Following the late-March leverage unwind, banks are exhibiting more caution when extending leverage to hedge funds and family offices, according to the report. Less leverage has forced hedge funds to rethink their strategy when investing in SPACs, according to the report.
Hedge funds would often employ leverage to buy SPACs at the $10 offering price, and then immediately sell any pops to get out early and lock-in gains. That leverage would significantly help juice returns for hedge funds.
A senior banker who works on SPAC deals told the Financial Times, “A lot of the return profile for hedge funds is derived from the leverage they employ. It was a gravy train when it was levered.”
Now, less leverage being offered to hedge funds in the wake of the Archegos fiasco has coincided with a significant drop in SPAC IPO listings. Over the past month, just 13 SPACs listed, compared to 110 SPAC listings in March.
“We are seeing it in the price action where securities are trading below par because banks are not offering leverage as freely as they did and it’s now more expensive,” Matthew Simpson of Wealthspring Capital told the Financial Times.
An analysis of Refinitiv data by the Financial Times found that 80% of SPACs that are still in search of a deal are now trading below the $10 level, which is often the IPO price for the blank-check firms.
“All the rocket fuel has come out of these things. If hedge funds were allowed to lever up, hedge funds would be levering up to buy all the SPACs trading under $10,” Matthew Tuttle of Tuttle Capital Management told the Financial Times.
But the unwind of leverage being offered to hedge funds isn’t the only reason why few SPACs have gone public in recent months. Increased regulatory scrutiny of SPACs and an unwind in the high-growth tech trade have certainly contributed to a decline in SPAC offerings.
Archegos Capital Management is reportedly preparing for insolvency as banks seek to regain roughly $10 billion in combined losses suffered during the meltdown in March, the Financial Times reported Wednesday.
According to the report, Bill Hwang’s family office has hired restructuring advisers to navigate financial and operational obstacles as well as the potential legal claims from the banks involved.
Credit Suisse, Nomura, Morgan Stanley, UBS, MUFG, and Mizuho all lost billions each after Bill Hwang’s family office failed to meet margin calls on highly levered positions in a handful of stocks.
As a result, some of the banks are drafting “letters of demand” to the firm requesting repayment before filing legal claims, according to the Financial Times.
Weber blamed the episode on a lack of oversight of family offices, which do not have to disclose as much information about investments to regulators compared to other asset managers, such as hedge funds.
Weber in an exclusive interview on Bloomberg TV blamed the lack of oversight particularly in family offices – entities typically established by wealthy families – which don’t have to disclose information about the firm to regulators, unlike hedge funds.
Weber urged regulators like the US Securities and Exchange Commission to enforce more transparency, adding that without action from official agencies, UBS itself would force more transparency at the bank.
“If it’s not enforced by regulators, we will enforce it because we need that information,” Weber told Bloomberg Wednesday. “If we finance activity, we want these disclosures and if clients are unwilling to give that, well there may be other banks that give them that same exposure, but it won’t be us.”
Given the “unusual” situation, Weber revealed that UBS is conducting an internal investigation to get to the root of the issue. The chairman did clarify that they are not subject to regulatory action.
“We’re not very happy with this event,” he said. “I’m hyper-focused on this …We’ve not changed our risk appetite. This was not within what should have happened. So we need to get to the bottom.”
Weber also clarified that no one will be stepping down at the bank as a result of the episode, adding that it was the process that needed improvement.
“I don’t see a single failure of a single part of the organization,” he said. “But what I do see is that the number of combinations that interacted wasn’t very good and so we need to improve each and every element of that so that those interactions don’t happen again.”
It imploded in March when some of its highly levered bets on US media and Chinese tech companies started to go bad.
Its prime brokers – the banks which facilitate lending and sales to hedge funds and family offices – demanded it put up more collateral to cover potential losses. When Archegos failed to do so, the banks began to forcibly dump its holdings, leading tens of billions of dollars of selling.
Credit Suisse was the most badly burned by these fire sales. It eventually took a hit of $4.7 billion from Archegos in the first quarter after being slow to ditch its exposure. It pushed the bank to a $275 million loss in the first quarter.
Morgan Stanley took a $911 million loss from Archegos in its prime brokerage unit. But its profit nonetheless jumped 150% to $4 billion on the back of buoyant markets.
UBS chief executive Ralph Hamers said: “Our first quarter results also factored in a loss related to the default by a single US-based prime brokerage client. We are all clearly disappointed and are taking this very seriously.
“A detailed review of our relevant risk management processes is underway and appropriate measures are being put in place to avoid such situations in the future.”
UBS shares fell 2.73% in early trading to 13.74 Swiss francs ($15).
It’s been a dramatic year for financial markets so far. Retail traders pumped up GameStop in January, captivating the financial world and whacking hedge funds who had been betting against the stock.
Then in March, the Archegos investment fund spectacularly imploded, wiping out a $20 billion fortune and sending banks scrambling to distance themselves from the collapse.
Yet, despite this turbulence, banks and hedge funds just had one of the best quarters in recent memory, smashing expectations and earning big bucks for their clients.
How did they do it? JPMorgan boss Jamie Dimon put it well himself when his bank’s earnings came out: “Stimulus spending, potential infrastructure spending, continued quantitative easing, strong consumer and business balance sheets and euphoria around the potential end of the pandemic.”
Hedge funds turn it around after rocky January
The year got off to a bad start for many hedge funds, when a band of online retail traders decided to pump up GameStop stock. A number of high-profile funds, who had been betting against the ailing company, were hit hard.
A narrative built up in the media and among the retail investors themselves that a day-trading army was laying siege to Wall Street. And in some places it was: Gabe Plotkin’s Melvin Capital, for instance, was left nursing a 49% loss on its investments in the first quarter, according to reports.
But the GameStop saga was only felt by a handful of firms, says Andrew Beer, managing member at Dynamic Beta Investments, an investment firm that follows some hedge-fund tactics.
Hedge funds made a gain of 4.8% in the first three months of 2021, the best first-quarter performance since the heady days before the financial crisis, according to data from Eurekahedge. North American hedge funds gained 6.8%.
“GameStop to me was a tempest in a teapot,” Beer told Insider. “Most funds actually did fine… because what was more important for them was getting the value rotation right.”
The first quarter saw volatility in stock markets as investors positioned for stronger growth, rotating out of big tech into stocks in neglected sectors such as finance and industry.
Beer says that with the market going through “regime changes,” hedge funds did well because they had the flexibility and agility “to be tech investors in 2019, but value investors and small-cap investors today.”
There were also opportunities for hedge funds who specialize in betting against, or shorting, stocks, says Mohammad Hassan, head analyst at Eurekahedge.
“The growth factor struggled in Q1, creating opportunities on the short side of the book for hedge fund managers as non-profitable technology stocks got a ‘speeding ticket’, so to speak,” he told Insider.
Banks smash earnings expectations as market income booms
Wall Street’s banks also escaped largely unscathed from the Archegos implosion. Morgan Stanley posted a record profit despite taking a $911 million hit tied to the fund.
Like hedge funds, the big banks also reaped rewards from highly active financial markets, helping big names like JPMorgan and Goldman Sachs wow analysts with record earnings.
Earnings at S&P 500 banks grew a staggering 248% year on year, according to FactSet. Investment banking revenue at Goldman Sachs shot up 105% as the lender’s traders cashed in on rising and volatile markets.
Even at the more consumer-focused Bank of America, sales and trading revenue rose 17% as clients played the market, helping its profit more than double.
The boom in retail trading, which lay behind the GameStop saga may also have helped, says Filippo Alloatti, senior credit analyst at Federated Hermes.
“[Retail investors] may trade with some of the bank’s platforms, but [it also] brings more inflows into equities and therefore facilitates equity capital market business,” he told Insider.
Crucially, the brightening in the economic outlook after the arrival of COVID-19 vaccines. In addition, the announcement of more major stimulus measures helped banks release $10.2 billion from the provisions set aside to cover loan losses, according to FactSet.
“There’s just no doubt that the… bear case scenarios that the banks had put into those forecasts around building their loan-loss reserves have gotten less bad,” Ken Usdin, US banking analyst at Jefferies, tells Insider.
But there are a few dangers on the horizon for banks. Although many of those involved seem to have escaped the Archegos affair unscathed, Swiss lender Credit Suisse is still struggling and similar events could yet have broader ramifications.
Meanwhile, banks’ traditional business of making loans has slowed, as stimulus money has helped people pay down their debts.
The Federal Reserve looks set to keep the party going
Underlying the very strong quarter for banks and hedge funds has been the Federal Reserve, analysts say, which has made borrowing ultra-cheap and pumped cash into the economy and markets.
William McChesney Martin, Fed chair in the 1950s, famously said the Fed’s job is to provide the punch at the party but take it away just as things start warming up.
Beer said this no longer seems to be the case, with the central bank saying it wants to see a hot jobs market and will tolerate higher inflation. “The Fed has basically said, here’s the punch bowl, have at it, and the party is going to go on well past curfew,” he said.
JPMorgan’s Dimon is bullish, despite residual concerns about lower loans and rising coronavirus cases around the world, saying: “We believe that the economy has the potential to have extremely robust, multi-year growth.”
Credit Suisse, Switzerland’s second-biggest bank after UBS, reported first-quarter earnings on Thursday that showed the bank witnessed a slightly narrower net loss than analysts had expected.
A net loss of 252 million francs ($275 million) beat the 815 million francs ($890 million) mean estimate conducted by the bank’s own poll of analysts.
The bank said it had exited 97% of its trading positions related to a US-hedge fund. Credit Suisse has consistently been reluctant to name the fund, but the bank has cushioned the blow from its remaining exposure to Archegos Capital.
It expects to incur related losses of another 600 million francs ($654 million) in the second-quarter this year and said it would raise $2 billion to shore up its capital, in the aftermath of the hedge fund’s collapse.
Here are the key numbers:
Net Revenue: CHF 7.6 billion ($8.3 billion) versus CHF 5.2 billion ($5.6 billion) in Q4
International wealth management pre-tax profit: CHF 523 million ($571.3 million) versus CHF 442 million ($482 million) estimated
Revenue from investment-banking division: CHF 3.9 billion ($5.4 billion) versus CHF 2.2 billion ($3 billion) a year ago
Net loss: CHF 252 million ($275 million) versus CHF 353 million ($385 million) in Q4
“Our results for the first quarter of 2021 have been significantly impacted by a CHF 4.4 billion charge related to a US-based hedge fund,” CEO Thomas Gottstein said in a statement. “The loss we report this quarter, because of this matter, is unacceptable.”
“Among other decisive actions, we have made changes in our senior business and control functions; we have enhanced our risk review across the bank; we have launched independent investigations into these matters by external advisors, supervised by a special committee of the Board; and we have taken several capital-related actions,” he added.
Swiss regulator FINMA announced the same day that it has opened enforcement proceedings against the bank after it suffered losses in connection with Archegos.
Credit Suisse has emerged as the hardest-hit among the banks affected by the Archegos collapse. Other banks were quicker to wind down their related positions, leaving them relatively unscathed. The Swiss lender was already battling with a controversy linked to supply-chain finance as it had $10 billion worth of funds tied to Greensill Capital.
The impact on Credit Suisse from both the Archegos and Greensill saga could add up to $8.7 billion, Bloomberg reported, citing JPMorgan analysts.
Shares in Credit Suisse fell 5% in early European trading.
Archegos, the family office of former Tiger Capital Management portfolio manager Bill Hwang, grabbed the attention of investors around the world in mid-March when the firm suffered catastrophic losses thanks to a portfolio that had two big problems: high leverage and intense concentration in a few stocks.
The Archegos mess grabbed global eyeballs not just for the size of the losses, but also for its distinct pre-financial crisis feel. There were derivatives, huge losses, exposure for large international banks, counterparty risks…all the echoes of the 2008-era blow ups.
But as disastrous as the unwinding of Archegos trades was, the billions of losses that ended up piling up at the banks (specifically, their prime broker units) facilitating the trades didn’t end up spilling into other markets. Specific stocks in the portfolio certainly got walloped – look no further than Viacom’s share price – and the dealers who took losses – like Credit Suisse and Nomura – saw a hit to their stocks as well, but broader market volatility did not tick up.
Indeed, the VIX (an index designed to measure stock market volatility) closed March at 52-week lows. Credit default swaps tied to large banks and brokers were basically unflustered. And there were no reports of contagion to other asset classes.
In other words, a multi-billion dollar blow up at a giant fund that some of the world’s largest banks had massive exposure to was basically shrugged off by the financial system at large.
That’s great news and evidence that reforms to raise the amount of capital banks hold following the global financial crisis worked.
The banking system is getting safer
As the US banking system approached the meltdowns of 2007 and 2008, US banks were highly leveraged. Borrowing by banks accounted for over 90% of risk-weighted assets and rising. Funding contributed by Tier 1 capital, that is first-in-line-for-losses equity and internally-generated earnings, was only about 8%. Post-crisis, that number is much higher at 12%, and very stable. Banks are holding more capital and are borrowing less relative to their assets. Leverage is lower, and capital is higher.
This is important because if a bank has capital equivalent to 8% of its assets, it is technically insolvent should assets decline in value by 8%. By raising capital levels, banks have raised the bar for insolvency should they suffer sudden drops in the value of their assets.
In addition to making it less likely a given bank goes bust, higher capital levels also ensure that a problem for one bank doesn’t spread. For instance, with less capital, the reported losses suffered by Credit Suisse (the worst-hit of the banks who lent to Archegos) might lead them to default on other obligations, passing on their problems to other firms.
This “contagion” was what led to a spiraling series of failures in the US financial system that claimed firms like Bear Stearns, Merrill Lynch, and Lehman Brothers. But in a well-capitalized system, a shock to one firm gets absorbed by its capital, without spilling to other dealers.
Put another way, Tier 1 capital is sort of like a wall holding back wastewater from a lake. As banks sustain losses, wastewater rises towards the top of the wall, and if it overflows, wastewater (a bank’s risky assets) that leak into the lake (the broader financial markets) can be dangerous and cause a mess.
Prior to the financial crisis, these walls were dangerously low and massive leaks of risky assets resulted in a broader contamination of financial markets around the world. But after that crisis, regulators made banks rebuild those walls to be much higher and able to hold back much more before leaking any of the waste into the larger lake. This has hurt banks’ profitability, but it’s also made the system safer.
Blow ups aren’t spreading anymore
Archegos is not the first time since the crisis that large shocks to the financial system failed to result in contagion. The 2014 to 2016 oil price collapse, 2016’s Brexit shock, plunging Treasury prices after the 2016 election, or the collapse in volatility-linked exchange-traded products in early 2018 all showed that the system has gotten more resilient.
In each of these cases, pundits speculated that the huge dislocations would create positive feedback loops of contagion that would spin out of control, something I’ve previously written about.
But a well-capitalized financial system makes positive feedback loops much less likely, because a given mess doesn’t extend beyond the institutions immediately exposed to it.
Economist Hyman Minsky identified a tendency for financial instability to repeatedly arise as participants are rewarded for speculative activity. He contended that preventing speculation was a fool’s errand – there would always be a new frontier for leverage and risk-taking to build up.
While instability may be inevitable, it can be contained. Regulators were not prescient enough to prevent investors from piling into short volatility ETNs, couldn’t have predicted the outcome of the initial Brexit referendum, and didn’t have the visibility to see how large Archegos positions were getting.
But if capital levels are sufficiently high, regulators don’t have to predict every possible disaster on the horizon. Should a given fund or dealer run into trouble, that would be bad news for investors directly exposed…but not for the financial system as a whole.
High levels of capital have worked well for the financial system since 2009, and that was proven again with the Archegos blow-up. Efforts to reduce minimum capital requirements should be viewed skeptically given their track record keeping specific meltdowns isolated and staving off the “Minsky moment” of financial system collapse we saw in 2008.
The Swiss bank isn’t yet done unloading stocks linked to Archegos, even though it’s already taken a $4.7 billion charge from the hedge fund’s collapse last month. Several top executives, including the chief risk officer and investment bank head, are departing following the fund’s failure to meet margin requirements.
In late March, Archegos used borrowed money to make large bets on some stocks until Wall Street banks forced it to sell over $20 billion worth of its shares as it couldn’t meet a margin call.
Tuesday’s block trades were offered at a discount to their closing prices. They included 19 million Class A shares of Discovery sold at $38.40, 22 million Class C Discovery shares sold at $32.35, and 35 million shares of Chinese online video-platform iQIYI at $15.85, Bloomberg said, citing one source.
Shares in Discovery and iQIYI fell sharply in after-hours trading on Tuesday. Credit Suisse fell 2% in morning trade on Wednesday.
Credit Suisse last week sold around $2.3 billion in block trades in Viacom, Vipshop, and Farfetch in an attempt to limit further losses from the fiasco.
A spokesperson for Credit Suisse didn’t immediately respond to Insider’s request for comment.
Then a decline in share prices sparked a massive margin call that Archegos was unable to meet, leading banks to liquidate the family office’s assets.
The result was combined losses of $10 billion for global banks, according to estimates from JPMorgan.
Now in order to prevent similar blow-ups in the future, banks are taking action to reduce risk associated with hedge fund clients. The Securities and Exchange Commission has also opened an investigation into the matter.
Specifically, Nomura is tightening leverage for some clients that were previously granted exceptions to margin financing limits, Bloomberg said, citing people with direct knowledge of the matter.
The Japanese firm is the second bank to take action after the Archegos collapse.
Credit Suisse said earlier in the week that it will change margin requirements on swap agreements to dynamic from static after the collapse. Dynamic margin requirements force clients to post more collateral as positions move down, rather than setting a fixed margin requirement at the onset of the leverage contract.
Before the Archegos implosion, Nomura had been hitting on all cylinders with net income reaching a 19-year high for the nine months ended in December.
Now though, the bank has been forced to cancel the planned issuance of $3.25 billion in senior notes and share prices are down roughly 20% from March 26 highs.
Global banks are expected to lose up to $10 billion following the Archegos Capital Management meltdown, JPMorgan said Monday – raising its estimate from an initial $2 billion-$5 billion – with Credit Suisse Group and Nomura Holding hardest hit.
“One line of argument which could explain why the scale of losses suffered by [Credit Suisse] and Nomura was higher could be a higher level of leverage extended by these banks compared to [Goldman Sachs and Morgan Stanley], which seem to have suffered smaller losses if any,” JPMorgan analysts led by Kian Abouhossein said in a research note Monday.
JPMorgan clarified that there may also be additional considerations that determined the sizable difference between the scale of losses suffered, such as the timing of the sale of positions, among others. Nonetheless, the entire episode affects the industry overall, given that global banks could end up losing five times the normal loss level for a collateralized daily mark-to-market business.
JPMorgan cites three lessons the industry could take away from the fund’s implosion.
First, investment banks in general are in better shape today and are more focused on high-volume execution platforms.
“There is no excessive leverage in the [investment banking] or [private banking] industry,” JPMorgan said. “Although [private banking] leverage has been increasing, it is nowhere near prior peaks.”
The bank also said it sees no excessive equity-swap growth, a simple instrument all parties will benefit from.
Second, US regulatory frameworks like Basel III and the Dodd-Frank Act have improved the risk profile of investment banks. JPMorgan, however, noted that there is still weak oversight for non-bank entities, especially when it comes to family offices.
Archegos, a family office founded in 2012, did not have to disclose investments, unlike traditional hedge funds. JPMorgan also pointed to the lack of transparency when it came to equity-swap filings.
The Archegos sell-off exposed the fragility of the financial system, especially those involving lesser-known practices such as total return swaps, a derivative instrument that enabled Bill Hwang’s office not to have ownership of the underlying securities his firm was betting on and the secrecy of family offices. Typically, family offices enjoy the “private adviser exemption” provided under the Advisers Act to firms as these usually advise less than 15 clients, among other conditions.
But JPMorgan said, “filing requirements would have applied to Archegos given its sizable exposure to some US securities. However, the fact that Archegos did not file with the [Securities and Exchange Commission] can be explained by the usage of total return swaps, which seems to be the primary method through which the sizable positions were built by Archegos.”
Dan Berkovitz, a Democratic commissioner on the Commodity Futures Trading Commission, denounced family offices and their ability to skirt some oversight.
“A ‘family office’ has nothing to do with ordinary families,” he said in a statement on April 1. “Rather, it is an investment vehicle used by centimillionaires and billionaires to grow their wealth, reduce their taxes, and plan their estates.”
Third, JPMorgan said private banks, specifically those linked to Archegos, moving forward could improve their onboarding, especially with clients with backgrounds such as Hwang, who has run into trouble in the past. Private banks could also strengthen their risk management by giving less leverage to non-transparent family offices with concentrated positions and ensure checking the clients’ rehypothecation risk, among others.
Archegos in late March used borrowed money to make large bets on some stocks until Wall Street banks forced Archegos to sell over $20 billion worth of its shares after failing to meet a margin call. Hwang grew his family office’s $200 million investment to $10 billion. Reports say the former Tiger Management trader lost $8 billion in 10 days.