Hedge fund meltdown: Elizabeth Warren suggests regulators should’ve seen it coming

Senator Elizabeth Warren is calling out regulators after little-known hedge fund Archegos Capital Management was able to borrow so much money that its implosion last week sent shockwaves across Wall Street.

“Regulators need to rely on more than luck to fend off risks to the financial system,” Warren, a Democrat from Massachusetts, said in a statement to CNN Business. “We need transparency and strong oversight to ensure that the next hedge fund blowup doesn’t take the economy down with it.”

The stocks of ViacomCBS (VIACA) and other media companies crashed late last week after Wall Street banks that lent to Archegos forced the firm to unwind its risky bets in a massive fire sale. Archegos was bankrolled by some of the biggest banks in the world, including Goldman Sachs, Credit Suisse, Deutsche Bank (DB)and Wells Fargo.

Some of those banks are now facing sizable losses of their own from their ties to Archegos, which reportedly used derivatives to mask the size of its large investment positions.

The collapse of Archegos serves as yet another reminder of the dangers of extreme leverage and raises questions about how this firm was able to amass such risky positions, especially given its founder’s checkered past.

“Archegos’ meltdown had all the makings of a dangerous situation -— [a] largely unregulated hedge fund, opaque derivatives, trading in private dark pools, high leverage and a trader who wriggled out of the SEC’s enforcement,” Warren said in the statement.

In other words, regulators should have seen this coming.

Insider trading red flags
Archegos was founded by Bill Hwang, best known for an insider trading scandal at former hedge fund Tiger Asia Management. In 2012 Hwang pleaded guilty to wire fraud on behalf of his firm, which was sentenced to a year of probation and forced to forfeit $16 million. That same year, the Securities and Exchange Commission charged Hwang, Tiger Asia Management and Tiger Asia Partners with making nearly $17 million in illegal profits in a scheme involving Chinese bank stocks. He and his firms agreed to pay $44 million to settle those charges.

Goldman Sachs (GS) stopped doing business with Hwang for a period of time after that, a person familiar with the matter told CNN Business. However, Goldman Sachs later resumed a relationship with Hwang, serving as one of his firm’s lenders.

In a statement on Tuesday, a spokesperson for Archegos said this is a “challenging time” for the firm, its partners and employees. “All plans are being discussed as Mr. Hwang and the team determine the best path forward,” the spokesperson said.

Regulators are probing what went wrong in this high-profile meltdown.

In a statement on Monday, a spokesperson for the SEC said the agency has been “monitoring the situation and communicating with market participants since last week.”

Big banks count their losses
Meanwhile, the toll from the Archegos collapse continues to mount.

Japan’s Mitsubishi UFJ Securities (MBFJF) (MBFJF) said in a statement Tuesday that it was expecting a loss of about $300 million “in relation to a US client.” It did not name the client and a spokesperson declined to elaborate.

Wells Fargo (WFC), another prime broker to Archegos, said the bank did not experience losses after closing out its exposure to the firm. The statement came after Wells Fargo shares dropped 3% Monday on concerns about the damage.

Japan’s Nomura said Monday that its losses could be as much as $2 billion, attributing the hit to “transactions with a US client.” Asked for further detail, the company declined to comment to CNN Business.

Credit Suisse (CS) warned of a “significant” hit to earnings after a client defaulted on margin calls. A person familiar with the matter told CNN Business that the client was Archegos.

Regulatory loophole?
How was Archegos able to keep such a low profile for so long, despite its large presence in major stocks and ties to leading banks?

The answer may lie in the firm’s structure. Archegos operates as a family office, a private firm that exists to increase the wealth of high-net worth individuals. Unlike hedge funds, Archegos is not allowed to manage outside money.

The family office space is huge, with at least 10,000 single-family offices around the world, firms that manage more than private equity and venture capital combined, according to Ernst & Young.

Despite their influence, family offices face little oversight from regulators. That’s because while the 2010 Dodd-Frank law called for tighter regulation of hedge funds, it gave family offices a special carve-out.

Family offices are not required to file regular reports with the SEC detailing their vast positions and activities. While the SEC pages of hedge funds like Soros Capital Management and Bill Ackman’s Pershing Square include quarterly reports on their portfolios, Archegos’ page with the SEC, says little, except for a notice: “Archegos Capital Management, LP has not filed any forms with the SEC apart from initial company registration.”