The Archegos Saga - The Need for Prudent Risk Management

"There is only thing that I like more than money and that is other people's money"

Those were the immortal words of Danny De Vito in the movie "Other Peoples Money". The Film is about a corporate raider who wants to take over a Manufacturing Company run by an industrious and benevolent Gregory Peck. Leverage - the subject then and now is nothing but "Murderous Blood in a Blizzard of Paper". It is worthwhile to see an indictment of folks playing with financial instruments and liquidation way back in 1991, I can't help see how prescient the facts were

The entrepreneur of post-industrial America, playing God with other people's money. The robber barons of old at least left something tangible in their wake- a coal mine, a railroad, banks. This man leaves nothing. He creates nothing. He builds nothing. He runs nothing. God save this country if that is truly the wave of the future. We will then have become a nation that makes nothing but hamburgers, creates nothing but lawyers, and sells nothing but tax shelters. And if we are at that point in this country, where we kill something because at the moment it's worth more dead than alive, well, take a look around. Look at your neighbor. You won't kill him, will you? No. It's called murder, and it's illegal. Well, this, too, is murder, on a mass scale. Only on Wall Street, they call it maximizing shareholder value, and they call it legal. And they substitute dollar bills where a conscience should be. Damn it! A business is worth more than the price of its stock. It's the place where we earn our living, where we meet our friends, dream our dreams. It is, in every sense, the very fabric that binds our society together.

Bill Hwang; Source - FT/Emile Wamsteker/Bloomberg

History is all too keen to repeat itself for those unfortunate enough to forget it. The two quotes became a reality once again, only that the tool of destruction was different. It was a Total Return Swap (TRS) this time and the Chosen Leader ("Archegos") was Bill Hwang.

The Misaligned Incentive - a case where regulation induced unintended consequences:

• The most pernicious factor was an incentive on part of Banks to move away from traditional Collateral financing like repos/reverse repos to derivative based funding that replicate Traditional Equity financing, in fact, these were called Synthetic Equity Funding.
• Low Interest rates have put pressures on Net Interest Margins, Balance Sheet building was influenced by higher risk weights on traditional transactions which required more Capital, Higher Liquidity Buffers, Loan loss provisioning using Expected Credit Loss, all created a conducive atmosphere
• Ironically, these TRS trades had lower Capital requirements and a lower Reporting burden
• The Family office structure is loosely regulated and Bill Hwang was not required to disclose his indirect exposure in stocks of various companies through a TRS

The Mechanism

What are Total Return Swaps? - Like any Swap contract, this allows the holder of the swap to receive returns from an underlying instrument (here Equity Shares) in return for a fee, you are receiving both Dividends and Capital Gains from Shares in return for a small fee. In short, for the holder, it is a way to receive the income from Shares without investing the full amount for it and for the Banks, it is a means to receive regular premium like income (much like Option writing). The Banks, in order to Hedge their Synthetic Short position in Equity had purchased the Shares of these companies and also collected these shares as Collateral from Hwang

You basically have a Levered position in the Stocks of companies where you enter into a position, hence both your gains and losses are magnified

Source: FT

Criticality of Risk Management

As long as the music never stops (ie) the Stock value goes up, Banks pay Hwang the appreciated value of Stock for fees and every one is happy, however, these positions have the following risks:

1. Being Over the Counter, it has Counterparty Credit Risk, stocks do not move up alone, and should the value of Stocks fall, Hwang should be able to pay the value lost
2. Collateral and Correlation Risk: Banks had accepted the Stocks as collateral and had taken Long positions in them, this is a classic case of Correlation gone awry, when the stocks fall, the value of collateral will fall requiring a Margin call AND the Long values of Stocks will reduce, The Banks in turn will be forced to Liquidate the Shares which will trigger further Adverse Market Impact and hence even more losses - It is a classic case of a Self Fulfilling Prophecy and a vicious cycle gone wild
3. The Losses from the transaction originated so that Banks can hold less capital will impair the Common Equity Tier 1 Capital ratio, which is what happened in the case of Credit Suisse whose CET 1 fell below their Target

The Margin Call

Source: FT

The Banks were basically picking up Nickels in front of a Steamroller, as the value of the Stocks on which Hwang was speculating fell, he had to face Margin Calls that he was unable to make good, leading to a hurried meeting of the Bankers who wanted to co-ordinate the sale, some blinked first, ruthlessly sold and took minimum losses while others waited and had to book huge losses.

It was all Deja Vu harking back to the days of Long Term Capital Management and the Sub Prime Crisis, John Tuld from Margin Call couldn't be more eloquent:

So, what you're telling me, is that the music is about to stop, and we're going to be left holding the biggest bag of odorous excrement ever assembled in the history of capitalism.

The Collateral Damage: One of the worst affected was Credit Suisse that had to book a $4.7bn Loss leading to a lot of Casualties at the Bank, most prominent being the Head of Risk Management/compliance and the head of Investment Banking

Lara Warner, former head of Risk Management/Compliance at Credit Suisse

Source - FT

Brian Chin, former Head of Investment Banking at Credit Suisse

Source - FT

The Two Pillars: Ethics and Prudent Risk Management

Ethics vs Profits Dilemma: The Man at the centre of all this - William Hwang was already indicted for Insider Trading long before this saga. So, how can a man already blacklisted be allowed to open a Family office and hence an entry into the Capital Markets? next why did the Prime Brokerage divisions of the Banks accept him as a client without due diligence? Was this another case of Profits before Ethics? If Ethical concerns were raised at the beginning, the entire episode would have been nipped in the bud. This episode highlights the central role Ethics should play in the lives of every Finance Professional and a compass that must guide all Financial Institutions whether it is crypto currencies, AI or plain physical money

Risk Management:

• The Banks had provided excessive funding to one customer - a classic case of concentration risk to one client - was this not monitored?
• The guy had exposure to multiple banks on the same transaction leading to multiplication effects for an already levered transaction (as much as 8 times), was this not being monitored by due diligence and client analytics?
• The hedges that Banks had undertaken was through holding Stocks, could that have been different (like entering into a mirror TRS trade, Purchasing Call Options, Index funds, Fixed Income Securities?)
• What about the Counterparty Credit Risk, Collateral and Correlation Risk highlighted above, weren't these monitored and measured?
• It is now known that the Risk Managers who had raised objections were overruled

Conclusion: Firing those responsible and incompetent will not solve the problem in the long run. Banks should be incentivized to perform the tasks which are their raison d etre, Efficient Capital Allocation through Financial Intermediation.

Regulations help in Balance Sheet building as much as Funds Transfer pricing and Interest Rate Risk in Banking Book Management, Regulations should be overhauled once again so that Banks take up more of Market making, provision of Liquidity and other functions lost to rapacious High Frequency Traders, Hedge Funds and the shadow banking world.

Risks should be monitored and highlighted and Risk managers should be provided with more power so that they are perceived not as "Speed Breaks to Profits" but as:

The Shields that protect the Banks from the sword lurking behind the Nectar of Profits

Folks who hold the twin Goblets of enhancing short term profits with reasonable risks and Enhancing Value and Survival of the Banks in the long run