What happened at Archegos? Everything you need to know in 3 minutes
Some people have asked me to explain what happened at Archegos, a family office that recently blew up (ie. lost a ton of money).
TL;DR: Archegos borrowed a lot of money from banks to trade stocks and couldn’t meet margin calls. Archegos’ lenders closed its positions and this resulted in some bizarre intraday moves in stocks like Viacom and some Chinese ADRs (Chinese stocks that trade in America).
Wait, this isn’t a hedge fund?
The guy behind the trades was Bill Hwang. He used to run a successful hedge fund called Tiger Asia. About a decade ago, Bill got in trouble for insider trading and shut down his hedge fund. But he had a lot of personal wealth and wanted to keep trading, so he set up a family office.
What’s a family office?
A family office only manages family money and doesn’t have clients. This means it doesn’t have to register as an investment advisor or disclose much information. Sometimes a family office is big and has teams of people and operates like a hedge/private equity fund; often, it’s just a few people.
So, what was Archegos’ investment strategy?
My understanding is that Bill Hwang ran a dollar neutral, long/short equity strategy. This is where you buy a stock and short sell the same dollar amount of another stock. So, if you buy $1,000 of Tesla stock you would short $1,000 of something else, like GM stock.
I read this in the last post. You bet that one thing outperforms the other. How can you lose money?
This strategy may protect you from broad market moves (stocks are usually correlated), but not idiosyncratic risk. For example, you could be long Tesla, but if a bunch of Teslas randomly explode, or Elon Musk dies, Tesla stock will probably go down. In response, GM stock could go up because the market may think it’s positive for GM. Your long is down and your short is up. Ugh.
In this case, Bill was long stocks and short the S&P 500 or some other index. Some of his longs went down a lot (doh!) and his shorts didn’t (double doh!).
How does leverage work in this case? I get that a broker can lend you money to buy/short stock.
Let’s say that you invest $1,000 in Tesla. Your broker can lend you some money like I mentioned here. But what if you buy $1,000 of Tesla and are short $1,000 of GM? You are long $1,000 of something and short $1,000 of something else. On one hand, your net exposure is zero; on the other hand, you have a gross exposure of $2,000 ($1,000 Tesla + $1,000 GM).
Your broker will ask you to post margin, say, 10% of gross exposure or $200. With the $800 left to play with, you can buy another $4,000 of stock and short $4,000 of stock, assuming these stocks are similarly risky. Now, you are long $5,000 of stock and short $5,000 of other stock so your gross exposure is $10,000 and your net exposure is $0. Using $1,000 of initial capital, you have $10,000 of exposure.
Hmm, seems risky but ok. But I heard Archegos used equity swaps. What are they?
You tell your broker that you would like to buy $1,000 of Tesla stock on swap. This means that you want exposure as if you owned $1,000 of Tesla stock without actually buying the stock itself. The broker agrees and charges you a small fee. For simplicity let’s say it’s 1% per year. Usually, the bank will ask you to put up some margin, say 15%, since it is effectively lending you money.
What happens is that the bank goes out and buys $1,000 of Tesla stock and holds it in its own account. Then, you get the returns of $1,000 of Tesla stock, without actually buying the stock and only putting up $150 of margin. Every day, based on Tesla’s stock performance, money is added to or subtracted from your account. At the end of the year, if Tesla stock is up 10%, you will have an extra $90 ($100 gain - $10 fee). If Tesla stock is down 10%, then you have to pay the bank $110 (-$100 loss - $10 fee) leaving you only $40. In reality, the bank probably gives you margin call well before that. If you don’t put in more money, the bank finds you in default, proceeds to sell the stock and keeps whatever money is left.
This sounds complicated. Why would anyone trade on swap rather than just buy the stock?
There are three reasons you would trade on swap.
1. Anonymity – No one knows that you have an interest in the stock and it doesn’t show up on any filings. This is because you technically don’t own any.
2. Leverage – The bank is lending you money. It is buying the $1,000 of Tesla stock and you are getting the return on stock that you don’t actually own, in exchange for some fee.
3. Access to funky markets – It can be tough trade stocks in some countries (like Brazil) due to various laws. Usually, the bank has an entity or a partner in that country so it can trade those markets on your behalf, but you can’t be the owner of the stock.
I kind of understand now. So, what actually happened?
Bill was long Viacom stock and short the S&P 500. Viacom stock had been on a tear this year, like it had gone from $38 in January to about $102 earlier in March, whereas the S&P 500 had been up as well but not by as much. So that was good! But then, Viacom announced that it would raise money by issuing stock and the stock dropped over 30% the next few days as a result. Meanwhile the S&P 500 didn’t move much. That’s bad, because Viacom was now performing worse than the S&P 500. At the same time, two other stocks Bill was long, RLX and GSX, also saw their prices fall a lot.
Because these stocks dropped so much, Bill got a margin call. At some point, he couldn’t or wouldn’t put up the cash. Remember, he didn’t actually own these stocks, the banks did. So now that Bill had defaulted, they had to sell that stock to get their money back. What happens when a bunch of banks are all trying to sell a lot of the same stocks at the same time? Well, they go down and have funky movements that you can’t explain aside from, “Hmm weird price action, must be a big seller.”
How did he get to borrow so much money? Isn’t that irresponsible?
Banks are profit-seeking businesses. Bill borrowed and traded a lot which means that he was a profitable client. So, there would probably be a bunch of banks clamoring for his business. As a result, Bill could go to one bank and say, “Yo, Bank A is lending me a lot of money at this rate, if you don’t match it, I’ll give them your business,” and then he could do the same to the four other banks. Think about a time when you could buy something from more than one store. You would probably try to play them off of each other to get a better deal, right? Same thing.
Bill was also careful to not let each bank know how much exposure he built up in these stocks with other banks. Most banks have limits on how much of a certain stock they may hold that can be traded through equity swaps and derivatives. Bill kept trading within his limits at each participating bank, but when combined, his exposure was far larger than any one of these banks’ risk departments could imagine.