The spectacular collapse of Archegos Capital, the family office of former hedge fund manager Bill Hwang, has dominated financial media headlines all month. As I discussed last week, Archegos fell victim to extreme leverage, a fate that has befallen many a fund over the years.
However, Hwang was not the only one to lose his shirt amidst the Archegos blow up. Several investment banks with which the family office had been doing business were also badly burned – none more so than Credit Suisse Group AG (CS, Financial).
Risk management failure
At the heart of Hwang's scheme was a little-known financial instrument, the total return swap. Investopedia offers a straightforward definition of this instrument:
"In a total return swap, one party makes payments according to a set rate, while another party makes payments based on the rate of an underlying or reference asset. Total return swaps permit the party receiving the total return to benefit from the reference asset without owning it. The receiving party also collects any income generated by the asset but, in exchange, must pay a set rate over the life of the swap. The receiver assumes systematic and credit risks, whereas the payer assumes no performance risk but takes on the credit exposure the receiver may be subject to."
A TRS-based strategy can create a leveraged bet on a security. However, no one anticipated just how much leverage one could achieve with it, given sufficient will and creativity. For Hwang, the key was to use multiple banking partners, exploiting the opacity they often provide to privacy-conscious family offices. Archegos exploited the relative lack of inter-bank communication to magnify leverage, while exposing multiple financial institutions to unexpected counterparty risk, as The Hustle's Trung Phan outlined on April 4:
"By 2021, he was leaning on six prime broker bank partners for his TRSs: Goldman, Morgan Stanley, Credit Suisse, Nomura, Deutsche, UBS. Despite the potential risks, the banks were happy to take fees from such a whale. Without realizing it, they created a financial time bomb...Due to the nature of the swaps, the prime brokers built up massive long positions in Archegos portfolio companies."
Too slow to react
As Archegos' portfolio ballooned toward $20 billion early this year, leverage had made its actual exposure on the order of $100 billion. When the firm blew up, its banking partners were left with billions of dollars in exposure. Once the extent of the crisis had become apparent, Credit Suisse met with several other exposed banks in an attempt to coordinate their actions so as to head off a catastrophic firesale. But, as CNBC discussed on March 29, this did not go as planned:
"Goldman managed to sell most of the stock related to its Archegos margin calls on Friday, helping the firm avoid any losses in the episode, according to one of the people. Morgan Stanley sold $15 billion in shares over a few days, avoiding significant losses...Before the stock sales spilled into public view late last week, five of Archegos' banks convened a call with Hwang to discuss ways to head off a messy fire sale...The cease-fire didn't hold, however, and Goldman quickly began pitching clients on massive blocks of shares."
Credit Suisse had hoped for cooperation, but instead it found itself holding the proverbial bag as other investment banks liquidated their Archegos books at maximum speed. Remarkably, while Goldman Sachs (GS, Financial) had liquidated its positions within a day, Credit Suisse waited until April 5 to begin unloading its biggest blocks. Unlike Goldman, which had gotten off largely unscathed, Credit Suisse found itself sitting on brutal losses.
Once the dust had settled, Credit Suisse was reportedly sitting on $4.7 billion in losses thanks to Archegos, forcing the venerable investment bank to slash bonuses in an effort to make up some of the difference.
My verdict
Credit Suisse has gotten a serious black eye from the Archegos debacle. It allowed the prospect of rich fees to blind it to the potential risk of TRS exposure, as did several other banks. Unlike other banks, however, Credit Suisse allowed itself to be caught in the savage firesale.
There will likely be further fallout from the Archegos mess. Credit Suisse is already down nearly 20% thanks to its losses. While the bank will undoubtedly attempt to draw a line under the incident quickly, I would submit that its failure to react expeditiously could be indicative of future risk. Should another similar disaster occur, Credit Suisse could yet again find itself losing out to its more nimble peers.
Disclosure: No positions.
Read more here:
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- Blown Up by Leverage: Lessons From the Collapse of Archegos
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