Tim Geithner Should Be Sleeping Easier These DSays

Just after New York Fed President Tim Geithner gives a speech about systemic risk and hedge funds, Amaranth blows up following a trading strategy that either had no method at all to it or was a failed attempt to corner next spring's natural gas market.

Yet there is not a sign of disturbance to the markets. Amaranth's investors have lost what is now said to be $6 billion. Some other people have the $6 billion--if they can, in turn, unwind their positions. But the system cruises on with no worries about liquidity or solvency and no changes in risk premiums.

Reassuring, I think.

Comments

[anne]

Agreed; I am pleasingly surprised at the resistance to economic shocks, whether demand based or financial, we have seemingly been showing along with other developed economies. Now, if we can get by the slowing in housing the Federal Reserve will surely have reason to be pleased, and with long term Treasury interest rates below 4.6% we just may.

[anne]

http://flagship2.vanguard.com/VGApp/hnw/FundsByName

Vanguard Fund Returns
12/31/05 to 9/25/06

S&P Index is 7.6
Large Cap Growth Index is 2.1
Large Cap Value Index is 12.5

Mid Cap Index is 5.1

Small Cap Index is 6.5
Small Cap Value Index is 10.0

Europe Index is 19.1
Pacific Index is 2.0
Emerging Markets Index is 8.7

Energy is 3.6
Health Care is 9.3
Precious Metals is 15.3
REIT Index is 23.4

Long Term Bond Index is 2.1
Intermediate Term Bond Index is 3.0

[brad setser]

oen question --

Amaranth's losses seem to be concentrated on a bet on the spread between one month's natural gas price and another, and in that particular corner of the market, it was the market.

What does that mean? My guess is that no one was there to take comparable losses. As it doubled down, Amaranth basically bought up all similar positions and let others exit. Hence, its losses had little collateral damage for other funds, since no one else was playing that corner, and thereby less contagion.

and obviously, Amaranth was able to get out of its other trades to meet margin calls without damaging those markets.

I would be a bit less sanguine if a trade that a lot of different funds were doing blew up -- though so far, some such trades have blown up (GM/ Ford and the correlation bets in may 05, EMs in may/ june 06), and no one has gotten absolutely killed a la amaranth. But there was contagion across emerging markets from position liquidation in may/ june in the early days -- only after a bit of time did the markets start to differentiate.

Then again, I probably worry way too much.

[STS]

Sure it's nice that we survived another blow-up. But the avalanches keep coming. Their size and impact is probably distributed somewhat like those of real avalanches (or at least those sand pile models we read about). Sooner or later the power law gods are really gonna let us have it -- right in the middle of a crowded trade.

But then, the same tactics which prevented the S&L crisis, or LTCM from doing widespread damage will probably work again. As long as the CBs of the world are united enough in the conviction that inflating a big fluffy credit cushion is the right strategy. (Suppress any stray doubts about moral hazard!)

[Barkley Rosser]

Um, maybe he is. Then again, maybe not. However, there is reason to believe that there is somewhat of a tradeoff between stability (measured let us say by variance of the distribution) and resilience (measured by leptokurtosis, those nasty "fat tail" outliers of extreme events the fin markets seem to possess). This is an old idea of Leijonhufvud and others.

A recent paper by Buz Brock, Cars Hommes, and Florian Wagener suggests that increasing the amount of derivatives is potentially destabilizing as people take longer and longer positions. Yes, the increase in credit derivatives during the first six months of this year from $19 trillion to $26 trillion presumably increases liquidity and efficiency and near term stability. But, these derivatives are all linked together. Remember how dicey the LTCM collapse was. The scale of what is out there and the opacity of the whole thing looks very unresilient. This may not be it right now, but there are a lot of commodity prices doing big drops right now, and housing is coming down, not to mention all that rising foreign debt that brad s. worries about.

Frankly, if I were Geithner, I would not be sleeping all that much more easily.

[STS]

... to say nothing of 'Rajan risk' which Brad S. brought up in his original post on Geithner's potential for insomnia:

http://www.rgemonitor.com/blog/roubini/119341/

[Bruce Webb]

"But then, the same tactics which prevented the S&L crisis, or LTCM from doing widespread damage will probably work again."

I hope that was sarcasm. Because those "tactics" were to have middle class income taxpayers bail out capitalists who somehow thought there should be no penalty built into the risk/reward ratio. You can bet Amaranth was not prepared to share had the position moved the other way.

I hope to hell I never hear another "free market" economic policy maker say some capitalist entity whose sole purpose is to make a dollar arbitraging risk is "Too Big to Fail".

[STS]

Bruce:

Yes partly sarcasm -- hence the final parenthetical about suppressing concerns about moral hazard -- but I also think the S&L crisis could have knocked over a lot of other parts of the economy were it not for the bail out. Seems the middle class gets it in the chin which ever way you slice it.

Of course the S&L bailout probably could have provided the same protection to the economy without making depositors whole over and above the $100K FDIC limit. That was a bit of a sweet deal for the ... shall we say ... "investor class".

[STS]

... and just to complete the thought ... the LTCM case was technically a bit of a "bail in" in the sense that the NY Fed pressured other big players to pony up some cash to keep the unwinding process orderly.

So: "You can bet Amaranth was not prepared to share" is true enough, but when the LTCM precedent is invoked there may be some degree of pain for the "players" as well as the taxpayers.

[christofay]

Complancency high, high, high, amongst some people on this blog. Part of it is technocratic love of central planning via central banking; it hasn't been until recently that Delong Semi-daily started writing up the Bush/Greenspan housing bubble as a worry. A couple of years ago it was wonder at the good Greenspan works of ultra-low interest rates. On the other hand it's good to see that more people are promoting the idea of rather than sock it to the middle class biomass to absorb the approaching shock have the prime beneficiaries bail in first and foremost. We need more of that, pay for your mistakes otherwise we get more Neil Bush.

Grant's Interest Rate Observer, Sept. 22, 2006, "'The Trouble with Serenity', Last week, Goldman Sachs borrowed $1.5 billion for 10 years at an interest cost of 5-3/4%. It paid just one percentage point more than the yield on the 10-year Treasury note.... Daily value-at-risk, a common measure of financial exposure, is up by 48% for the securties industry as a whole since 2001; for Goldman, it is up by 136% (and by 21% since only last summer, to $92 million from $76 million). Assets-to-equity, a basic marker of balance-sheet leverage, is up by 29% for the securities industry as a whole since 2001; for Goldman, it is up by 49%. At the latest reporting date, in May, Goldman showed $32 billion of equity to support $799 billion of assets." Many Greenspan dollars dancing on a pinhead of capital.

There's almost a yin-yang thing about volatility, when low, it will become high, when high, it will settle. Whatever control our nation and our Goldman/JPMoregain masters of the universe ever had, correlations will discorrelate. Paulson was not, I repeat, was not, in China this month promoting Goldman Sacks as the repo man of choice for the Chinese to get their hard-earned loans back from the U. S.

Rather than pay hundreds or thousands of dollars per taxpayer to pay for the clean-up, let's go spend $14.95 for "Fooled by Randomness."

[christofay]

Amaranth lost only $6 billion, why that isn't much money except to its investors. Grant's again, "Ford disclosed that its automotive operations in 2006 could lose $9 billion, an $8 billion disimprovement from 2005, the long dated Ford 7.45s hardly budged." See that $6 billion is not very much. Culture Czar Bennett if left to jerk off in peace at the one-armed bandits might have lost $6 billion by now.

From the same Grant's, "ACA Aquarius 2006-1 is the subject under discussion.... ACA Aquarius [named after the softdrink or the rock opera?] 2006-1 is a $2 billion, mezza-nine-structured, hybrid collateralized debt obligation, or CDO. What is a CDO? A CDO is a kind of bond, the collateral of which is debt. In the case at hand, the underlying, or reference, collateral is residential mortgage debt. What does it mean to call this contraption a 'hybrid?' It means that Aquarius holds not only mortgages, and structures packed with mortgages, but also options on mortgages."

Further from the Grant's, "'Big foot stomps index,' "'What is your best bid $2.3 billion notional of the triple-B minus tranche of the ABX.HE index?' a mortgage bear asked a devivatives broker last week. The bear was referring to an index of mortgage derivatives, specifically to an index of credit default swaps on a low-rated tranche of home-equity loans (actually, not to be pedantic, to securities backed by home-equity loans). The bear hit the proferred bid and the index fell hard.

"It dropped by a full pint, to 99.25 from 100.25, as the bear had apparently intended: $2.3 billion was four times the index's average daily trading volume. On Tuesday, the bid side of the market was quoted at 99.11. A falling index means that mortgage spreads are widening, a rising index that they are tightening.

"Mortgage spreads ought to widen, we believe. Maybe they have begun to."

[bartman]

Every dollar Amaranth "lost" was gained by the other party in their trades. No wealth was lost or destroyed. Except for the Amaranth investors, this is really a non-story. There is absolutely *nothing* in this tale that could cause "instabilty" or distress in the economy.

Why not write about the people who made the $6B over a span of 3 weeks?

[Alex]

I wonder if there might be another Amaranth-sized bet out there, on oil?

[Barkley Rosser]

I will agree with brad d. that probably Geithner is sleeping somewhat better, only to the extent that he was worrying (which he probably was very briefly) that the Amaranth blowout was the beginning of a much larger blowout. Clearly it was not.

But the bets that are out there are far larger than what was the case at the time of the LTCM crash. There are over $250 trillion in interest and exchange derivatives out there now, a total that was probably closer to two orders of magnitude lower at the time of the LTCM. It takes a lot of faith to say that all this is hedging itself in an efficient way. Frankly, Amaranth's $6 billion is small change compared to what could move very suddenly in a really nasty situation. Again, remember that what did in LTCM was an adverse move in the interest spread between Russian GKOs and Danish housing bonds.

[anne]

Barkley Rosser:

"There are over $250 trillion in interest and exchange derivatives out there now, a total that was probably closer to two orders of magnitude lower at the time of the LTCM."

Nonetheless there are real owned assets underlying the sum of derivatives, and asset owners are protected against derivative failures. So, the questions really are who owns dangerous derivatives and are these owners institutions whose failure could effect an economic system?

[Barkley Rosser]

"Asset owners are protected against derivatives failures." They are? Please explain.

[anne]

Berkshire Hathaway has several times entered the commodities market in recent years, but in each instance has bought and taken hold of and stored the commodity. Near term swings then in commodity prices due to derivative trading have almost no particular meaning for the commodity holder.

[anne]

The problems of Long Term Capital Management in August 1998, were obvious to traders in bond derivatives but were no problem for institutions or individuals holding bonds as such. The problems at Amaranth are significant for the hedge fund investors, but oil and gas company shares were little effected.

[Barkley Rosser]

anne,

LTCM's problems may have been "obvious," but there were a whole lot of major New York banks that were suddenly in very serious trouble when it blew. Those meetings that were held outside of any regular authority to make the banks not force mass liquidations are exactly why Geithner is not sleeping all that easily. Again, the scale of what might have to be dealt with is far greater than in 1998.