Risk and Reward: A Cautionary Tale?

The big news in the financial markets this past week was the blowup of Bill Hwang's Archegos Capital, a $10 billion family office, that sent shockwaves across Wall Street. At least two investment banks, Nomura and Credit Suisse, and possibly several others who lent to Archegos, suffered multibillion dollar losses. Bill Hwang, until last week, was quietly one of the 50 richest people in America. 

Bloomberg has a probing profile on Hwang titled "God and Man Collide in Bill Hwang's Dueling Lives..." While article focuses on the seeming contradictions of a pious man taking on massive risks, what I found most interesting was the breathtaking speed with which he accumulated that wealth. After his hedge fund career ended ingloriously in 2012, he opened his family office in 2013 with an estimated $200 million. Within a decade his fortune had swelled over 100 times to around $20 billion according to bankers (at least on paper), him making one of the richest persons ever on Wall Street! Even more remarkable, much of that wealth was accrued in the last 24 months!! That has to be a record, if not the record. How? Leverage, of course. Massive, massive amounts of leverage.

Archegos' strategy was simple enough: concentrated, directional bets on fast growing technology and media stocks, boosted by leverage. No hedging. (Of course!) And Hwang seemingly was very good at finding things that grew. Obviously it helped that Growth has been the dominant risk premium of the last decade (thanks Federal Reserve!) and outperformed crazily during the pandemic (click chart to enlarge).

Now just add leverage! Lots and lots of leverage. And Archegos did it through equity return swaps. A perfect way to take huge risks without anyone knowing, even your lenders. The chart below from the WSJ shows how total return swaps work. For a fee, you get your favorite investment bank(s) (i.e., prime broker(s)) to buy your desired basket of stocks for you. The bank owns these stocks, not you. As part of the swap, the bank will pass on the gains (including dividends) from this basket of stocks to you should the value of the basket rise, and you will cover any losses if the value falls. To make sure you are able to cover potential losses you need to put up collateral, usually 15% of the value of the basket. If the value of the basket falls, you will get a margin call to put up additional collateral so that you always have that 15% cushion, else the bank will seize your assets and sell them to manage their exposure. So, for putting up $15 you get exposure to $100 worth of stocks. 

  

The fees are nice, so all the banks want to do swaps. And Archegos didn't mind paying up for service, so Hwang was a particularly attractive client for prime brokers. In any case, the banks assumed the assets were liquid, so if things did go south they could sell them quickly and quietly without causing their price to drop. Well, you know what they say about assume? (...it makes an ass out of you an me) 

The problem was Archegos was doing swaps at roughly 6:1 leverage for the same basket of stocks with basically every prime broker on the Street. But none of them knew that. Because there is no requirement for Archegos disclose that to them (or the SEC, despite the massive notional sums). So, Hwang probably put up $500 million with each prime broker to gain exposure to $3 billion of his favorite stocks: Viacom, Discovery, GSX, Baidu, Tencent Music, Fubo and Farfetch, etc. And he did that with 10 banks? So that resulted in exposure possibly as high as $30 billion to a handful of stocks!

As a result the value of these stocks skyrocketed. Viacom stock rose 150% in over two months. Proving no good deed goes unpunished, Viacom announced on March 23rd that it was raising $3 billion in capital through stock issuances...because why not take advantage of this sudden, massive rise in the value of your company? (Or something like that). That sent the price of Viacom tumbling, precipitating margin calls. There was also this pesky rotation out of Growth into Value that was also taking place which put pressure on Archegos' other positions as well. The thing about leverage is that how ever fast it may push you up, it can always pull you down faster...

Naturally, things got out of hand quickly. When Archegos held a conference call on March 25 with all its bankers to let them know there was problem, a big problem, it was off to the races...GS, of course, was the first out of the gate, doing a huge block trade on Friday morning. Within a day Viacom's stock had fell 55% -- a $55 billion company! Of course it wasn't just VIAC, all the other Archegos stocks plummeted similarly in the face of Wall Street's fire sale.

It's unclear at this point what Hwang's end game was, force a squeeze on these heavily shorted stocks that would boost their returns even more (something Hwang painfully knows about) or just, you know, Diamond Hands. All told by April 1st, Bill Hwang is estimated to have lost at least $8 billion of personal wealth in less than a week. He is still likely very wealthy, just not Forbes 400 wealthy. Of course, it was the very same leverage that got him into trouble that made him over $10 billion in the first place. So, from another perspective, if the cost of making $2 billion is to lose $8 billion...well that's still a great trade. Just not for Archegos' bankers.