How lack of disclosures led to Archegos blowup

John Coffee, Adolf A. Berle professor of law at Columbia Law School, joins Yahoo Finance to discuss the Archegos hedge fund chaos.

Video Transcript

JULIE HYMAN: I want to ask first of all, about the rules governing swaps, which also seem to be at issue here. Because normally when a firm takes a position in a given company of 5%, they have to disclose 10% certainly, they have to disclose. If it's taken through swaps though, apparently they do not. Does something like that need to be changed? Is this an illustration of that?

JOHN COFFEE: Yes, among many things. I think the biggest hole in the system here is not swap reporting, but the fact that a family office could hold $30 billion in a concentrated limited number of securities and sell $30 billion in a day or two and never have made any disclosure about this. Family offices are exempt from the kinds of disclosures that other institutional investors have to make.

The premise was, they were small. Mr. Hwang and Archegos sold $30 billion in only a few stocks he held extremely concentrated, extremely leveraged [AUDIO OUT] swaps. And no one else really knew that. I'm not sure that his prime brokers knew what the other prime brokers knew. If they'd all seen how concentrated he was, they would have been much [INAUDIBLE]

Still, I have to say, this could have been another Long-Term Capital Management, but it wasn't. And that's a testimony that our financial system is stronger, the dams are a little higher and a little deeper and a little wider than they were back in 2008 or at the time of Long-Term capital. For those who don't remember it, Long-Term Capital nearly sank the financial system and required the Fed to bail out one defunct hedge fund, because otherwise, it could have sunk a number of banks.

We're somewhat stronger now, but we have this anomaly that things like family offices are simply not regulated. And when you're not regulated, you can grow up and take huge positions and take huge risk and sometimes you take huge risks, things explode. That happened.

BRIAN SOZZI: But John, do you think this is not an anomaly? There are other family offices out there managing just lots and lots of money, using leverage, trading in swaps. What type of regulation you think could and should come down to help avoid this happening again?

JOHN COFFEE: Remember, there are other family offices, famous names like George Soros, running family office. But you can't raise capital from investors if you're running a family office. He was able to do this on his own without having a significant number of investors. If you go over a few investors, you're going to have to register with the SEC. Hedge funds do have to register. And all institutions other than family offices have to disclose what their total holdings are if those holdings are sizable. And he just was off the radar screen until everything fell apart last Friday.

JULIE HYMAN: And professor, the reporting initially was that there might be some other funds that were following him. They've denied that they were in those trades as well. But when you're watching these situations, does it tend to be concentrated in one fund or do you find that there's sort of this as I mentioned earlier, groupthink or a crowding effect in some of these trades that then can exacerbate these situations?

JOHN COFFEE: I think you may get funds concentrating on one stock. They may all have seen ViacomCBS as a huge growth opportunity because it was shifting from old fashioned production over to streaming. And that did cause CBS stock to go way up this year. And I think people like Mr. Hwang and his firm were inflating the price. So they led the stocks up and they led the stocks down.

One other point that's getting missed in all of this, just to make it briefly, this was a very uncoordinated liquidation. The firm itself, when it realized it was insolvent, called together all its prime brokers to discuss an orderly liquidation. It didn't stay orderly for long. Goldman realized the size of the exposure it had and began selling everything on Friday morning. And Morgan Stanley followed.

The other banks didn't know or respond as quickly, and they're left holding the bag, because if Goldman and Morgan sell off all of CBS, Viacom and Discovery, that means the others are going to sell out at a much lower point on a very sharp slope. I think there could be some consideration given not only to the regulation of family offices, but to the need for better coordination in this kind of high stress liquidation. It became a race for the fire exits with Goldman and Morgan Stanley getting out first.

BRIAN SOZZI: And John, how would you regulate a family office?

JOHN COFFEE: Well, I think first of all, I'd want them disclosed. If they hold the position over X billion dollars, and this, you know, they sold $30 billion in just four or five stocks in just a day and a half [AUDIO OUT]. The size of your holdings should require some disclosure, because you are able to cause a major impact on the market. These stocks fell 50% in the case of Viacom and Discovery. That's almost unprecedented, a one-day 50% fall.

So this firm is big enough to impose externalities on others, and therefore, I think there has to be enough regulation so those who are playing with it know just what's going on. If they all knew that the stock, this company was invested almost exclusively in three other stocks, they'd have been much more worried, because they would know if there was trouble, their collateral was going to be exposed. You can't sell off a lot without the price going down by 40% or so.

BRIAN SOZZI: And John, do you believe this event erodes market confidence?

JOHN COFFEE: Oh, it's just one of several events. I mean, just a few weeks ago, we were dealing with GameStop and we found that retail investors could cause a wild swing. Here we see wild volatility caused by just one firm, which told its primary brokers that it was insolvent and said, how do you want to liquidate us? And instead, they got into a war.

But no one really knew just how exposed they were. If all of those prime brokers knew that this company basically had all its money and assets in several stocks, four or five, they would have been much more nervous and recognized the need for, or at least the dangers of one selling out first before the rest. They could have made a much more orderly and even liquidation.