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Counterparty Credit Risk: Amaranth Aftermath
October 4, 2006

Counterparty Credit Risk: Amaranth Aftermath

Our latest Basel II by the Numbers survey for Q2 2006 will be available for sale on the IRA web site starting tomorrow. As we noted last week, our Economic Capital simulation using financial statement data from the Federal Deposit Insurance Corp suggests that money center banks such as JP Morgan (NYSE:JPM) and Citigroup (NYSE:C) should have several times more capital than currently required by federal regulators to cover growing risks from the trading book.

Indeed, for us the Amaranth episode illustrates the fact that�the�major dealers do not adequately understand the risks being taken with their capital, both for their own account and indirectly via customer risk.� Whatever rationale was behind the Amaranth trading strategy in natural gas created a situation which the market could not sustain, but which the credit markets have nonetheless assimilated

One estimate places the economic cost of the margin on the Amaranth natural gas trades at over $1.5 billion, a vast figure for a single counterparty.� It has�been suggested by some observers,�for example, that JPM took a substantial hit while meeting margin�calls as Amaranth's futures clearing�broker.� However, we are told by sources close to the matter that not only did Amaranth make all of its margin calls, but that JPM emerged unscathed, and that the money center bank and Citadel expect to make out quite handsomely�with the energy portfolio they purchased from the crippled fund.�

Call it a near miss for JPM and Amaranth's other derivatives dealers.� The same cannot be said for the�fund investors, individuals and institutions.� And, next time around,�will the OTC derivatives dealer community be lucky enough to again�make a profit as they�triage another hedge fund client?

The growing counterparty risk emanating from the trading books of some of the largest banks and broker dealers, and their prime brokerage customers, is cause for national concern. In the space of just 6 months, the hedge fund formerly known as Amaranth went from apparent double digit profitability to failure and disgrace. The largest ever financial failure involving a hedge fund caused $6 billion in losses or more than 50 cents on the dollar to�investors.

We hear some market participants patting themselves on the back and saying that while investors in hedge funds are facing tremendous risks, the dealer banks are going to be alright.� But this view misses the fact that the derivative trades used by high risk hedge funds like Amaranth are adding risk to the financial system and create the possibility for truly horrendous systemic events down the road.� Indeed, were it not for the existence of the OTC market in energy derivatives, a cash settlement market with no connection to the physical�energy market save pricing, Amaranth could never have accumulated such a large position and lost so much of its clients' money.�

What are some of the preliminary lessons to be taken from the Amaranth fiasco?

The first thing which comes to mind is that using VaR model to price energy market risk is probably a bad idea. Not only are VaR models useless for assessing credit obligor default risk, but using them to understand the financial risk of a spread trade in a physical commodity is like driving really fast at night with you headlights turned off. Dealers who accept VaR models and Monte Carlo simulations for assessing the loss probability of a prop or�client portfolio deserve all the problems such methods must inevitably create.

Second is that the combination of plentiful liquidity, OTC derivatives and inexperience in an area like energy (aka a "multi-strategy" investing) is a truly noxious combination.� It�was suggested by one risk management veteran that the losses caused by the spread trade run by Amaranth may have been influenced by the sheer weight of speculative long positions pushing prices in natural gas futures to even more extreme levels last year.� That is, follow the herd.

When the spread between certain gas future contracts peaked at an all time wide and specs started liquidating positions, it is hypothesized, the bull side of the Amaranth energy trade collapsed, but the short leg moved not at all. Why? Because of the particular features of the physical market for natural gas, something only a seasoned specialist in this peculiar market would understand.

We have said it before and we'll say it again: the fact that Wall Street and federal bank regulators are willing to accept failed statistical models for measuring and managing real financial risk�means that events like Amaranth must become commonplace. VaR models and other statistical tools regularly used to justify trading strategies like those apparently employed by Amaranth do not begin to capture the true "tail risk" of such transactions.

The only way for dealers in OTC derivatives to manage counterparty risk is to get sufficient data from clients to understand the economic fundamentals of the transactions being executed and the real world financial risk being taken. Once this type of analysis is performed and the data is assessed using automated and human intelligence, perhaps then some of the larger dealer banks will realize that not all hedge funds are necessarily good clients -- or�good investments.

Questions? Comments? [email protected]

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