Amaranth Vs. LTCM

Amaranth, the natural gas trading hedge fund announced yesterday that it lost $5 billion in the last month, and pretty much all that was in the last week.  Funny enough, that's more than LTCM lost over four months.  So why isn't the market reacting the same way?  Here's a clue (from Wikipedia):

Because these differences in value were minute — especially for the convergence trades — the fund needed to take highly-leveraged positions in order to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.

As well as Amaranth had been doing, it's doubtful it had borrowed anywhere near $124.5 billion.

It may seem like hedge funds are risky, but these tales are actually a great reminder of what a great deal they are for their investors.  There's no way that an individual could get this much leverage on their own.  And if they did, they'd expose all of their personal wealth in the process.  Via the magic of a hedge fund, they get lots of upside, but only stand to lose their principal.

Question for retail bankers: would you be more inclined to give someone an enormous loan if they had a Nobel prize?

Comments

[Roger]

Yes, but there is a little more texture to the story. Traders across the fixed income landscape take massive leveraged spread bets all the time. This is their job and their area of expertise. The catalyst that triggered the LTCM meltdown, while leverage certainly played a significant role, was correlation. The brains at LTCM mistakenly thought that by spreading out their capital across 1000+ positions and, further, across geographies, that they had, in fact, hedged their book. As we all know by now the once-in-a-hundred year storm happens far more frequently than that, market returns are NOT normally distributed and Taleb drives this point home with analytical rigor in Fooled by Randomness. So, it was "death by a thousand cuts" in the case of LTCM.

But what of Amaranth? Quite simply, risk management gone awry. This was death by guillotine. It felt good to be up $2 billion by rolling the dice, why not press it and shoot for more? "Up $2, down $5, hey, what's a few billion among friends?" One massive, mis-sized and mis-managed position. I'm sorry, but multi-strategy funds are supposed to be exactly that - multi-strategy - in order to dampen volatility through diversification. This clearly was not the mind-set at Amaranth and now people (read: investors) are paying the price.

So I'm not sure whether the story is really about leverage or distinctly different break-downs in risk management practices. And the fact that, as of now, Amaranth is still in business. If something else comes out that forces additional margin calls, well then, the story might begin to sound a lot more LTCM-like.

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