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
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
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?
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
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.
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.