Family offices big enough to trigger the biggest margin call in history are big enough to regulate.
The long era when private investment offices could elude Washington’s scrutiny is rapidly coming to an end. This is a threat to some HNW advisors and an opportunity for others.
The threat is simple. Family offices and other sophisticated funds that don’t court outside money stayed under the radar because they kept a low profile and they kept their noses relatively clean.
Bill Hwang abused that privilege by letting his Archegos operation get too big and too noisy for Janet Yellen and other jumpy regulators to ignore.
Oversight is coming. And that’s the opportunity for the rest of us.
The $10 Billion Breakdown
Yellen has started publicly pondering whether hedge fund leverage represents a systemic risk to the financial system.
She ran the Fed and worked closely with Alan Greenspan. She knows every hint can conceal a warning if not a threat.
After the Robinhood debacle, the hedge fund community was already on her radar. Concerned legislators like AOC are up in arms over tactics that sophisticated investors take for granted.
Shorting obviously pandemic-damaged companies and then squeezing those shorts when they get in over their heads is only a problem when you’re only thinking of the retail investor.
While bleeding hearts in Washington will bemoan the thought of hardworking people buying on credit and losing their retirement savings when the margin calls come due, Archegos was always a very different proposition.
In theory, it was a sophisticated play that multiplied the impact of one “client’s” wealth. Depending on who you talk to, Archegos had as little as $5 billion in the market but controlled up to $40 billion in stock.
Hwang gambled his personal fortune on at least 6X leverage structured through complex swaps. As a storied history in the market, he clearly knew the risks.
If he didn’t build these trades himself, he at least signed off on the general strategy. Either way, it was his money.
Outside investors just weren’t a factor here. That’s traditionally been a firewall against regulatory oversight at this end of the market.
But while Hwang was smart, he wasn’t smart enough. The old argument that private funds are too smart to fail is dead.
And that’s the problem Janet Yellen now sees. Because private funds are no longer a niche industry.
The Systemic Threat
When LTCM died two decades ago, it didn’t even have $5 billion in equity on the books. And it still shook the global market when its swaps imploded.
After all, 5-6X leverage becomes a killer when you stop buying stock on margin and start accumulating derivatives priced at a fraction of their market impact.
It’s hell on your trading partners. Credit Suisse and various Japanese banks have already reported the strain of being on the other side of Hwang’s margin debt.
Morgan Stanley has been a little too quiet for some people. Wells Fargo and Goldman Sachs have been reserved but relatively sanguine about having to dump Archegos stock to settle the fund’s accounts.
Unfortunately, the hedge fund world has gotten extremely crowded. When a firm like Archegos has to liquidate, the aftershocks are contagious.
You’ve seen this on the retail advisory level. When a big fund blows out, its counterparts tend to spread the selling.
Retail investors register the losses as a test of their cash flow as well as their nerve. The “smart” ones try to get ahead of the curve by selectively rotating into perceived strength, creating new crowded trades while again feeding contagious weakness elsewhere.
Either way, when the value of stock pledged to secure margin debt drops, once-reasonable ratios can dive deep underwater in a heartbeat. That’s where things really get bad.
Again, niche funds limited by their own capital are nobody’s problem. They live and die according to the skill of the people calling the shots.
Archegos, like LTCM before it, got greedy and rocked other people’s boats. In Janet Yellen’s world, that makes it her problem.
Right now, private funds don’t really need to register except as an adjunct to their trading activities. All that’s required then is disclosure of their positions so the regulators can track concentrated positions across the market.
However, while Yellen has reactivated the “hedge fund working group” at the Treasury’s Financial Stability Oversight Council, the real muscle will come from the SEC, which already monitors over-the-counter derivatives dealers so can get a sense of overall flows.
In theory, the SEC can create new rules that shape the amount of debt any market participant can take on. Mary Jo White talked a good game when she was running the commission, but shifting political current ensured that it never went beyond that stage.
Every Bank For Itself
In practice, the banks and brokerage firms need to decide on their own whether to chase riskier business or turn trading partners away.
The risk impulse really only kicks in after a disaster. To use the 2008 model, Bear Stearns needs to implode before regulators get interested, and by that point Lehman Brothers is already approaching a terminal stage.
The market knows you can get too big to fail. The Fed and the Treasury are not going to let another Lehman Brothers happen if they can possibly avoid it.
With that in mind, there’s little reason for the banks to regulate their own lending patterns. They’d might as well chase commissions while they can, relatively secure in the knowledge that “regulators” will pick them up if they fall down.
We’re a long way from “moral hazard” now. Yellen and company will talk a good game but that talk is unlikely to have teeth behind it.
She’s a dove shaped by the 2008 crash. Her world is built around supporting the financial sector and not negative reinforcement. She’d rather make it easy than make it difficult.
Sure, market makers would appreciate a clearer and more holistic view of their customers’ overall risk . . . not just the positions on their books, but full 360-degree transparency.
But that’s on them. If they want to get together and share information, they can do it. Or if that’s too close to active cooperation, fund something like the credit reporting agencies.
Account aggregation works both ways, after all. The institutions that push customer data out can also pull it in from each other.
Talk of regulation aside, it’s up to them to use that power. I think they’ll do it.
Survival of the Fittest
It’s going to get harder for upstart firms to follow in Bill Hwang’s footsteps. That’s okay. When you’re a family office, you want longevity above all else.
That’s how we know these aren’t the smart guys. A real family office wouldn’t feel the urge to double down on high-impact bets.
They’re in wealth preservation mode. Keep enough cash flowing to fund the lifestyle and the office itself. Stay ahead of inflation and taxes.
Hwang kept trading like he was trying to build a fortune. No return without risk.
If your clients are in that mode, it’s time to remind them what hedge funds are really all about: hedging risk in pursuit of a smoother glide.
That’s where you add value. If you don't want to be the hare living fast and dying young, you can be the tortoise.