Archegos’ implosion forces family offices to reconsider loading up on more debt. How much is too much?
Low interest rates and rising stock markets have offered investors a golden opportunity to gain a lot by borrowing. As a result, the financial system has become more leveraged and vulnerable, according to analysts and advisers.
“The increased liquidity in the system has been exacerbated by central bank actions during the pandemic,” says Maria Rivas, senior vice president of Global Financial Institutions at DBRS Morningstar. “Therefore, the search for yield can lead to excessive risk-taking.”
Borrowing money to buy securities—also known as margin debt—increased by about 72% during the pandemic, to $822.6 billion in March 2021, according to the US market regulator Financial Industry Regulatory Authority. “The market is forcing people to take a bit more risk in their portfolios,” says Samy Dwek, founder and CEO of the Family Office Doctor wealth-advice blog platform and of White Knight Consulting.
Archegos Capital Management’s implosion may remain a rare event in Wall Street history due to its massive leverage, which reportedly was five times assets worth about $10 billion. But the case has brought closer scrutiny to less regulated players such as family offices and hedge funds.
“Counterparties taking concentrated risks is not a specific US market issue; it could cause significant volatility anywhere,” says Julien Courbe, financial services leader at PwC. “Leverage in the system looks quite different than it did before the 2008 financial crisis. According to the most recent Federal Reserve stability report, it is at low levels for banks but high levels for hedge funds.”
The Bank of Japan, in its April Financial System Report, also warned of risks from the “growing interlinkage” between the Japanese financial system and overseas nonbank institutions.
“Regulatory arbitrage is a consistent feature of the financial system. These recent cases highlight that this remains the case and that banks and regulators need to pay attention to this,” says Rivas.
Since Archegos’ closure, regulators have called for closer oversight of family offices. Under US Securities and Exchange Commission (SEC) rules, family offices, unlike hedge funds, are exempt from registering in the US as fund advisers. Early this year, the SEC started a review of that rule to possibly extend its oversight.
After Archegos, Dan Berkovitz, one of the three commissioners on the US Commodity Futures Trading Commission—another regulator—also called for monitoring family offices. One of the regulators’ concerns is that hedge funds may register as family offices to avoid disclosure.
Most family offices are taking moderate leverage, according to White Knight’s Dwek. “Large families with immense wealth are not looking to push the rules. The family office is there to protect the nest egg, not to go take excessive risks.”
Archegos used total return swaps to borrow money from banks and build a portfolio. Total return swaps do not require investors to own the stocks and disclose them. The banks working with Archegos reportedly lost $10 billion when some of the positions soured in March and the firm defaulted on its margin calls.
“I’ve dealt with a lot of large and sophisticated family offices,” Dwek explains. “It’s so rare to find them using total return swaps and to the amount that Archegos was doing.”
Large family offices deal with investment banks rather than private advisers for more-sophisticated trades. Dwek noted that private banking is better suited to serve entities “with two legs and two arms.” The adviser adds that “Unless they are institutional in nature, they should be in a private bank; because a private bank is never going to allow them to take that kind of risk.”
In May, Federal Reserve Governor Lael Brainard called for “more-granular, higher-frequency disclosures” regarding hedge funds. “Continuous risk management is essential for businesses with volatile risk profiles,” says James Lam, president of James Lam & Associates, a risk management consulting firm.
Credit Suisse is introducing real-time margin requirements after being burnt by the Archegos blowup for an expected loss between $4.7 and $5.5 billion. Also known as “dynamic margining,” the system allows banks to immediately adjust collateral requirements of clients as soon as securities prices change.
