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.

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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.

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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.

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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?

Comments

[Greg Battle]

Hey Roger, I agree with you, but wanted to add a little color to a few items.

Long response: Near the end, LTCM was over 100X levered (which is the only way anyone could turn tens of thousands of nickel and dime mispricing trades into 40+% returns many years in a row). I know I've said it on your blog before, but this is why so many prop guys fail when going over to hedge funds - what do they do when they no longer have the (nearly) endless cash or collateral to weather a margin call storm/100 year flood (that happens every few years..haha). When your capital is fixed, it's a classic cycle of having to sell your winners to cover the margin on your ever increasing losers. LTCM tried to mimic having the same "endless" supply of cash they had on the Solomon prop desk through an obscene amount of preferential margin treatment afforded them by banks who bought into the myth of their collective genius.

Though people discount it, I think hubris (the inability to separate skill from luck) was the single biggest reason why both AA and LTCM failed. We can have a separate discussion on the failings of risk management in general (inane models, backward looking scenarios, failures of randomness), but let's just discuss the power (or lack thereof) of risk management within any organization. Everything about AA and LTCM's undoing blows through all "conventional" risk management wisdom - stop loss discipline, management action triggers, position sizing, diversification/concentration risk, etc. I don't care what anybody says, but some risk management PhD making $500K/year to play Chicken Little ("the sky is falling!") is not going to challenge Mr. Hunter who made $600mm for the firm (and $75mm personally), the year before the blow up. It is our nature to admire and reward the guys who put points on the scoreboard.

Short response: Bad things befall those who let hubris trump discipline.

[Yaser Anwar]

Leverage is best assessed by its effects which can be observed in the possible amplification of market, funding liquidity and asset liquidity risks. Senior management, at both AA and LTCM, failed to highlight/and in general should highlight, possible concentrations of market and credit risk resulting from positive correlation among the firm’s own principal positions, counterparties’ positions with the firm and collateral received/posted.

Prime brokers, in general, have increased the depth and strength of the ongoing monitoring of their own risk and the risk posed by their large trading counterparties by utilizing an integrated framework for evaluating the linkages between leverage, liquidity and market risk (which I think is partly why we didn't see any ripple effects from AA calamity; but this was majority due to, as you pointed our sir, the difference in book values of AA and LTCM: some billions vs. 1.25 trn!).

If the fund’s risk managers had employed scenario analysis that evaluated the range of Natural Gas & Interest Rate Swap spread relationships in AA & LTCM's case, respectively, that occurred in the not-too-distant past, they would have realized the very high risk the funds' structural position-taking was in their magnitude/inappropriate for the size of their capital base(s).

[JB]

Why is it you gloss over the whole counterparty risk point the article makes? I'm by no means 100% in agreement with the FT author about the particular Amaranth/LTCM comparison- in fact, as I understand it, the vast majority amaranth's natural gas postions were otc swaps which is why the cftc didn't notice / couldn't do anything about it. But he makes a fair point about exchange traded products greatly reducing systemic risk through the use of a central clearing house. Maybe some of the LTCM crisis could have been avoided if exchange traded swap futures had been viable back then. There would not have been any specific counterparty bag-holders.

[Bill aka NO DooDahs!]

This is nitpicky, but I would combine bet size in relation to liquidity (properly defined as volume clearing in a market per unit time). Leverage just exacerbates the problem.

Another issue: I firmly believe that the type of bet was a problem, and that spread bets (interest rate, time spreads on commodities, etc) are inherently more risky than conventional wisdom would say they are.

Name a hedgie that actually blew up based on directional bets. Yeah, I know, Cramer's fund almost blew up b/c they were overweight small banks in a fund designed for day trading, and Syke's fund did the same based on a "loan" to a pink sheet stock, but name a BIG blowup based on direction bets ...