office” hedge fund with about $US10 billion under management.

LTCM, at least, was run by former Wall Street luminaries and included two Nobel Prize winners on its board. Archegos was run by Bill Hwang, a former Tiger Management fund manager who pleaded guilty to insider trading in 2012 and paid $US44 million to settle the charges.

How either LTCM or Hwang could have convinced some of the world’s largest banks to lend so much against such risky positions – the Archegos portfolio was not just extremely leveraged but highly concentrated in a particular sector of quite volatile stocks – is a mystery. It is conceivable that the individual banks didn’t have a complete picture of the fund’s exposures and therefore of the extent of the leverage and risk.

There’s no mystery about why the banks were prepared to deal with Hwang. Just as LTCM was a gravy train for investment banks because of the scale and volume of its dealings, Archegos provided a stream of lucrative fees and commissions, until it didn’t. Wall Street and greed are a familiar pairing.

Among the banks known to have been involved in the Archegos mess are Japan’s Nomura, Switzerland’s Credit Suisse, Germany’s Deutsche Bank and Wall Street heavyweights Goldman Sachs and Morgan Stanley.

Nomura has owned up to $US2 billion of losses, causing its shares to fall more than 16 per cent.

Credit Suisse, fresh from its Greensill exposures, hasn’t quantified its losses but has said they will be “substantial”, with external estimates ranging from $US1 billion to $US4 billion. Its shares have fallen about 14 per cent.

Deutsche says its losses will be immaterial, while Morgan Stanley and Goldman appear to have escaped unscathed after going in hard and early to dump the collateral for their exposures.

The implosion has roiled markets.Credit: AP

Goldman’s involvement is revealing. After Hwang pled guilty to insider trading it vowed never to lend to him and kept that vow – until, it appears, last year. Why did it have that change of heart? Its reasons would have been the same as the other banks’ and the traditional Wall Street motivation: greed.

The banks weren’t lending conventionally. Hwang’s exposures to a relatively small range of media and telecommunications stocks were through total return or cash-settled equity swaps, a form of “contracts-for-difference” that enabled him to get leveraged to tens of billions of dollars of shares while putting up minimal amounts of capital.

It seems that a $US3 billion capital raising by Viacom, which sank its shares, may have triggered a margin call on Archegos that Hwang couldn’t meet and which subsequently caused a cascade of defaults in which the banks that acted first and fast fared best.

It shows that, while they might be well-compensated, banks aren’t properly evaluating and pricing risk. If they had done we wouldn’t have seen such a collection of the world’s larger and more systemically important banks lining up to provide so much funding and leverage to a character with Hwang’s history.

What isn’t yet apparent is whether the losses are confined to Archegos or whether there are other hedge funds with similar positions that may have been side-swiped by the turmoil in the stocks Archegos had exposures to.

Hedge funds tend to crowd trades. With Viacom shares having fallen about 55 per cent in a week, Discovery 47 per cent and other big Archegos-exposed stocks like Tencent and Baidu continuing big declines that started last month – Tencent is more than 20 per cent off its peak and Baidu 40 per cent – the potential for more widespread losses is obvious.

While post-2008 banking reforms and the big increases in capital requirements they imposed means the big banks involved can absorb multi-billion dollar losses, the involvement of those banks in such large-scale and risky derivative exposures ought to ring some alarm bells.

Risk has been shifted from bank balance sheets to shadow banks, like hedge funds, but Archegos and Greensill demonstrate that it still isn’t completely at arm’s-length.

More particularly, it shows that, while they might be well-compensated, banks aren’t properly evaluating and pricing risk. If they had done we wouldn’t have seen such a collection of the world’s larger and more systemically important banks lining up to provide so much funding and leverage to a character with Hwang’s history.

Nomura and Credit Suisse have been hit hard. Credit: Bloomberg

The most dangerous side-effect of the monetary policies pursued by the major central banks since the 2008 financial crisis and which have been ramped up again in response to the pandemic is that torrents of liquidity and zero-to-negative interest rates overwhelm the notion of pricing for risk across all asset classes and activities.

The central banks are trapped in the environment they have created – they can’t remove liquidity or raise rates without causing implosions in assets prices and another financial crisis on an even more destructive scale – and therefore institutions and individuals are incentivised and coerced into accepting ever-increasing risks for diminishing rewards.

That creates the conviction that financial markets, and property markets, can only move in one direction, with the central banks effectively providing a rising floor under asset prices and eradicating risk.

That conviction is being tested as concerns are emerging that the unprecedented stimulus occurring within the US will lead to the rekindling, for the first time since the financial crisis, of inflation.

Yields in the US Treasury bond market have been rising and, if there were evidence that inflation is getting real traction, would shoot up and provide a real test of whether risk has really been underwritten by the Fed and its peers.

In the meantime, that uncertainty about the direction of rates, and the lesson learned from the Archegos experience, might make the banks more wary about their hedge fund exposures. The damage generated by the implosion in Hwang’s fund might not be contained within it.