Not sure if you guys are following, but Archegos is really interesting.
I did a mid-week article for Patrons on this, but more information has come to light since.
There may be broader implications here.
Basics: What happened with Archegos Capital Management?
Bill Hwang establishes Tiger Asia Management after Tiger Management (created by renowned hedge fund manager Julian Robertson) closes down.
He is part of the Tiger alumni, known as “Tiger Cubs”.
Tiger Asia grows into a multi-billion-dollar hedge fund, and one of the largest investors in Asian Financial Markets.
The SEC charges Bill Hwang and Tiger Asia with insider trading and manipulation of Chinese stocks.
Hwang pleads guilty, agreed to criminal and civil settlements of over $60 million and later closed the fund.
Hwang converted the firm into a family office – Archegos Capital Management.
Archegos grows to become larger than many hedge funds.
Reported AUM is about $10 – $15 billion.
Archegos uses very high leverage, estimated at 6 : 1.
On the $10 – $15 billion AUM, that puts the total nominal exposure at about $60 to $100 billion.
The banks that Archegos uses are:
- Goldman Sachs (US)
- Morgan Stanley (US)
- Wells Fargo (US)
- Credit Suisse (European)
- UBS (European)
- Deutsche Bank (European)
- Nomura (Japan)
- Mitsubishi (Japan)
How did Archegos do it?
Archegos doesn’t actually own the underlying stock or call options on the stock.
They use derivatives – Total Return Swaps (TRS) or Certificates For Difference (CFD).
To illustrate how this works – Imagine that Archegos wants to bet on Viacom’s stock.
Archegos will then go to Goldman and buy a derivative against Viacom. If the price of Viacom goes up, Goldman will pay Archegos. If the price of Viacom goes down, Archegos will pay Goldman.
On the backend, Goldman will then purchase the Viacom stock, to hedge their position. So in this scenario, it is Goldman who owns the Viacom stock, and not Archegos.
All Archegos owns is a derivative against the stock.
So Archegos does this with Goldman. Then it goes to Morgan Stanley and does the same thing. And then Credit Suisse, Nomura, you get the idea.
But because Archegos doesn’t own the stock, they don’t need to make any regulatory disclosures.
Unless Morgan Stanley and Goldman come together and compare notes, they actually don’t know how much exposure Archegos has to the underlying stock.
Now Archegos has that very high leverage, and they take it and blow it all on a bunch of momentum stocks.
You can see the list below, it’s basically a Reddit fantasy list: GSX, Tencent Music, Vipshop, Palantir, Bilibili, AMD etc.
From April 2020 to Feb 2021 they absolutely killed it, ridiculous profits.
And then of course, yields started going up, and March 2021 happened.
All the momentum heavy tech stocks started going down, which was very bad news for Archegos.
Remember all that leverage works very well on the way up, but on the way down, the margin calls start coming in.
Mon, 22 March 2021
Now Viacom is one of the stocks on the Archegos list.
And over time, Archegos built up a total exposure of about $10 billion to Viacom.
This is crazy because the total market cap of Viacom is only around $30 billion today.
Which means at some point, Archegos would have owned more than 20% exposure to Viacom.
Normally if you own more than 5% in a company, you need to disclosure the stake to the SEC.
But because Archegos did this via derivatives, they don’t actually own the stock, and hence they didn’t disclose anything, and none of the banks knew about it.
With Archegos owning such a big chunk, Viacom share price goes vertical.
Remember this was the Jan to March period when momentum tech was going parabolic.
The catalyst came on 22 March 2021, when Viacom announced a $3 billion share issuance.
Together with broader macro weakness, this hits the stock price, and it starts to go down.
As the price goes down, the Prime Brokers start hitting Archegos with margin calls.
Wed, 24 March 2021
This is where it gets really interesting.
And a bit murky.
Financial Times reports that during the week:
Representatives from its trading partners Goldman Sachs, Morgan Stanley, Credit Suisse, UBS and Nomura held a meeting with Archegos to discuss an orderly wind-down of troubled trades.
The banks had each allowed Archegos to take on billions of dollars of exposure to volatile equities through swaps contracts, and Hwang was struggling to deal with margin calls triggered by a plunge in ViacomCBS shares. An orderly wind-down would minimise the market impact and the hit to their own balance sheets as they worked to sell down stakes in companies that Archegos had amassed through the derivatives instruments.
Basically, it was during this time that the banks found out how much exposure they all had to Archegos.
And then they found out that the other banks had been doing the same thing with Archegos.
They put two and two together – and risk management starts freaking out for obvious reasons.
So the banks came together to discuss how to get out of the mess.
Someone suggests that let’s all sell slowly, so we don’t crash the market all at once.
The American banks (Goldman and Morgan Stanley) mutter something non-committal, and everyone departs without agreeing on anything.
Friday, 26 March 2021
Now on Friday morning US time – which is Friday night Japan time and evening European time, Goldman decides to go first.
They force the margin call on Archegos, and they start dumping the shares.
Billions of dollars’ worth.
While the Japanese are at KTV and the Europeans at happy hour.
Viacom, Tencent Music, Baidu etc, these shares plunge 20 – 30%.
Many are sold via block trades – which are basically block sales to other institutional funds, off the market (eg. Blackrock may buy 10 million in shares direct from Goldman at x price).
Morgan Stanley realizes what is going on, and they join in hours later.
By end of Friday US time, Goldman and Morgan Stanley had sold roughly $19 billion alone via block trades.
Saturday, 27 March 2021
Now imagine you’re Credit Suisse / Nomura.
You just had a discussion with the Americans a few days ago on this.
And now you wake up on Saturday morning to hear that the Americans have completely dumped their stakes while you were in bed.
Man… what I would give to see the look on their faces.
There must have been a whole bunch of angry phone calls that weekend.
Monday, 29 March 2021
Monday morning – Nomura announces losses of up to $2 billion. They don’t officially name Archegos, but it’s fairly obvious who this was.
And then Credit Suisse announced ““significant” hits to first-quarter results.”
Nomura and Credit Suisse’s share price drop about 15% on Monday alone.
JPMorgan estimated that the Prime Brokers facing Archegos may end up absorbing as much as $10 billion in combined losses.
BTW – we share commentary on financial markets every week, so do sign up for our mailing list, its absolutely free (goes out every Sunday).
What happens next with Archegos?
Which brings us to today.
The impact from Archegos can be potentially quite far ranging, and can be split into first, second and third order effects.
First Order Effects
I would say most of the immediate and disorderly selling is probably over.
Goldman and Morgan Stanley probably exited most of their stakes on that Friday / over the weekend.
Nomura / Credit Suisse and the remaining bagholders, they’ll probably exit slowly over the next few weeks.
But based on trading this week, is seems the first order effects are probably priced in now.
Second Order Effects
This is the potential margin calls on the other hedge funds.
Remember that these stocks are momentum names like AMD, Tencent Music, Vipshop etc.
They’re held very broadly by other hedge funds, all of whom use their own leverage.
With a 20 – 30% fall in share price, the other hedge funds may be hit with their own margin calls. They may need to absorb the loss or reduce some exposure.
This one’s tough to call, don’t know the true impact here.
Third Order Effects
Third order effects are where it gets really interesting.
Now a bit of background – Goldman is the best risk manager in the industry. Hands down, I think very few banks even come close.
Just look at how ruthless they were in cutting exposure to Archegos (and screwing over the other banks), and you get an idea of how good these guys are.
Remember Goldman escaped this saga unscathed, unlike Nomura or Credit Suisse. Lesson learnt: In a fire sale – you always want to be the first guy out of the door.
And as good as Goldman is, they still built up 6 : 1 exposure off balance sheet to Archegos.
Imagine the kind of exposure the other global banks have, where risk management is not as good (not naming names here, I don’t want a lawsuit).
Third order effects is when all the risk management teams at the global banks start reviewing each and every ISDA, for each and every client account.
To bring down counterparty risk and leverage across the board.
This one will take months to play out.
How does Archegos fit into the broader picture?
Don’t look at Archegos in isolation here.
Look at the bigger picture.
LTCM, Lehman, they all started with leverage. But the systemic risk didn’t come from leverage.
Systemic risk came in from the unwinding of leverage.
Leverage is very high across the board
Global leverage is very high right now.
It’s everywhere – on and off balance sheet, retail and institutional, cash and options, banks and non-banks. Everywhere.
And at the same time macro risks are playing out very quickly. We have:
- Steepening yield curve
- Interest rate volatility
- Anticipatory changes in monetary policy
- Forex volatility etc
Is Archegos an isolated accident, or part of a broader trend?
Year to date, we have had the Gamestop saga, Greensill, and now Archegos.
3 major leverage unwinding events in 3 months.
Throw in a weakening IPO market, weakening SPAC performance, and weakening tech leadership.
Don’t even get me started on the bond market. Most big institutional investors are very long duration – which means a small move in interest rates hits them very hard (convexity for those familiar with it).
I’m not saying that Archegos is going to be the catalyst that brings it all down. But you do need to note the backdrop in which all this is playing out.
There’s a lot of fragility and systemic risks hiding under the surface here.
Is this a buying opportunity?
I shared my macro framework for 2021 in a recent article, and so far it’s playing out perfectly.
Phase 1 is a period of rising yields, with high volatility.
Reflation plays like banks and commodities do well, while interest rate sensitive sectors like growth tech, REITs, utilities, gold underperform.
With the world so exposed to long duration assets, at some point this will hit markets.
I think the Feds will be forced to step in then, but feel free to disagree with me on this.
If the Feds come in, we move to Phase 2 with more orderly yields.
If the Feds don’t come in, could get really ugly.
How long will Phase 1 last, nobody really knows, because it depends on how quickly yields go up. If I had to bet, I would say sometime in the second half of 2021.
I bought some more Tencent Music the past week.
I like the stock long term, so I took the opportunity to average into the stock.
I think the whole Phase 1 volatility is a good time to build long term positions, as long as one has holding power and can continue to average into a declining market.
You can check our my portfolio and stock watch on Patron.
But the macro is genuinely tricky.
I don’t think Gamestop, Greensill, and Archegos are isolated events.
I think they’re all playing out in a broader backdrop of fragility here.
So again, while I’m a buyer, I’m very cautious of macro risks at this stage.
We may get a couple more months of this up and down, but at some point the rising yields are going to hurt.
If you’re investing in the market today, I think the most important question is to understand your timeframe.
Are you in to make a quick buck the next 3 to 6 months, or are you in to invest for a 5 to 10 year period?
Many people are actually doing the former, but when the stock drops 20%, they transition into the latter.
Because the portfolio you need to build, and the way you react to market volatility, will be very different for each.
As always, this article is written on 2 April 2021 and will not be updated going forward. Latest thoughts (and my stock watch and personal portfolio) are available on Patron.
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