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October 4, 2007

Lessons from Amaranth and LTCM: Is it the Trading Venue or the Size of the Bet?

LTCM and Amaranth, two case studies for what can go wrong when risk management goes awry. Lots of other stuff, too, but poor risk management, mis-managed liquidity and lousy managerial oversight is pretty much the punch line for both. A few notable differences are the size of the bets made by each fund and the depth of the market when each went bust. But an Op-Ed piece in today’s Financial Times is making a different point, that somehow Amaranth was more easily absorbed by the markets because of the fact that it was trading listed instruments versus the heavily OTC book of LTCM. I won’t keep you in suspense - I think the writer, an academic, is completely wrong. I believe the three principal differences between LTCM and Amaranth are the sheer size of the bets placed (though both books suffered mightily from a lack of bids when word of their distress got out), the amount of leverage used and the much deeper pool of risk capital available eight years later when Amaranth went bust.

As I see it, I think The Professor fell into the trap of (mis)interpreting the facts to fit a theory. But hey, what do I know? Here are some excerpts from his missive in the FT:

In September 2006 Amaranth
Advisors, a US-based hedge fund specialising in trading energy futures,
lost roughly $6bn (£3bn) of the $9bn it was managing and was
liquidated. With the exception of its shareholders, most people watched
with detached amusement. Eight years earlier, reaction to the impending
collapse of Long-Term Capital Management was very different: people
were horrified and the financial community sprang into action. One big
difference is that Amaranth was engaged in trading natural gas futures
contracts on an organised exchange, while LTCM’s exposures were
concentrated in thousands of interest-rate swaps.



********************



The difference between futures and swaps is that futures are
standardised and exchange-traded through a clearing house. This
distinction explains why Amaranth’s failure provoked a yawn, while
LTCM’s triggered a crisis. It suggests that regulators, finance
ministries and central bankers should be pushing as many securities on
to clearing house-based exchanges as possible. This should be the
standard structure in financial markets.



A critical part of any
financial arrangement is the assurance that the two parties to it meet
their obligations. In organised exchanges, the clearing house insures
that both sides of the contract will perform as promised. Instead of a
bilateral arrangement, both buyers and sellers of a security make a
contract with the clearing house. Beyond reducing counterparty risk,
the clearing house has other functions. The most important are to
maintain margin requirements and “mark to market” gains and losses. To
reduce its risk, the clearing house requires parties to contracts to
maintain deposits whose size depends on the contracts. At the end of
each day, the clearing house posts gains and losses on each contract to
the parties involved: positions are marked to market.



********************



Returning to the comparison of Amaranth and LTCM, we can see why the
former did not provoke concerns of a systemic crisis. Amaranth was
required to hold margin to maintain its position in futures markets.
When it started to sustain losses, the clearing house forced the sale
of the positions into a liquid market; counterparties sat calmly,
knowing their interests were protected. By contrast, the swaps LTCM
held were with specific institutions. Since interest-rate swaps are not
exchange-traded, selling them was not feasible. The collapse of LTCM
would have led to defaults on the contracts and put other financial
firms at risk.



********************



The goal is to structure financial markets in a way that minimises
­system-wide risk. Yet we also need to remember that there are gains to
asset-backed securitisation. When the system works, it turns illiquid
bank loans into readily marketable securities. This should reduce the
overall riskiness of the financial system. Shifting these securities to
exchanges with clearing houses would help ensure that these benefits
materialise.

Oh boy, where to start? I’ll try not to be sarcastic, but it will be really, really hard. So, let’s say you have a leveraged position in a mid-cap stock and you own a lot of it. Or maybe you are short a small-cap name in size. According to Mr. Tweed Blazer with Leather Elbow Patches:

Beyond reducing counterparty risk,
the clearing house has other functions. The most important are to
maintain margin requirements and “mark to market” gains and losses. To
reduce its risk, the clearing house requires parties to contracts to
maintain deposits whose size depends on the contracts. At the end of
each day, the clearing house posts gains and losses on each contract to
the parties involved: positions are marked to market.

Both of the underlyings mentioned in my example trade on exchanges. But if you have a position and things go against you and you’ve got to get out (let’s say the market gaps and you’ve blown through your margin), you’re screwed if you sized your bet wrong and/or levered up. And it doesn’t make one bit of difference if it trades on an exchange or not. Just ask Brian Hunter. Sure, he was trading listed stuff, but once word got out of his troubles, all the bids dried up and he had to post more and more margin. Prime brokers hold margin, too. And they are mean. And they learned a thing or two from LTCM. So don’t tell me a “clearinghouse” or a fixed rule is materially better in a stress situation than a prime broker. Stress frequently doesn’t happen in a smooth, linear way. It often happens in bursts, which is precisely why the outcomes of hedging transactions diverge from the theoretical because of gapping and non-linear behavior. As positions move against you and you have to post more margin against futures contracts, prime brokers are making you do the same thing against OTC positions. So this clearinghouse-providing-better-protection-than-OTC-counterparties argument, in this context, is a big fat red herring as far as I’m concerned.

Ok, now let’s get down to brass tacks. Mr. Chips writes the following:

The difference between futures and swaps is that futures are
standardised and exchange-traded through a clearing house. This
distinction explains why Amaranth’s failure provoked a yawn, while
LTCM’s triggered a crisis.

Now that I’ve explained (at least to my satisfaction) why I don’t think the difference between exchange-traded vs. OTC positions are material in the meltdowns of LTCM and Amaranth, then why did the Whiz Kids cause so many problems while the Royal Canadian did not? Two reasons. No, actually, three:

  1. Bet size;


  2. Leverage; and


  3. Market depth.

Amaranth’s Mr. Hunter ran a nice little leveraged natural gas position totaling several billion loonies in notional value. Mere child’s play, however, when compared to our stable of Nobel laureates. Messrs. Meriwether, Scholes et al. were running a leveraged asset book of, oh, around $125 billion, with an OTC derivative notional of, say, $1.25 trillion. Yikes! And all of this piled on top of a measly $5 billion of capital. So, in the cases of both LTCM and Amaranth you’ve got mis-sized bets, too much leverage and inadequate market depth, even for those listed natural gas futures positions. But with LTCM both bet size and leverage were much, much greater, and the market was much shallower in terms of a single party stepping up and taking over the entire book. In the case of Amaranth you had multiple parties step up very, very rapidly, with Citadel getting the nod to step into Amaranth’s shoes to take over its hemorrhaging natural gas position for a song. It just sat there and rode out the storm, extracting hundreds of millions of dollars in profits by being a liquidity provider - in size - at a time of distress. Could Citadel have taken over the LTCM book back in 1998 all by itself? Doubtful. So the fact that Amaranth got in trouble with listed futures didn’t mean it avoided a fire sale - the sale of its dead book was a fire sale! So except for the fact that its loss was manageable relative to the depth of the market standing ready to pick up the scraps, the whole listed-vs.-OTC argument is a bunch of hooey.

The real moral of the story, IMHO, is that higher than normal instances of market distress and non-linear market price paths are, in fact, the norm. And this calls for a wholesale review of pricing, risk management and lending practices. Leverage and mis-sized bets are dangerous, and having instruments traded on an exchange doesn’t mitigate these risks. Good risk management and prudent borrowing/lending practices by both investors and prime brokers does. So let’s get on point, shall we? We all have the same goal in mind, reducing systemic risk and ensuring the efficient functioning of the capital markets, right?

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