In March 2021, a little-known family office called Archegos – effectively a private hedge fund – collapsed after making massive, wrong-way bets on several listed companies – ViacomCBS, Baidu and several others. As well as the collapse of Archegos, the losses impacted eight major investment banks. Credit Suisse lost $5.5bn and Nomura $2.9bn. Goldman Sachs, Morgan Stanley, UBS, Mizuho, MUFG and Wells Fargo also suffered losses, though of smaller and varying magnitudes. So how did a relatively small, little-known investment company inflict such losses on large, international and sophisticated investment banks?
It all comes down to leverage. Leverage is the concept of gaining a large exposure to a financial asset using a far smaller amount of capital. We see it every day in the housing market. Consider a homebuyer getting an 80% mortgage. That homebuyer puts down 20% of the money and gets the mortgage company to fund the remainder… but the key here is the homebuyer gets full exposure to the value of the house. Say the homebuyer puts down £20k for a £100k house. If the value of the house doubles to £200k, then the homebuyer has made £100k — but the size of the mortgage hasn’t changed. This is described as “five times” or 5x leverage — £100k of exposure for capital of £20k. The profits are five times what they would have been if the homebuyer had bought a house outright with their capital for £20k and it had doubled in value.
Most hedge funds do the same thing, but with financial instruments rather than property, and with instruments called total return swaps (TRSs) rather than mortgages. The hedge fund will putdown a small amount of capital with an investment bank to get exposure to a larger amount of, in this case, a stock. And when the stock price goes up, the hedge fund does very well – its profits are boosted by the amount of leverage employed. The concept is very similar to contracts for differences, or CFDs, in the retail market.
So that’s all fine when the property value or stock prices increase. What about when they fall? Well, the homebuyer or hedge fund losses are also boosted by the amount of leverage employed. What the Lord giveth, the Lord taketh away… mortgage companies are fairly relaxed about this, because house prices are relatively stable and don’t tend to drop massively very often. Even if they do fall most people want to stay living in their home regardless and they will keep paying the mortgage.
It’s a very different situation with a TRS and a stock price. At the start of the TRS, the bank will have bought the stock – so that as the hedge fund makes money with an increasing stock price through the TRS, then the bank makes enough money to pay the hedge fund. But if the price falls, the bank will start worrying. It’s losing money on its stock position, and hoping that the hedge fund will pay it back. If the bank is in danger of losing more money than the hedge fund putdown, the bank will ask the hedge fund for more capital. If the hedge fund doesn’t pay up, the bank will terminate the TRS and sell their stock position.
Which brings us back to where we came in. Archegos entered into TRSs with all those banks on the same stocks– but the banks probably didn’t realise that there were other trades. So when the stock prices started falling, the first bank started selling the stock(adding to the selling pressure on an already falling stock), then the second, and so on… and the impact on the stock prices was large. The drop in the ViacomCBS price at the end of March is shown below:
Why do the banks do these deals? Well, they earn decent fees and as long as stocks don’t move around quickly it’s a relatively easy way to make money. Just ask a mortgage firm. It looks like what happened here was Archegos took positions at several banks, the positions were far larger than usual, and so when they all started selling at the same time it caused trauma in those stocks.
What can be learnt from this episode? Firstly, leverage can be great and can be dangerous. In the correct circumstances – mortgages, for example – it makes sense. But it can amplify risk and return and needs to be employed judiciously. Secondly, concentration of risk can be toxic. All eight banks had the same concentrated risk – without realising it. Diversification is the salve for this – during good times it may feel like a handbrake on returns, but can act as a crash cushion at times of stress. Method can assist clients with careful use of leverage and ensuring their investments are suitably diversified.