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.
Goldman Sachs was quicker than its rivals at offloading billions of dollars of stock held by the imploding investment fund Archegos. Japanese banking giant Nomura wasn’t so fast, according to reports, and is facing losses of around $2 billion in one of its arms.
Now, Goldman analysts have downgraded Nomura’s shares, pronouncing on Tuesday: “We now think upside for the stock looks limited.”
The analysts, led by Shinichiro Nakamura, also lowered their earnings forecasts for Nomura, saying: “We assume the company would look to adopt a generally more risk-focused or cautious approach.”
The major banks that lent to Archegos Capital Management tried to reach an agreement last week when it became clear that Bill Hwang’s fund was struggling to come up with cash to cover its bets, according to reports in the Financial Times and Bloomberg.
Yet those talks broke down, the reports said, and Goldman started selling huge blocks of Archegos’ holdings in companies such as ViacomCBS on Friday, causing stock prices to tumble.
Michael Brown, senior market analyst at Caxton FX, said it was a case of “every bank for themselves.” He added: “Unsurprisingly, [any agreement] quickly fell apart, such is the cut-throat nature of the business.”
On Monday, it became clear Nomura had not been fast enough when it said it was facing “a significant loss arising from transactions with a US client.”
Goldman, itself the heart of the action, swiftly downgraded Nomura’s stock from “buy” to “neutral” on Tuesday.
“We lower our [earnings] estimates given Nomura’s March 29 disclosure that it could book losses/provisions [of] approximately $2 billion,” the analyst said.
Nomura Holdings was down around 19% for the week on Wednesday at 581 Japanese yen, roughly $5.25. Goldman’s new 12-month target price is 630 yen.
Goldman said that if losses in the bank’s prime brokerage business rise to $3-$4 billion, “we would see a possibility that the company could rein in shareholder distributions.”
Nomura and Goldman Sachs both declined to comment.
JPMorgan now reckons the losses at certain banks involved with Archegos, such as Nomura and Credit Suisse, could be as high as $10 billion.
A person with knowledge of the situation said Goldman had “proactively managed” its risk and that its losses were “immaterial.”
Brown said: “For now, it’s a point to GS in this one.”
The implosion of Archegos Capital over its derivative holdings that went sour should not come as a surprise to anyone, given the opaque and volatile nature of the swaps market in which the US hedge fund invested, Paul Schatz, president and founder of Heritage Capital, said on Monday.
Archegos Capital was forced to dissolve its holdings at the end of last week as it had become unable to meet margin calls from its lenders, sending major entertainment and tech stocks tumbling. The family office was facing financial difficulties even before then and various big banks had to tried to prevent a crisis by entering into swaps contracts with Archegos last week. This exposed its funds to volatile equities worth billions of dollars.
On Monday, Credit Suisse and Nomura announced that they would suffer significant losses after a US hedge fund was forced to liquidate its stock holdings when it could not meet margin calls from its lenders. Their share prices dropped significantly on Monday along with those of other major banks and the companies Archegos – which a number of media outlets confirmed was the fund in question – had previously held.
Years of super-cheap financing thanks to low interest rates set by central banks has fueled a record boom in investment, sending stocks to record highs and inflating the value of everything from cryptocurrencies, to junk bonds.
Schatz said this had led to “epic greed and euphoria” in the sector over the last six months. Paired with high levels of confidence and the hubris of investors, this inevitably leads to people making “egregious mistakes” and engaging in “beyond irresponsible behaviour” he continued, drawing lines between the current situation and cases like the 1998 Long Term Capital Management crisis, in which one of the world’s biggest hedge funds blew up, roiling markets and requiring government intervention.
Fund managers that own assets beyond a certain size must report their positions regularly to the US regulator. However, this does not apply to the type of swaps that Bill Hwang’s Archegos Capital used. Schatz said these were “essentially non-disclosed, undisclosed, secret derivatives”.
Schatz pointed out markets were already jolted once this year in January, when retail traders organized themselves through Reddit and bought up shares in GameStop, which resulted in skyrocketing prices and forced some institutional investors who had bet against the video retailer to close those positions, even at a loss.
Schatz predicts the public will continue to lose confidence in the stability of financial markets and regulators and politicians will get involved. “These large funds that have very little disclosure requirements like this certainly need to have more disclosure in the swaps market,” he said.
He said the problem with using swaps – a form of derivative – was positions being leveraged over and over again, without prime brokers being aware of what their competitors are doing – this “can become this ginormous pile of leverage that only takes the slightest little prick” to unravel.
“The swaps market should not exist the way it is. It fully should be brought on exchange, there should be better disclosure and there should be better protection for investors” Schatz said.
The financial hit, it said in a statement, came out of “a significant loss arising from transactions with a US client.” The firm declined to name the client.
Nomura said it would no longer be issuing planned US dollar senior notes, noting that “an event that occurred after pricing that could impact the company’s consolidated financial results,” according to Reuters.
Following the news, Nomura’s shares were trading down 15% Monday morning.
The loss follows a wild week for markets dominated by a reported liquidation of positions held by Archegos Capital Management, an investment firm led by Tiger Asia founder Bill Hwang. The liquidation appears to have been led by Goldman Sachs and Morgan Stanley.
The two investment banks sold billions of dollars worth of media and Chinese stocks, with ViacomCBS and Discovery dropping as much as 35% on the heavy selling. Chinese companies Tencent, Baidu, and Vipshop also saw a major drop. Market watchers told The Wall Street Journal the “size and speed” of the sell-off was “unprecedented.”
Despite the sell-off, the market saw a last-minute rally on Friday, with the Dow ending up 450 points and the S&P 500 closing at a record high.
Nomura said the $2 billion loss shouldn’t impact operations.
“As of the end of December 2020, Nomura maintained a consolidated Common Equity Tier 1 ratio of over 17 percent, which is substantially higher than the minimum regulatory requirement,” the statement continued. “Accordingly, there will be no issues related to the operations or financial soundness of Nomura Holdings or its US subsidiary.”
Nomura operates in 30 countries worldwide, as has total assets of $432.2 billion.