Annals of Financial Legerdemain: Natural Gas Futures and the Mystical Power Grain of the Aztecs

The Economist writes about hedge funds and others:

Economist.com: The industry is splitting in two--and investors are gambling on the expensive bit: IT HAS never been easier to pay less to invest. No fewer than 136 exchange-traded funds (ETFs) were launched in the first half of 2006, more than in the whole of 2005.

For those who believe in efficient markets, this represents a triumph. ETFs are quoted securities that track a particular index, for a fee that is normally just a fraction of a percentage point.... No longer must investors be at the mercy of error-prone and expensive fund managers.

But as fast as the assets of ETFs and index-tracking mutual funds are growing, another section of the industry seems to be flourishing even faster.... "[A]lternative asset investment" (ranging from hedge funds through private equity to property) grew by around 20% in 2005, to $1.26 trillion. Investors who take this route pay much higher fees in the hope of better performance. One of the fastest-growing assets, funds of hedge funds, charge some of the highest fees of all....

If the fee paid to the fund manager increases, the return achieved by the average investor must decline. After fees, hedge-fund returns this year have been feeble. From January 1st through to August 31st, the average hedge fund returned just 4.2%, according to Merrill Lynch, less than the S&P 500 index's 5.8% total return.

So why are people paying up?... That such fees endure might suggest investors can identify outperforming fund managers in advance. However, studies suggest this is extremely hard.... [E]ven where you can spot talent, much of the extra performance may be siphoned off into higher fees.... And yet investors may be willing to gamble, despite the higher fees, because they desperately need high returns.... Peter Harrison, chief executive of MPC, a fund manager, says that American pension funds have analysed their liabilities. "They need more than 6% to make up the shortfalls in their funds. Whether they earn alpha or not, they have to roll the dice and try to get it."...

[I]nvestors will probably keep pursuing alpha, even though the cheaper alternatives of ETFs and tracker funds are available. Craig Baker of Watson Wyatt, says that, although above-market returns may not be available to all, clients who can identify them have a "first mover" advantage. As long as that belief exists, managers can charge high fees.

And its writing is followed by the near-implosion of Amaranth. Which raises the threshold question, "Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?"

A Hedge Fund%'s Loss Rattles Nerves - New York Times: By GRETCHEN MORGENSON and JENNY ANDERSON: Amaranth Advisors, based in Greenwich, Conn., made an estimated $1 billion on rising energy prices last year. Yesterday, the fund told its investors that it had lost more than $3 billion [i.e., 30%] in the recent downturn in natural gas and that it was working with its lenders and selling its holdings "to protect our investors." Amaranth's investors include pension funds, endowments and large financial firms like banks, insurance companies and brokerage firms. The Institutional Fund of Hedge Funds at Morgan Stanley was an investor in Amaranth; as of June 30, it had a stake valued at $124 million....

[L]ast week, Charles H. Winkler, chief operating officer at Amaranth, had met with prospective investors at the Four Seasons restaurant in Manhattan and reported that his fund was up 25 percent [$2.5 billion] for the year, according to a meeting participant. Days later, rumors began circulating that Amaranth was losing money in one of its natural gas bets, a trade that had generated enormous profits for the fund in recent years. Late in the week, the fund's traders began dumping large stakes in convertible bonds and high-yield corporate debt, securities that could be sold without disrupting the market.

Mr. Winkler did not return a phone call seeking comment.

The scale of Amaranth's losses -- and how quickly they appear to have mounted -- was the talk of Wall Street yesterday.... Amaranth's woes are largely the result of a decline in [futures] natural gas prices that began [sic; should be "begins"] in December [2006], well before the spring months of March or April [2007] when they typically fall off. Amaranth's biggest stake was a combination bet on the spread between natural gas futures prices for March 2007 and those for April 2007. Amaranth had often bet that the spread on that so-called shoulder month -- when natural gas inventories stop being drawn down and begin to rise -- would increase.

But instead the spread collapsed. In the last six weeks, for example, the spread between the two futures contracts ranged from $2.50 at the end of July to around 75 cents yesterday....

The natural gas market is exceptionally volatile, making it an ideal playground for hedge funds that thrive on wide price movements in securities. Natural gas prices are subject to more severe swings than oil, in part because gas cannot be stored easily....

Amaranth was founded six years ago by Nicholas M. Maounis, a former portfolio manager who had specialized in debt securities at Paloma Partners, another large hedge fund.... In his letter to investors, Mr. Maounis, 43, wrote: "In an effort to preserve investor capital, we have taken a number of steps, including aggressively reducing our natural gas exposure."

Amaranth has additional offices in Houston, London, Singapore and Toronto and employs 115 traders.... Its energy portfolio has been overseen by Brian Hunter, a trader who joined the fund from Deutsche Bank in 2004 and conducts trades from his hometown of Calgary, Alberta. Mr. Hunter made enough money at Amaranth in 2005, an estimated $75 million to $100 million, to place him among the 30 most highly paid traders in Trader Monthly magazine....

Last week, in a speech in Hong Kong, the president of the Federal Reserve Bank of New York, Timothy F. Geithner, said greater attention needed to be paid to the margin requirements and risk controls in dealings with hedge funds...

The Fund of Hedge Funds at Morgan Stanley presumably sent a dozen people to do due diligence at Amaranth before it invested its bit of a billion in Amaranth. It's unclear what more Tim Geithner and his people could do. And Amaranth's problems are not related to exposure to systemic or systematic risk.

What did go wrong with Amaranth? If the numbers reported are correct, Amaranth lost $5 billion in less than two weeks.

Natural gas is traded in contracts of 10 billion BTUs--the rough equivalent in energy of 1700 barrels of oil. (One BTU is the amount of energy to raise 1 pound of water 1 degree fahrenheit.) Natural gas is priced in dollars-and-cents per million BTUs. So Morgenson and Anderson's fall in the spread from $2.50 to $0.75 is a reduction of $17,500 per contract. To lose five billion requires that you have been long 290,000 March and short 290,000 April contracts as the gap closed--a notional principal amount equivalent on each side to three days' worth of the world's total energy consumption or a month's worth of global natural gas consumption.

My suspicion is that there was a "valuation issue." That Amaranth was such a big player in this market that the current spread was simply what Amaranth had made its last trades it. And so if its traders wanted to make it look good on any particular day, all they had to do was buy a little more March gas at a higher price and sell a little more April gas at a lower price, mark their total positions to the market in which they are price setters--and voila! Big profits!

Whether the people doing this knew what they were doing--and whether their bosses knew what they were doing--and whether this is what they were doing--these are all open questions.'

But Nicholas Leeson's $1 billion loss betting on NIKKEI derivatives has now been eclipsed.

Comments

[Ginger Yellow]

Stupid question time: everyone bangs on about the dangers of systemic risk from hedge funds, yet regulators seem unwilling or unable to do much about hedge fund transparency. So why don't they just make regulated institutions deduct hedge fund investments from capital? If you want to take a gamble, pay for it.

[wcw]

A bad bet is a bad bet. There's no way I would have bet on the March/April NG spread, but then I didn't take home $100m last year, either. The trader who did has guaranteed his kids die rich. I can't fault him.

Cf http://www.rgemonitor.com/blog/economonitor/147346

[Everett Dirksen]

A billion here, a billion there, and pretty soon you're talking real money...

[Sunlight]

As a full-time trader of 13 years: natural gas happens to be one of the most extremely difficult and volitile commodities to trade. As far as I'm concerned even the biggest speculative accounts should swear the thing off... or trade it in very small size, for kicks. The only people who should touch gas futures, are "commercial" players who have physical gas (or future needs of physical gas) to hedge. Period. If Morgan Stanley's people saw large gas bets and approved this fund they need to be fired, pronto.

[anne]

Brad DeLong:

"The Fund of Hedge Funds at Morgan Stanley presumably sent a dozen people to do due diligence at Amaranth before it invested its bit of a billion in Amaranth."

Sunlight:

"If Morgan Stanley's people saw large gas bets and approved this fund they need to be fired, pronto."

[anne]

"If the fee paid to the fund manager increases, the return achieved by the average investor must decline. After fees, hedge-fund returns this year have been feeble. From January 1st through to August 31st, the average hedge fund returned just 4.2%, according to Merrill Lynch, less than the S&P 500 index's 5.8% total return."

There has been a broad and deep international bull market in stocks since October 2002, so money, lots of money, has been and should have been made since that time by hedge funds, but I have found no reason to believe after fees they have collectively beaten relevant indexes.

[David Lloyd-Jones]

One of the constants in the situation of very large traders is that they underestimate the degree to which other people are aware that they are there. They boast that they are kings of the jungle, and are somehow ignorant of the fact that lions smell and elephants make a lot of noise.

I speak with some knowledge of this world, since the president of my Japanese company is a very bright man who is effectively banned from orthodox business over there because his ex-boss when he was a youngster managed to piss away $100 million in oil, a lot of money back in the late sixties, while seconded to a trading firm's inadequately supervised Hong Kong branch. The ex-boss took all of his people down with him.

In the Sumitomo copper case -- I seem to remember that one as $5 billion, with a B, down the tube -- everybody in the trading world was chortling about Sumitomo's position. Yet the dolt at Sumitomo thought he was trading secretly on a magical insight of which only he was aware.

Nick Leeson, the very bright and extraordinarily hard working fool who took Barings, one of England's most venerable banks, down, was totally unaware that everybody in Hong Kong got together at night to exchange notes on the "Leeson overhang," the elephant in the room of what would happen to the market when he had to unwind his positions.

If he had been genuinely secret, and minuscule, in a perfect market then of course he could have unwound himself easly, and perhaps profitably. As a very unsecret King of the Jungle this was not a possibility -- though he was blithely unaware of this.

And so it goes.

These idiots preach the rationality of free markets, the inevitability of convergence on true prices, and are then surprised when they are ruined as a result of their having destroyed the possibility of any such markets existing in their particular niches.

[Tom Womack]

Are any of the ETFs traded on European, or ideally British, bourses? One of the last things I want in an emerging-market fund is 'now multiply your gains by the drop in the value of the dollar since you invested' ... isn't the whole point of these funds to be reasonably uncorrelated with the US economy?

[jerry]

Investments with some certain high risk profiles (that I will let you determine) should be called bets, and companies should be forced to categorize their investments in terms of investment grade investments and gambling investments.

That way the stockholder can better determine, how much of this companies profits is due to investing and how much is gambling.

[david]

First time I've heard Leeson called bright. Frank Portnoy has him as a back office rube, as do others. Bet they're wrong.

[Oberon]

Brad writes: "Which raises the threshold question, 'Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?'"

Might as well ask why my company borrowed $20 million from Cereberus Capital, aka the 3-headed monster hound that guards the gates of Hades.

[anne]

David Lloyd-Jones, agreed.

[christofay]

Here's a prediction, more of these blow-ups will come. And a question, what's gonna happen when JPMoregain blows? Can we get a claw-back on the bonuses paid to the top 5 execs and 100 "traders" who enjoyed the 7 fat years but, except for missing out on more boneness, don't suffer the 7 lean years?

[christofay]

Leeson's boneheadedness was apparent in H K and not to the Barings management in Singapore? No one in the ole boys club told one of their pals at Barings, 'watch out for that one, Leeson?' Read everything with a grain of salt.

What's needed before Goldman Sacks and JPMoregain give a push-off to the liferaft as we go over the Niagra, is some accountability to these banks, the last vestige of American socialism with their too-big-to-fail card. The top officials should have their personal finances at risk just as they did before the 1933 bank reform act, board members were 100% at risk for bank failure. If strick bankruptcy laws are needed for the middle and forgotten class, let's have some accountability for our doled out upper class welfare. Accountability for more than the bonus pool would quicly cut out a lot of this trading.

[christofay]

There are Masters of the Universe and cartoon characters.

"Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?"

Well, the masters of the Universe have their power lunches, secret decoder proprietary trading desks, the plague of infallibility MBA from HBS, and the power grain, why wouldn't some well-off dupe invest with them?

Remembering the commie Burt Ives Snowman in Rudolph the Red Nose Reindeer singing "SLV and GLD, SLV and GLD", I'll go with the cartoon's advice.

[Anthony Damiani]

"Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?"

While it was sacred to the Aztecs, it's also very slow to wither, and has long had mythic and poetic connotations with immortality. The name literally means 'unwithering'. Not a terrible name for an investment fund.

Um Not terribly accurate HERE, but nevertheless...

[Jon Fernquest]

'Fooled by Randomness' Nicholas Taleb's literary catalog of cognitive distortions in financial markets will never convince
true believers of their own mortality.

Market liquidity from speculation in small quantities, sure, but government insured betting of whole fractional shares of economies?

Economic heroes of high finance, until their LTCM moral hazard planes, go careening into the twin towers of the American economy.

Why does this seem to be only an American problem? Why doesn't this happen in other wealthy economies like Japan, Europe, Saudi Arabia?

[dsquared]

[First time I've heard Leeson called bright. Frank Portnoy has him as a back office rube, as do others]

He was bright. He was a back office guy, but not a rube, and he had several years of genuinely excellent performance behind him; he'd built Baring Futures Singapore from the ground up into one of the biggest traders on SIMEX, which I would like to see Frank Portnoy achieve. This is pure snobbery toward the back office.

OTOH, I think Brad might want to be careful here; at present I don't think anyone's claiming that Brian Hunter was a rogue trader though I daresay that the lawsuits of various sorts will start to fly soon.

[monboddo]

Brad--I think you are making one major mistake here, which is assuming that anyone has been doing significant due diligence on most hedge funds. The WSJ reported that several funds of funds wouldn't invest in Amaranth because of its secrecy (and you think the other big players are different?), while Bayou Management, which by the end was a flat-out sham, was given a clean bill of health by Hennessee. This may be changing very slowly, as the major rating agencies begin examining some funds, but for now I would not assume that JPM or anyone else has been scrutinizing funds like they should.

[A. Zarkov]

"Why in the Holy Name of the One Who Is would anybody invest in a fund named after the mystical power grain of the Aztecs?"

That’s exactly why they would invest in such a fund.

[A. Zarkov]

How could Nick Leeson know that the Kobe earthquake would take down Asian markets? Besides Barings was asking for it when they allowed Leeson to assume the roles of Chief Trader and the one responsible for settling the trades. Moreover had they purchased a $50,000 software package, they could have avoided the debacle. A fool and his money are soon parted.

[Ginger Yellow]

"Why does this seem to be only an American problem? Why doesn't this happen in other wealthy economies like Japan, Europe, Saudi Arabia?"

It does. The Economist wrote a big feature a while ago accusing Deutsche Bank of being a glorified hedge fund because of its extensive proprietary trading activies: http://www.economist.com/printedition/PrinterFriendly.cfm?Story_ID=3128013

[kharris]

There are similarities between the famous episodes of trading disasters, but differences as well. Natural gas is not part of bank capital. The LTCM problem drew the attention of the Fed in part because it involved systemic risk in the Treasury market, so to bank capital. Barings, as a bank, was part of an intricate web of payments between banks, and so also represented a risk to the banking system. The Hunt brothers I'm not so sure about, but I suspect in their day, silver was far more important to the financial system, and the financial system from which the Hunts borrowed was far less well girded against shocks than it is today, so that they also represented a substantial risk to the financial system.

Amaranth, despite its size and the size of its losses, is not in that league. That makes this a fortunate event, in that it might demonstrate to regulators that lenders are not performing and will not perform adequate due diligence. Regulators have turned down opportunities to rein in hedge funds. They need to rethink those decisions. Hedge fund investors, particularly those investing others' money, need to get over the romance of fighter-pilots and pirates and understand that they are buying a pig in a poke when they give money to hedge funds. Financial educators could help.

[crust]

Brad,

Your calculations look ballpark correct to me. However, there is one major problem. The peak open interest in NGK7 (i.e. April Natural Gas futures on Nymex) is only around 26,000 contracts, i.e. a factor of 10 less than your estimate of Amaranth's position. So there is something else going on. Perhaps they had over the counter positions or perhaps this much reported trade was only one piece (at most 10% or so) of the picture.

[anne]

http://krugman.page.nytimes.com/b/a/258010.htm

September 19, 2006

On Tracking Inequality
By Paul Krugman

Now that rising income inequality has become a big political issue, people are throwing around a lot of numbers. Some of these numbers are reliable, other aren't. But how are readers to tell the difference?

Well, one thing that might help is knowing where the standard sources are.

The first point of call is data from the Census. Census numbers are based on the Current Population Survey, a questionnaire filled out by a sample of Americans, then extrapolated to the nation as a whole. For historical comparisons, go to Historical Income Tables, http://www.census.gov/hhes/www/income/histinc/histinctb.html.

Data there are gathered under several categories: households (people living together), families (they have to be related), and individuals. (Formal definitions at http://www.census.gov/population/www/cps/cpsdef.html.) As of now, only the household data have been updated to 2005, which is why I recently turned to Table H-13 – Educational Attainment of Householder – to show that most Americans with a college education have lost ground in recent years. http://www.census.gov/hhes/www/income/histinc/h13.html. ...

There are other sources, too – which I'll explain when I use them. You see, I've decided to institute a new policy. On inequality, and in fact on many matters economic, it's all too common to have numbers – some from unknown sources – flying in all directions. The issues are hard enough without clarity about where numbers come from. So from now on I'm going to post sources for the numbers in each column on TimesSelect, with links where possible (it usually is.) Basically, this is the same thing I do when filing my columns; I always provide sources and links to my copy editors. But now I guess my explanations will have to be grammatical! Anyway, I hope that other economic commentators will follow the same practice, which is easy in this Internet age, and will save all of us a lot of confusion.

[anne]

Notice, then, that Paul Krugman's sources which were always readily available at

http://www.pkarchive.org/,

will now be routinely and immediately available at

http://krugman.page.nytimes.com/.

[mickslam]

There is almost no doubt that the risk managers at Amaranth did not know about this potential size of this trade.

This is essentially a case study into how market forces cannot always be successful in getting what they want. Greater transparency would have prevented this, however, there was essentially no way to force Amaranth to open its books for that transparency.

I am a CAIA charter holder and a CFA charterholder. I have a decent amount of training and experience in is hedge fund risk management, and in risk management of non-transparent entities. I was a futures and options trader as well.

Most large, successful funds are so secretive about positions and how they generate trading profits that there is no way to accurately determine if the fund is at greater risk than usual.

Additionally, even if every position was provided, the risk managment software required to accurately judge risk is expensive and difficult to get useful results from even for the most experienced people.

Even for pairs trades, a simple alphabetical position list would be largely incomprehensible to anyone without knowledge on how the strategy is constructed. For energy options like this, it would take someone with extensive energy futures options experience to realize the magnitude of the risk exposure before the fact.

They are saying that the leverage involved in the trade was 5:1, which for me seems quite low given the magnitude of the loss. Hey, I know its high in relation to normal leverage levels. At 5:1 you are looking at a $1B notional to support this trade. Thats a ton of capital to allocate to one trade. This is why I don't think anyone knew, even internally.

We can assume that the potential of a $5B loss wasn't transparent to the outsiders, or even known to the risk managers at the firm itself.

[David Lloyd-Jones]

Zarkov,

Leeson was aggressively buying Japanese longs *after* the Kobe Earthquake. The drop of prices caused by the 'quake made him think it was a good time to buy; it did not ruin his existing position. Further, he had lost several hundred million dollars during the previous calendar year.

In other words your facts are wrong, and your conclusion from them nonsense.

Christofay,

Everybody in Hong Kong knew about the Leeson overhang because many of them were busily selling him the contracts he was buying. The management in Singapore knew what was going on: Leeson *was* the relevant, i.e. trading, management. He simply lied to the stuffed shirts in the other office.

Between your notional "good ole boys" and floor traders, there is a great gulf fixed. The Establishment, of course, is to some extent made up of people who were formerly traders -- but successful ones.

Anne and dsquared,

A pleasure, and in Anne's case an honour, to read your posts.

-dlj.

[anne]

http://www.calvorn.com/gallery/photo.php?photo=3892&u=11601%7C4%7C...

American Goldfinch About to Leap from Perch
New York City--Central Park, The Ramble.

David Lloyd-Jones, same, for sure. These are important observations.

[im1dc]

Stimulating comments, imo.

One thing touched upon by two comments but not explored imo is that the NG Futures and options markets were and are not big/liquid or enough to allow Amanath's to enter and exit without taking the market in the same direction, e.g., the market could absorb the sale of 1, 10 or 100 size contracts/options but when contract size became 1000 and 10,000 one after another on the floor the trades could not be absorbed without massively affecting the price--against the seller, in this case Amanath.

Therefore, Amanath's tracks could not be disquised and once the commodities fundamentals, increased NG supply relative to decreased NG demand, went against his positions in his trades' timeframe he was caught with too big of a bet in too short of a time frame in a too thin (small/illiquid) market with too little money to hold it together for a turn in the market, to reverse his position or extend the trade out several months when winter would increase demand.

He made a bad bet.

And it was a bet. He was gambling pure and simple.

Makes me believe there is a lot more gambling going on out there in unregulated land.

[Ian Whitchurch]

I'm personally scared at how many of these are lurking on the oil side as well.

We have seen seriously wild swings in the oil market, and the question is how many hedge funds and similar got caught in big, wrong, leveraged bets.

Me, I think hedge funds need to be regulated for their own good, and a centralised register of standardised trades needs to be established. At the moment, it appears to be as regulated as Jonathon's cafe in the days of the Sword Blade Company.

And thats a bad thing for the functioning of a healthy capital and risk-management market.

Ian Whitchurch

[MikeD]

A couple of things:
1. commodities typically can be traded with 10% collateral, so a $1B notional position only requires $100m posted. Not such a huge amount if you are a star trader, so I am not clear that it should have attracted that much attention. In fact, given that he was trading this stuff regularly, I doubt he even had to wire his counterparty any cash at all. Between the other stuff held at his counterparty, he probably had more than enough collateral.
2. My understanding was that he was short ng6 (March) long ng7 (april). Whether it is that way or the other way long ng6, short ng7, he was not betting on gas prices, contrary to what one sees all over the press. He was betting on the spread, which is an entirely different animal. Spreads blew wide on 8/30 (-$2.18) from being ridiculously tight throughout July/August (as low as 2-3 cents), so perhaps that trade did make a bundle, but they didn't/couldn't close it out fast enough to capture the value, as the spreads receded back to about 75 cents within 2 weeks. Rumor has it that their brokers, Goldman Sachs, were trading the opposite of their book precisely to blow them up and make bundles on the trade. They have more capital to pull that off, and in a game of the first person to cry "uncle" they win. I think it is silly to blame it all on one trader/one fund. Things are always more complicated.

[Qhamer]

Its all one big house of cards people!! way too many variables all over the place to be considered. Software isnt capable of factoring it all in because the environement is simply too damn dynamic, constantly changing. Just the recent crash all over the markets because of China dipping was totally NOT justified, not to the extent we saw anyway. The winners, get LUCKIER than the losers, the variables simply happened to favor them..on that day. I think these types of incidences can be avoided if the leveraging capabilities are minizmized. If not, the Leesons, the Hunters..will always try to work the system to the detriment of others..