Tuesday, September 26, 2006

Amaranth: Was It The Market?

That Amaranth had a losing position is [now] a USD $6billion undeniable fact. But the nagging question that I have about this trade-gone-bad is: (a) did the position itself sink Amaranth", (b) did the market sink Amaranth or (c) did some more nefarious interplay of causes sink Amaranth?

The common perception is that it was (a) "the position", which means the size of its bet, and the severe wrongness of the bet was responsible. This ascribes the disaster essentially to bad luck and poor risk-management and oversight. An elephant skating on thin ice, so to speak, that broke. To the young (after all, he IS rather green) Mr Hunter's defense, he didn't expect such a large move in such a compressed period. And he had been blessed with remarkable luck and prescience before so he (and his boss) might be foregiven for a lapse whereby they extrapolated Mr Hunter's (and by extension Amaranth's) luck into skill.

But I have been around the block a few times, and things are rarely what they seem. I am not ruling it out, but "the market" is rarely as big an anonymous as lore and certainly financial hacks purport. "The market" is, after all, the sum of participants, and though the mythology of capitalism would be furthered by widepsread belief that prices are set in pure competition by thousands of small anonymous ineffectual hedgers and speculators, reality very often differs. For the inconvenient truth (to borrow Mr Gore's pleasant turn of phrase) IS that some players are huge and alone can set or at least [temporarily] have great impact upon the marginal price. And all-too-often, large investors DO collude thus acting in concert. Yes it's prohibited, but when has that ever stopped anyone from trying to squeeze a profit? And it is none-too-easy for authorities to prove it in fact. And there are other feedback mechanisms such CTA trend-following strategies that have the same de facto collusive effect, even if the particpants never speak.

Where I am going with this? Metalgesellschaft's oil plunge, Sumitomo-Hamanaka's "little" copper problem, as well as Codelco's Juan-Pablo Davila's copper cock-up were all examples where feedback mechanisms whether overtly revealed, parsed from price-action, or driven by plausible rumour, innuendo, or margin calls, are rather different from the over-sized wrong-footed bet where the market random goes against. In all these, and potentially Amaranth's case, the market is hunting. They smell blood, and may not know why or what is precisely causing the move but as it moves, "they" (the market-as-hunter-killer) increase positions and press, thereby shaking the proverbial tree to see what falls. In Amaranth's case, there was information available to the market as it was common knowledge to the Energy cognoscenti that they'd bought MotherRock's book. And LTCM's [rightly} resident paranoic Lawrence Hillenbrand will tell you that unles you're Exxon that is the beginning of the end...

To my suspicious mind, this is getting warmer to the truth. And it somewhat shifts the "blame" from "stupidly unlucky" to "unluckily stupid", since getting caught out as such reveals hubris, overconfidence, and a feeling that one is smarter than "the market". All cardinal market sins and Bad! Bad! Bad!

But there is third possibility that is understandably NOT discussed in the mainstream media, but surprisingly is not discussed in the trade press either. And this is the possibility that their clumsy and quasi-public long Natty position was the subject of predatory trading by those with material non-public information about the Fund and it's positions. You see, Securities firms and Mega-Banks are required to have what are called Chinese walls, ostensibly to reflect the scale and impermeability of the Great Wall of China. But this is a rather poor analogy. "Shoji Partition" might be better. Or perhaps, "A Blood-brain barrier", or even "Placenta-like Separations". These are more accurate because information can and does flow to "those who require it" in the firm, i.e. risk-management personnel, Executive Committee members, CEO, CEO staff. Irrespective of what these firms might advertise, whe information flows, nothing is secure - certainly not as secure as one with an oversized-Natty position and already high-leverage would require to feel safe and secure (at least where I sit).

Roger Lowenstein's account, When Genius Failed reconstructed the scenario pretty well. Essentially, if you're very leveraged, once someone sees your positions, you're a target. Hillenbrand was seemingly the only one who really understood this risk. He made sure they used multiple Prime Brokers, swapped positions between leverage providers to insure no one saw the full extent of their leverage or their positions. If one cannot be certain as to whether one has an offsetting position at another shop, the risk-reward equation for "gunning" is greatly reduced. After LTCM started to take a hit, and needed either new capital or bigger lines, anyone who might supply the credit that was needed also needed to see "the position". All the Positions. He fought it, but there was recourse, and that was the precise point at which Hillenbrand knew they were dead.

LTCM accused many of the people of trading against them once they saw their positions, Goldman Sachs being singled out, in particular. But AIG, Citigroup, Berkshire, all had seen the enitre book. But everyone had lines with LTCM, so even for those who didn't see the whole book, and even they didn't know whether there was a hedge on the other side, they knew what THEIR risk was, or rather what as a lender to LTCM, they would soon be owning as principal in the event LTCM missed their call, or violated the fine print. As a creditor, a firm knew precisely what to sell and its childish to think they didn't take measures to protect themselves directly by "hedging" their risk (i.e. selling some or all of the position out directly in anticipation) or that opportunists managing the various trading desks didn't understand "the wink & the nod" that this client was now "shark bait", or that the sales manager on the bond desk couldn't resist helping another large client who would still be a client AFTER the mess was mopped up, make a little money.

But there was another incident a couple of years ago called "Eifuku" (amusingly pronounced "I F*ck You"), in which a Japanese hedge fund priming with Goldman Sachs took on entirely too-much leverage, and ploughed it into rather stupid concentrated positions. And in the span of a few short days, "the market" moved against them, and lo and behold, Goldman "owned" the position. The proprietor screamed "foul play", and sent a letter to his investors that all his positions mysteriously moved against him at the same time, causing margin call after consecutive margin call until POP!! Rumours circulated later that they had been "gunned" by Goldman. And Admittedly, this is suspect since it would make very bad business sense to risk a franchise for a little trading profit. But the world is small. And there ARE other plausible, though unproven, possibilities. For example, the head of a large London hedge fund might have worked at Goldman, and still had private friends there, and might have even been a big client of theirs. Perhaps Mr "Eifuku" had an oversized ego and inflated opinion of himself, was a Cowboy, and a potential liability to the white-shoes. Coveted position information thus passed could have seen such a client and fund trade against the position. Given the leverage, it would only take a couple days to torpedo it. Goldman would then "own the inventory" and would presumably sell the offsetting position to the client hedge fund locking in a lovely profit, and solving the problem of a loose cannon. Not to mention that the now-enriched client, with boosted returns, would gather more assets, thus completing a virtuous circle. "Boat drinks!!" Of course all the foregoing is pure and unsubstantiated conjecture, and by way of disclosure, is meant to entertain a plausible alternative explanation for very real events.

Which brings us to what really happened to Amaranth. We know they had a big energy position that was compromised from the get-go because others bid for it, so they knew marfin calls were being made. We know that they had reasonably high leverage across the fund (and I don't care what anyone says or what comparisons they make to LTCM, it WAS high). We know Citadel is very active in the energy markets and has boatloads of capital, and probably "saw" the MotherRock position. Having missed it, and seen the market tail south, did THEY "gun" it? Did their Prime Brokers "see" the position and decide it was scarily big and thus sell some Natty to hedge their credit risk, thus creating larger margin calls? Did the IB prop desks (through their Prime's) "get wind" of the position, see the margin calls, and give it a friendly "push"? Did the CTA Trend followers acclerate the trend through their "informationless" feedback loop? Maybe all? Maybe none. But be assured that there is an objective reality out there and the NYMEX Natty "time and sales" audit trail that flows back to the ultimate traders will reveal a story. How nefarious that story ultimately is will have to wait for a determined investigative pit-bull. I wonder to what extent "plausible deniability" is being manufactured as you read this?


Anonymous said...

its about time someone hit the nail on the head...has anyone looked at the last 2 hours or so of trading on expiration day for the sept. contract where nat gas moved 72+ cents in under and hour?

Anonymous said...

The time and sales exists. And its easy for authorities to track back and evaluate whether the traders were manipulating the market, i.,e. it was an impact trade or a bona-fide delta-hedge. Of course IF one was to "do it right" the impact trade and the options position would be held by completely different entities not traceable back to a single owner or participants colluding. I think equity investors in Amaranth would have to sue for market surveillance to dig and/or release data to motivated and experienced financial forensic experts to see if it was an accidental market fluke of something more nefarious.

Admin said...

read this (well, at least the first bit)and thought of you...

Arnold's hedge fund thrives as Amaranth falls