The Cascade Effect…

The recent rapid demise of Archegos Capital Management, (a hitherto relatively obscure family office and investment fund controlled by former “Tiger cub” (alumnus of Julian Robertson’s Tiger Management) Bill Hwang), apparently because of its inability to meet margin calls from banks providing it with prime brokerage services (including trade processing, structuring and lending) has, yet again, shown the dangers of becoming too “comfortable” with leverage, underestimating volatility and concentrated risks, and not knowing what an obligor’s true exposures are.

We have a distinct sense of “déjà vu”, harking back to the collapse of Long Term Capital Management (LTCM) in 1998, which involved most of the largest investment banks of the time, and required the US Federal Reserve to orchestrate a “private bail-out” of LTCM because of concerns about the overall financial market impact. What makes this case unusual is the relative obscurity of Archegos, compared with the fame of the storied background of LTCM.

From recent disclosures about Archegos, it would appear that it had significant, leveraged exposures to a relatively small number of US and PRC stocks, whose subsequent rapid decline in price led to at least one prime broker asking Archegos to provide additional collateral- i.e., making a margin call. When Archegos failed to meet the call, the prime broker(s) would have started to liquidate its positions to repay loans extended, or to unwind transactions, which then forced down further the market prices of the underlying stocks, triggering a cascade of similar actions by other prime brokers, leading to concern about whether or not the rapid unwinding might have knock-on effects elsewhere. As one Tokyo-based banker (quoted by the Financial Times) said: “The first cut is the cheapest.”

The issue which seems to have been a significant factor is the combined scale and level of leverage which had accrued within Archegos’ positions.

Of course, as equity markets had been rising and margin capacity remained widely available, the scale of the underlying risk exposures would have been masked by valuations. However, as markets fell, and “everyone headed for the exits at the same time”, because the exposure they had to Archegos was the same (wrong) way round, the sheer size of the aggregate positions being liquidated created a negative feedback loop, further compounding the scale of realized and potential losses.

So, the question might reasonably be asked how could such a comparatively obscure fund create such immediate havoc? No doubt, as more details come to light, that will become clearer; and enable an informed analysis of whether there were failures of regulation (because funds designated as family offices currently have minimal disclosure requirements) and/or of risk management.

For the Awbury Team (some of whom have been around long enough to remember the demise of LTCM as if it were yesterday!) it simply reinforces the time-worn adage: It is the risk(s) you cannot see (or ignore) that will ruin you- in this case, the level of Archegos’ overall trading, as well as its concentration and leverage. When all is seemingly ordered, controlled and defined one should be concerned about what is being missed, and the risk of an adverse shock. Call it “protective paranoia”, if you will.

Such a lesson applies equally in the (re) insurance arena; although, fortunately, without the backdrop of material financial leverage. One must never stop reviewing one’s portfolio of risks, looking for hidden correlations or aggregations that might be triggered by an unexpected catalyst.

Footnote: Archegos (ἀρχηγός) is the English language transliteration of the Biblical Greek noun for leader, or ruler…

The Awbury Team

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