Before he almost lost everything overnight, Bill Hwang was having a comeback.
In 2012, Mr. Hwang, a former hedge fund manager, pleaded guilty to wire fraud and settled insider trading charges. But he started over in 2013, using $200 million from his shuttered hedge fund to create Archegos Capital Management — a so-called family fund. The scandal-tainted Mr. Hwang then turned that $200 million into some $20 billion, betting big on a portfolio of high-flying media and tech stocks.
But Mr. Hwang built those riches on a mountain of debt — and when his bets went bad, it wasn’t just Archegos that paid the price: The banks that lent Mr. Hwang money, including Credit Suisse and Morgan Stanley, lost over $10 billion, while the stocks he gambled on shed $33 billion in value.
From regulators to the financial press, everyone seemed mystified by the implosion of Archegos. In part, this is because when Congress passed the 2010 Dodd-Frank Act, which brought new measures of oversight to private money managers, they exempted family funds like Mr. Hwang’s. Hedge funds must publicly report certain stock and option positions every quarter, filing a Form 13F with the Securities and Exchange Commission. But family funds don’t need to file a 13F, so their portfolio positions remain hidden.
For the average American dealing with the ravages of life under Covid, the story of Bill Hwang and Archegos may seem like just another Wall Street fat cat who got too greedy. But there may be many more Archegos-size risks — hidden from regulators, lawmakers and traders alike — now threatening to spark the next financial crisis.
In 2021 Archegos bet that the price of approximately nine hot stocks, including ViacomCBS, Discovery and Baidu, would keep climbing. It seemed to have good reason: Discovery and ViacomCBS were investing in streaming services, a booming sector. But Archegos wasn’t just buying and holding. It used borrowed money and under-regulated derivatives to make bigger, riskier bets.
Just as you can borrow money against the value of your home, you can borrow money against a portfolio of stocks. Regulators limit nonprofessional investors to 2-to-1 leverage — brokers will let them purchase $200 in stock for every $100 in assets. But private money managers like Mr. Hwang face no hard upper limit: Many private funds are able to borrow five or 10 times the value of their portfolio. Archegos may have gotten as high as 20-to-1.
Once Mr. Hwang’s investments starting soaring, he wanted more. Rather than cashing out, he kept borrowing from the world’s biggest banks, driven to make even bigger bets. To do so, he used what’s known as a total return swap, a type of derivative that provides all the economic benefits of owning a stock without requiring Archegos to spend the money to actually buy it.
Here’s how it worked: Archegos paid a bank like UBS a preset fee. In exchange, the bank bought ViacomCBS stock and then paid Archegos any income and capital gains the stock generated. When the stock price dropped, Archegos would pay the bank the amount by which the stock fell. All Mr. Hwang had to do was find a bank that believed Archegos was creditworthy enough — and he found plenty. But the same leverage that powered Archegos’s success also proved to be its undoing.
At the end of March, ViacomCBS sought to capitalize on a blistering four-month stretch that saw its stock triple, issuing new shares. ViacomCBS didn’t know that its growth was mostly a byproduct of Mr. Hwang’s giant swaps bets. Mr. Hwang didn’t participate in the ViacomCBS issuance, even after initially expressing interest: Reporting suggests he may have been so leveraged that he simply didn’t have money left to buy any shares.
As a result, ViacomCBS’s offering finished well short of its target. In just a week, the stock lost half its value. Because of how total return swaps are structured, Archegos had agreed to pay for any losses on the stock. When it couldn’t pay, it defaulted.
Without Mr. Hwang propping up these stocks, their recovery would be tough. Meanwhile, the banks needed to liquidate the stocks the swaps were based on and discussed creating a plan to do so without disrupting the market.
But Goldman Sachs and Morgan Stanley didn’t wait for a plan to be finalized and jumped first. The stocks cratered, and the other banks had little choice as the bottom fell out. Credit Suisse bore the worst loss: $5.4 billion, thanks to one bad trade.
If the banks knew how big Archegos’s position was, they may have realized other banks were supplying it with the same leverage — and reconsidered the trade. But a set of worrisome regulatory loopholes kept them from detecting this lurking whale.
As a family fund, Archegos did not have to file reports with the S.E.C. detailing its positions. Even if it were a hedge fund, there is no requirement for reporting total return swaps on 13Fs. In addition, Archegos’s lenders may have presumed that the fund wasn’t simply long on all its stock.
That is to say: They most likely believed Mr. Hwang balanced his risk by taking at least a few “short” positions, or betting on a fall in price like most funds. Reporting indicates Archegos shorted only indexes, not individual stocks, meaning it would profit only if the whole market fell. But even if Archegos reported its positions, its total exposure would have remained a mystery: The S.E.C. also doesn’t require the reporting of short positions on 13Fs.
Lax regulations for private funds are a longstanding problem. Republicans have fought against increased oversight and repeatedly argued to slash the S.E.C.’s budget. In 2020, the S.E.C. introduced a proposal that would excuse any hedge fund managing less than $3.5 billion in assets from reporting its positions to the public — a move that would have allowed all but the largest hedge funds to operate in secrecy. (The proposal was widely opposed by investors and ultimately dropped.)
While Democrats wrote new oversight requirements for private funds into the 2010 Dodd-Frank Act, they exempted family funds from the law altogether. The House Financial Services Committee chairwoman, Maxine Waters, proposed draft legislation requiring family funds managing more than $750 million to be subject to Dodd-Frank’s regulations. In the Senate, a bill soon to be reintroduced by Tammy Baldwin, a Wisconsin Democrat, will also impose greater disclosure requirements on the kind of derivatives Archegos was using.
Under Gary Gensler, a tough regulator who served in the Obama administration, the S.E.C. could stiffen regulations and tighten reporting requirements for private funds. This would help regulators — and banks — identify future Archegos-size whales.
Not everyone in Washington may be taking these risks as seriously as they should. Last year, the Federal Reserve, which oversees the nation’s largest financial institutions, presciently warned that banks were giving their favorite private fund clients increased leverage. If one of those funds imploded, volatility could spike across the markets.
Yet in a news conference on April 28, Jerome Powell, the chairman of the Federal Reserve, dismissed Archegos-size risks. He defended the Fed’s failure to catch this in advance, saying, “we don’t manage [the banks’] companies for them.” But it is the Fed’s job to ensure that banks aren’t lending recklessly to funds whose blowups could reverberate back to the taxpayer-backed banking system.
One way the Fed monitors for such risks is through annual bank stress tests. In 2019, Credit Suisse failed part of its stress test because the Fed feared it couldn’t accurately project major trading losses. Instead of forcing substantial changes, it seems the Fed let them off the hook too easily: After Credit Suisse’s staggering $5.4 billion Archegos loss, it scrambled to raise $2 billion in new capital. The Fed needs to recognize its own regulatory failures and take action, not minimize the significance of the fallout.
While the banks mostly managed to sustain the losses, had they been greater, the simultaneous, forced liquidations of the same assets at the same time could have cascaded into a larger crisis — much as it did when Lehman Brothers fell in 2008. Without reforms to bring family funds out of the shadows and ensure more reporting by private money managers, and closer supervision of banks by the Federal Reserve, it will be difficult to spot and impossible to fix other large risks to the financial system.
The 2008 crisis was catastrophic because it wasn’t just one fund borrowing too much to make risky, under-regulated bets — it was every major player on Wall Street. Whether an obscure family fund survives isn’t important unless its blowup threatens to crash the banks that house people’s savings.
If policymakers leave private funds under-regulated, we may not know how many others are following Archegos’s dangerous playbook until it’s too late.
Alexis Goldstein (@alexisgoldstein) is a former Wall Street professional who works at Americans for Financial Reform. She is the author of the newsletter “Markets Weekly.”