Family Offices and Opaque Securities
Once again a blow-up in an opaque corner of the financial markets made news.
This time a family office, Archegos, lost $10 billion dollars after its bets using opaque, securities turned sour. The problem wasn’t just the money the family office lost, but several Too Big To Fail banks managed to lose almost $10 billion dollars themselves as they unwound these securities.
The securities used were total return swaps. The swaps allow the buyer of the swaps to bet on the economic performance of a company’s stock without having to buy the stock or disclose their position. Swaps involve an exchange of economic returns. In this case, the banks purchase the underlying stock. They received from the family office a fee plus interest to cover its cost of holding the stock plus cash should the value of the stock fall. The family office receives cash if the underlying stock increases in price. It pays the fee plus interest plus cash if the underlying stock decreases in price.
While fairly straightforward, the problem with swaps is their risk is hidden.
The risk analysis starts with “the family office is not able to meet its obligation under the swap agreement”. To minimize this risk, the bank requires the family office to put up collateral.
But what if the family office runs out of or won’t put up more collateral? The bank faces the potential for losses. It hopes it can sell the underlying stock at prices that are high enough so any losses are covered by the collateral in its possession. If it cannot, the bank loses money. $10 billion across the banks in this case.
The cap on each bank’s potential losses is the price the bank paid for the stock less the collateral. Of course, this is just for one total return swap. How large a portfolio of these swaps a bank has is unknown to the market.
This opacity to the market creates another risk. No bank knows what any other bank’s total return swap exposure is to the family office. As a result, when the family office no longer performs on the swap, the bank can be facing a fire sale as every other bank is trying to sell the same stock at the same time.
Of course, all these risks could be managed if the banks were required to disclose the swaps to the market. Each bank would then have the information necessary to manage it portfolio of total return swaps to what it can afford to lose. And more importantly, each bank would be subject to market discipline to limit its losses.