Wednesday, September 20, 2006

Sharks in the Water

The partners began to sense that they might not make it. Their exquisitely wrought experiment in risk management, to say nothing of their fabulous profits, was in danger of unraveling.

—When Genius Failed, by Roger Lowenstein

According to natural-gas investors who traded alongside Amaranth, Mr. Hunter repeatedly used borrowed money to double-down on his bets

—Wall Street Journal. 9/20/06

The most memorable part of Roger Lowenstein’s excellent book on the Long Term Capital Management debacle (quoted above) was when LTCC’s founder, John Meriwether, called a retired, street-wise, market-savvy ex-Bear Stearns confidant for advice.

When he heard LTCC was down 50%, the old-timer didn't mince words. He told Meriwether: “You’re finished.”

What the old pro was telling the computer-driven “Genius” of the book title was that when the market smells blood in the water, it goes after whatever is bleeding and doesn’t let go.

Now, this week’s blow-up of Amaranth, a Greenwich Connecticut-based hedge fund which appears to have fallen victim to some wild and crazy natural gas trading, does not, as far as anybody knows, rival LTCC’s when it comes to potentially bringing down the system.

After all, LTCC had margined their positions into a nominal exposure close to a trillion dollars, compared to the multiple billions involved at Amaranth.

Nevertheless, the two situations are not entirely unrelated. As happened with LTCC, when word of a problem at a hedge fund hit the natural gas markets last week, those markets appear to have started going precisely the wrong way for the fund most exposed to those moves—Amaranth.

I have no idea how the situation will unwind, and I certainly hope there isn’t the kind of second and third-derivative damage in other markets of the type that caused LTCC’s demise to force an emergency session of the Federal Reserve. Those were very dark days.

But the lesson is obvious: for all the confidant talk about how derivatives off-load risk and therefore create a safer financial world, there is something to the notion that what we are building up here is the potential for a liquidity crisis that brings the system down.

Before you scoff at this, try to guess who told the Wall Street Journal the following less than three weeks ago:

“Spreads and options are of their very nature instruments for positions which are designed to allow the user to capture upside with a much clearer understanding with respect to downside exposure.”

Give up? It was the CEO of Amaranth.

Three weeks after that statement, reports the Journal, institutional investors in Amaranth are now trying to sell their interests in that hedge fund to a firm that provides secondary markets in such things. Says the market-maker:

“Sellers want 30 to 40 cents on the dollar, but buyers are only willing to pay 10 cents to 20 cents on the dollar.”

When sharks smell blood...

Jeff Matthews
I Am Not Making This Up

© 2006 Jeff Matthews

The content contained in this blog represents the opinions of Mr. Matthews. Mr. Matthews also acts as an advisor and clients advised by Mr. Matthews may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Matthews' recommendations. This commentary in no way constitutes a solicitation of business or investment advice. It is intended solely for the entertainment of the reader, and the author.


C. Maoxian said...

Actually Vinny told Meriwether "You're fucked." Did Lowenstein clean it up to "you're finished" for the book?

gvtucker said...

Speak to people in the oil and gas industry, and you'll find that they don't fully understand the financial side of hedging at all, even the guys that are doing the hedging.

Speak to people that are doing the trading of oil and gas futures and forwards at various sell side firms and hedge funds, and you'll find that they don't understand the oil and gas business at all.

Asymmetric information exists on both sides of the trade. It is destined not to end well. Amaranth is an indicator, not an aberration.

Sam S. Park said...

I guess they forgot to do that whole hedging thing. The pace that they lost money makes their strategy seem more like leveraged betting rather than hedge fund managing.

jaylive1005 said...

Funny, on CNBC this morning I swore I heard the banterers say that if one fundy heard another fundy was in trouble he would ask what he could do to help him out. And I am NOT making this up!!!! I think it was one of those guys from fast money. Which is entirely unwatchable.

RichL said...

There is nothing new under the sun. In the early 90's the problem was Tesobonos. Not everyone in hedgeland understands all of the positions that they own.