How Did Bill Hwang and His Chief Financial Officer Deliberately Mislead Banks to Borrow Money?
The world of finance is marred by unethical practices, among which the deliberate misleading of financial statements and loan approvals has been a persistent issue. In the case of Bill Hwang, the cooking of financial books through the strategic use of total return swaps exemplifies how complex financial instruments can be utilized for fraudulent gains.
Understanding Total Return Swaps
Total return swaps are a type of financial derivative used to exchange payments based on the total return of an asset, including both price appreciation and dividends. Unlike stocks, they are not traded on exchanges and must be arranged through financial institutions or dealers. A key feature of these swaps is their notional value, which is used to calculate the size of payments without requiring the full amount to be held in margin.
Significance and Operation of Total Return Swaps
Instead of purchasing stocks outright, which requires substantial capital, an investor can enter into a total return swap agreement. Under such an agreement, Hwang would receive the returns from the underlying assets (Viacom, in this case) while paying a fixed or floating interest rate. This reduces the initial capital requirement and allows for significant leverage.
The swap's nature as a cash flow exchange on a hypothetical asset means that the notional value does not appear on the balance sheet, making it easier to hide the extent of leverage. This method creates an illusion of stronger financial health, as the financial statements do not reflect the full extent of the leveraged investments.
Detailed Explanation of Bill Hwang's Operations
Bill Hwang, who was the founder and CEO of Archegos Capital Management, strategically engaged in these swaps to create a highly leveraged position in various stocks, particularly Viacom. By signing total return swaps on Viacom, Hwang could enjoy the gains from the stock price appreciation without the need to hold a large amount of cash or equity.
When the stock price of Viacom moved, Hwang would receive a payment proportional to the notional value of the swap. However, the critical aspect of this operation is that the swaps were not reflected on the company's balance sheet, giving Hwang and his team a false appearance of financial stability. This deception extended to his interactions with banks, where he lied about the extent of his financial exposure to secure more loans and further leverage his position.
Exploiting the System
Hwang's strategy relied on the misrepresentation of his financial status to banks, which would then not fully recognize the scope of his leverage. Investment banks typically hedge the swaps with the underlying assets, such as Viacom shares. This hedge creates a stable environment, but when the stock price of Viacom began to fall, the banks faced a challenging situation.
The banks realized that Hwang had bet heavily on Viacom, and with the stock price dropping, they needed to make margin calls to prevent losses. However, the leverage Hwang had created was so extensive that he controlled a large portion of Viacom shares, causing a sell-off when the banks tried to sell them off to cover their positions. This was a trading storm that resulted in billions in losses for the banks and a financial collapse for Archegos.
Consequences and Lessons Learned
The intentional misrepresentation of financial exposure and the misuse of total return swaps by Bill Hwang and his team led to a cascade of events, including the bankruptcy of Archegos and significant financial losses for the banks involved. This case underscores the importance of accurate and transparent financial reporting and the risks associated with over-leverage.
Financial institutions need to be vigilant in their due diligence and internal audits to prevent similar fraudulent practices. Moreover, individual investors and financial professionals must understand the complexities of derivative instruments to avoid falling into fraudulent schemes.
The case of Bill Hwang serves as a stark reminder of the potential pitfalls of unethical financial practices and the critical role of transparency and honesty in preserving the integrity of the financial markets.