Explaining the biggest stock market event of the year

In today's Finshots we talk about Archegos Capital and how the seemingly innocuous fund sent shockwaves across the globe.

The Story

Archegos Capital Management is a family office. And while the name “family office” might sound rather lacklustre, these entities manage billions of dollars of private wealth — belonging to rich families. And the most important bit — They are not heavily regulated either, partly because these companies are wholly owned and controlled by the family members setting up the office. In the case of Archegos for instance, Mr Hwang (a once celebrated hedge fund manager) was managing his own private wealth. So you can see why US regulators weren’t paying too much attention to the likes of Archegos.

But here’s the thing. Mr Hwang was still a big-money player. We still don’t know a lot about the kind of money he was dealing with, but it’s safe to say it ran into a few billions. And considering he was an ex-hedge fund manager, he had a propensity for risk-taking as well.

Mr Hwang had made some big bets and was hoping they would do extremely well. In fact, he was so convinced that his bets would do well that he was willing to gamble massively on these assumptions. So he traded using leverage i.e. buying stocks on credit. Think of it this way — You deposit a small amount of money and then make a big bet by borrowing a substantial amount of money from someone else. Why would anybody else fund your risky proclivities you ask? Well, if you’re an individual who’s really good at managing money, then the intermediaries aka the big banks could stand to make a lot of money themselves by way of commissions. So they have every incentive to fund you so long as you pledge some form of collateral. Usually, the collateral includes the stocks you intend to buy and the arrangement works well for the most part.

We use the words “most part” because sometimes stocks have a tendency to lose value really quick. And when that happens cracks can begin to appear within these arrangements. Consider for instance what happened to Archegos.

First, shares of a Chinese e-cigarette company (RLX technology) tumbled sharply after Chinese regulators presented new laws regulating the industry. Then, shares of GSX Techedu — a Chinese ed-tech company started capitulating. Then a few days later, ViacomCBS sold new shares in the hope of raising money to finance its streaming business. And while this might seem like a positive development, a new sale offering always comes at the expense of old shareholders. If you were holding 50% of a company and the company decided to offer new shares to your friend, then your 50% won’t be worth as much anymore, right? So this event dented the price of ViacomCBS shares further.

And Mr Hwang, unfortunately, had bet on all three stocks, only to watch them crumble right before his eyes. Meanwhile, the banks holding these stocks as collateral had to work through their own crisis event.

See, once the share price tumbled below a certain level, bankers were left holding collateral that wasn’t worth as much. They wanted more protection. They wanted Archegos to put up more money by way of pledging additional shares. And when Mr Hwang refused to comply, they had to presume he didn’t have anything to pledge. This meant he could default on his obligations any time and bankers had to come to terms with this eventuality rather quickly.

And if you’re a banker holding collateral (stocks) that’s losing its value in a volatile environment, you have two choices in front of you. You could opt to hold the collateral and pray for a recovery in prices or you could simply dump and sell hoping to salvage whatever’s left. The second option might look tempting, but you have to remember that we are talking about stocks here. If you sell these stocks in the open market, then you risk denting confidence further. The very act of selling could precipitate a further crash in prices. So as you keep selling these stocks, the value of your collateral keeps eroding. It’s a death trap.

Unfortunately, the first option isn’t any better either. Sure, you could hold on to these stocks hoping the price recovers, but what happens if another banker decides to go out in the open and sell their share of the collateral. After all, Mr Hwang had borrowed from a whole host of banks including Goldman Sachs, Credit Suisse and Nomura. They were all contending with the same prospects and if one of them chose to dump the collateral in the market before you, then the value of your collateral would plummet some more.

Bottom line — Every banker dealing with Archegos was desperately trying to get rid of the collateral as soon as they found out Mr Hwang was ready to default on his obligations. And they were all hoping to be the first ones off the block.

However, not everybody can be first.

And it seems as if the likes of Nomura and Credit Suisse came out worst. Nomura said it's likely to face losses to the tune of $2 Billion. Credit Suisse said its losses would be highly significant and material to its results this quarter. Goldman Sachs and Morgan Stanley meanwhile stated that their losses would be immaterial. So you can see how some banks did better than others.

But at the aggregate level. Mr Hwang, his family office and the big banks managed to precipitate a mini-crash in the markets last week — all because they continue to be reckless and greedy.

And now you know how.

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