The biggest financial news of late – the kind everyone enjoys because opportunities for true schadenfreude in financial markets are rare – is the blow-up of family office / hedge fund Archegos Capital Management.
The firm reportedly had accumulated ~$10-12bn in assets against which it borrowed 5-6 times. This means the blow-up was probably around $50-60bn in total “value” as measured in notional exposure through swaps and the sum of outstanding margin debt at the firm. The sheer size of sales in the fund’s holdings implies large multiples of equity in overall firm leverage as it has been reported since the value of these sales massively exceeds the firm’s equity.
It was not that long ago that smaller hedge fund implosions of a smaller magnitude evoked not only financial journal headlines but direct central bank involvement due to tighter weaves of financial dependencies. When Long Term Financial Management, a hedge fund that employed no fewer than two Nobel Prize laureates, failed in spectacular manner it became the crisis du jour of 1998.
Long Term Capital Management’s peak equity value was $3.6 billion – a pittance in comparison to the reported equity value of Archegos at ~$10-12 billion. It should be noted that the notional value of either LTCM or Archegos cannot be publicly confirmed; it is this author’s opinion that LTCM’s notional exposure was substantially less than the staggering $1.2tn figure thrown around including recently. This 1998 Fortune article indicates LTCM carried $30 in leverage to each $1 in equity, implying exposure of $120 billion at peak. Hedge funds and family offices are not required to disclose this type of information, so discerning a precise figure is subject to speculation.
If Archegos was limited in exposure (likely due to regulatory rules), then it is to the benefit of financial markets. The Federal Reserve needed to organize a bank-led bailout of LTCM to maintain stability in the markets under Chair Alan Greenspan, a noted Ayn Rand acolyte. According to famed financial writer Michael Lewis, Alan Greenspan said that he had never seen anything in his lifetime that compared to the terror of August 1998.
Fast forward 22 years and a family office with a larger equity base using a highly leveraged approach akin to LTCM exploded yet may never evoke any substantial commentary from current Fed Chair Jerome Powell at all – it certainly has not provoked any Fed commentary to date. Why is that?
The implosion of Archegos has caused only a blip in widespread equity index measures and seemingly will have no effect on the real economy. The prime brokerage desks at a few banks may see staff turnover. But overall indices closing near all-time highs after this news suggests that fall-out is limited to the banks who loaned to the firm. When LTCM failed, the S&P 500 sold off 10%, sparking widespread contagion fears that LTCM’s collapse would usher in calamity in the real economy.
Some of the same banks who engaged with LTCM have found themselves entwined with Archegos yet are better capitalized than they were in 1998, due to growing regulatory oversight over the past 20 years. Derivatives markets have better clearing functions and counterparty risk requirements as a result of a raft of regulatory efforts over the past twenty years. Though the regulation was not politically or economically painless to secure for the U.S. economy, the benefits of stability are clearly paying off.
Despite unforeseen economic crisis in the Covid-19 pandemic, a near-implosion of a retail brokerage in Robinhood/Gamestop saga, and now a massive hedge fund imploding with five-star counterparties such as Goldman Sachs, the limited impacts is is a testament (for now) to stricter regulatory oversight. Instead of threatening the jobs and retirement savings of ordinary Americans and the real economy, only the participating banks will feel the pain along with the fund itself.
Thanks to hard-fought regulations to ensure financial market stability, it seems that we can generally worry less about hedge fund blow-ups.
San Francisco Securities Outlook 