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    Capital Markets | 6 min read

    When Genius Failed—Again

    Wall Street has had more than its share of drama over the last three decades. However, what started to unfold two Fridays ago with Bill Hwang’s Archegos family office had grizzled Wall Street veterans staring, stupefied, into the abyss.

    Bill Hwang, one of the disciples of the famed hedge fund manager, Julian Robertson’s Tiger Fund (known as “Tiger Cubs disciples”), managed last week to complete a career hat-trick of destroying investor wealth, violating securities law (although, to be fair, his 2012 settlement with the SEC for insider trading was neither an admission of guilt or innocence), and blowing holes in Wall Street bank financial statements!

    On Friday March 26, the stocks of nine bellwether Chinese, Canadian, and U.S. companies saw block sales (very large transactions that are often negotiated outside the market before being reported) go through the market. According to Bloomberg,

    They were part of an extraordinary spree that erased $35 billion from the values of bellwether stocks ranging from Chinese technology giants to U.S. media conglomerates. “I’ve never seen something of this magnitude in my 25-year career,” said Michel Keusch, portfolio manager at Bellevue Asset Management AG in Switzerland.

    Goldman Sachs alone sold $10.5 billion of the stocks on Friday. As Friday turned into the weekend, Morgan Stanley, Credit Suisse, and Nomura Securities were also identified as large block sellers. Nomura stated that they may incur up to $2 billion in losses due to one specific client. Credit Suisse also reported that they expected significant losses due to the mysterious “Specific Client.”

    By Sunday, the “Specific Client” was identified to be Bill Hwang and his family office, Archegos. The next question to be answered was what exactly did these banks—prime brokers for Archego—do with Hwang to trigger the colossal, forced sale of nine stocks—sales that totaled more than 10% of the outstanding float for those companies? The answer turned out to be derivative transactions known as “Total Return Swaps.”

    Total return swaps have been around for a long time. The transaction essentially replicates for the client (usually hedge funds) the profile of being long or short a specific asset or basket of assets. The derivative dealer, generally Wall Street banks, puts the asset in question on their balance sheet and structure the transaction as follows:

    1. The dealer acquires the asset—in this case, a stock like Viacom—and puts it on its balance sheet.
    2. The hedge fund or family office—in this case, Archegos—posts liquid collateral as initial margin with the dealer.
    3. The dealer pays Archegos if the price of the Viacom increases.
    4. Archegos pays the dealer if the price of Viacom goes down.
    5. Archegos pays the dealer a funding charge since the Viacom stock resides on the dealer’s balance sheet.
    6. Based on the value of Viacom, Archegos may have to post additional margin if Viacom’s value drops.

    In these transactions, especially these Archegos transactions where dealers were purchasing large blocks of stock in negotiated deals, fees are very lucrative—unless, of course, something goes wrong.

    Based on the Archegos desire and the dealer’s assessment of counterparty risk with Archegos, the amount of leverage is decided upon. An example of leverage would be doing a Total Return Swap on 100 million shares of Viacom, where Archegos would post as margin the value of ten million shares of Viacom; the other 90 million shares are borrowed.

    It would be the same as if Archegos purchased ten million shares of Viacom and borrowed from the dealer to purchase the remaining 90 million shares with one big difference. Archegos was doing Total Return Swaps that were so large that they were accumulating over ten percent of the target companies. If that sounds slightly insane, it is, especially if you consider this from Bloomberg News:

    Mr. Hwang built his fortune swinging for the fences, often focusing his investments in just a few stocks, paying little attention to hedging his positions while borrowing large amounts of money to boost his returns.

    That doesn’t exactly sound like the guy you want to literally bet the bank on. Additionally, in 2008, when Hwang was managing other people’s money in his hedge fund, he was supposed to be trading Asian equities, the area that he had expertise in (it has also been said that his “expertise” was gathering inside information to generate his “alpha”). His investors were quite upset to find that Hwang had gotten them into what was the “GameStop” short squeeze of the 2000s, Volkswagen, which ended in disaster. VW skyrocketed in value over 350% in two days as Porsche announced it was amassing a 75% stake in the company crushing short sellers.

    Then, in 2012, Hwang reached a $60 million settlement with the SEC on claims of insider trading. From this point on, having accepted a temporary ban on managing other people’s money, Hwang created his family office, Archegos. Meanwhile, forward to the present day, why did Bill Hwang use derivatives? If Hwang was actually purchasing the amount of stock that was referenced by the Total Return Swaps he would have to file a 13-D with the SEC, announcing that he now owned more than five percent of the target companies. Therefore, to avoid having to file a 13-D, he –helped along by obliging dealers—gained ownership behind the curtain of dealing banks.

    It appears that Archegos and the dealers began amassing his stake in the companies in early 2021. If we look at Viacom share price, the price nearly doubled from February 1 to March 22. Viacom was so pleased at the performance of their stock—we guess without wondering why Morgan Stanley, Credit Suisse, Nomura, Goldman, and others were amassing such a significant position in their stock—that they announced on March 22 that they would issue $3 billion of new stock.

    Viacom shares dropped sharply on the news, and then they plummeted as the Hwang’s highly leveraged positions generated margin calls that he could not meet and hence, the unprecedented selling of what were now the dealer’s positions on Friday, March 26. Essentially, it only took one big loser to wipe out the entire book.

    Now comes the dark comedy of this tale. Just as maybe Viacom seemed incurious as to why their stock all of a sudden became such a darling to go up nearly 100% in a six weeks, the dealers who fueled Archegos’ insane risk taking seemingly did not know that they were all in the same trade together with Hwang!

    The week leading up to the Friday blowup, the SEC apparently got wind that that something funky was going on and apparently called on the dealers involved. This is when Goldman, Morgan Stanley, Credit Suisse, Nomura, Deutsche Bank, and the rest realized, seemingly for the first time, that Archegos had done the same trade with all of them! We imagine that they were all blinded by the fees they were making to set up and structure the funding spread they were earning, and the rosy dreams of more deals and fees to come.

    It is said (but not completely verified at the time of this writing) that the banks got together on a call before the fateful Friday in an attempt to manage this dumpster fire. Credit Suisse and Nomura suggested that the banks worked together too slowly and quietly unwind the mess. It seems that, while nodding their heads, Goldman, Morgan Stanley, and Deutsche Bank ran to the exits and pulled the rip cord, selling millions of shares of the nine companies. Viacom dropped 27% that Friday. It appears that Credit Suisse and Nomura were left holding the bag and took the majority of the losses associated with Hwang’s Archegos.

    What are the takeaways here? Well, we have confirmed, once again, that when it comes to making money, people in positions of authority do incredibly stupid and greedy things. What makes this maddening is all these firms, especially the two that took the biggest losses, were coming off great years. For Nomura and Credit Suisse, 2020 was being hailed as a “turn-around year.” It was not as if they had to go out and throw a Hail Mary like this, rather they did it because it seemed like gobs of easy money.

    However, the real takeaway is, would you buy a stock like Viacom if you knew the largest shareholder is a sketchy investor who leveraged himself to the hilt to buy the stock? What would happen if one of the companies did something like unexpectedly announce their intention to issue $3 billion of stock? If you knew that over 10% of the company could become a forced seller at any time, would that give you pause?

    In this case, Total Return Swaps acted to mask the position of a giant whale investor in at least nine companies, which in turn harmed real investors. While this mess appears to have been “only” a $10 billion one, you have to ask yourself, are there other transactions like this out there ready to blow? History strongly hints yes.

    ---

    Investing involves certain risks, including possible loss of principal. You should understand and carefully consider a strategy’s objectives, risks, fees, expenses and other information before investing. The views expressed in this commentary are subject to change and are not intended to be a recommendation or investment advice. Such views do not take into account the individual financial circumstances or objectives of any investor that receives them. All indices are unmanaged and are not available for direct investment. Indices do not incur costs including the payment of transaction costs, fees and other expenses. This information should not be considered a solicitation or an offer to provide any service in any jurisdiction where it would be unlawful to do so under the laws of that jurisdiction. Past performance is no guarantee of future results.

    Securities offered through SWBC Investment Services, LLC, a registered broker/dealer. Member FINRA & SIPC. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor, registered as such with the US Securities & Exchange Commission. SWBC Investment Services, LLC is under separate ownership from any other named entity. SWBC Investment Services, LLC a division of SWBC, is a nationwide partnership of advisor.

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    Capital Markets

    John Tuohy

    John Tuohy is CEO of SWBC Investment Services, LLC, a Broker/Dealer and SWBC Investment Company, an SEC Registered Investment Advisor (RIA). In his role, John is responsible for identifying, developing, and executing the division's strategic plan and all business development, sales, and marketing activities.

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