Amaranth: Was it failure of risk management or a failure caused by risk management?

In September the US Hedge fund Amaranth collapsed losing $6.5 billion dollars over a couple of weeks when its positions in natural gas futures turned bad. With prices falling, Amaranth was unable to off load its position and the losses continued to mount.

While it didn’t cause the sort of near disaster that the LTCM collapse triggered, it did wipe out almost the entire value of the fund which has now been taken over. Here is how the CEO of Amaranth described it:

In September 2006, a series of unusual and unpredictable market events caused the Funds’ natural gas positions (including spreads) to incur dramatic losses while the markets provided no economically viable means of exiting those positions. Despite all of our efforts, we were unable to close out the exposures in the public markets.

Market conditions deteriorated rapidly during the week of September 11. Material losses began early in the week, and we accelerated our efforts to reduce our exposures. On Thursday, September 14, the Funds experienced roughly $560 million in trading losses on their natural gas positions. We continued to attempt to reduce our natural gas exposures, while also selling other positions to raise cash in order to meet margin calls. As news of our losses began to sweep through the markets, our already limited access to market liquidity quickly dissipated.

The fund lost an average of $420 million per day for the first 14 trading days of September, totaling a final loss of around $6 billion.

How does this happen? Hedge funds employ smart people to model the risk on such deals to ensure this type of thing doesn’t occur. While I don’t know what exactly the fund used they should have had some sort of measure like Value at Risk (VAR), and stress tests to try and detect the possibility of such an event occurring. From the statement issued by Amaranth it seems they indicate that such systems failed to detect the possibility.

Our September losses were caused by a combination of highly unusual market behavior – not simply adverse price movements — that not only eroded the energy book’s capital but also virtually eliminated the firm’s liquidity. We had not expected that we would be faced with a market that would move so aggressively against our positions without the market offering any ability to liquidate positions economically.

We viewed the probability of market movements such as those that took place in September as highly remote, and our energy-risk models correspondingly discount the Funds’ exposures to the losses associated with such scenarios. In addition, the trading desk expressed confidence that we would be able to achieve our position reduction goals economically and expeditiously. But sometimes, even the highly improbable happens. That is what happened in September.

One way of looking at this is that this was a failure of their risk management system, but an alternate view is given by Nassim Taleb, a critic of systems such as VAR. On his webpage Taleb writes, quoting the same Amaranth message as above:

How risk managers can cause blowups: “It was not, however, for lack of applying resources or personnel to energy risk analysis that our funds experienced this severe drawdown. (…) we have assigned full-time, well-credentialed and experienced risk professionals to model and monitor our energy portfolio’s risks.”

False sense of security and illusions of knowledge: The problem, of course, is that most of these “hedge fund analysts” giving money to funds use “Nobel crowned” methods that resemble astrology, and use them to allocate to these people. They apply complicated “optimization” methods from past data –but they do not look into the funds’ positions to see if there is a vulnerability to the Black Swan (something that takes 3 minutes). Portfolio theory and “risk management” as practiced by the hedge fund consultants and “allocators” are intellectual frauds.

In Taleb’s view all risk models will be incomplete in measuring the true risk and it is the false confidence given by these models that are a large part responsible for such events. If we believe our models do reflect reality then we will not look at scenarios not predicted by them and therefore discount the possibility of them existing.

In my opinion this sort of thing does not invalidate VAR, but rather is a warning of its limitations. It is not the all encompassing measure of risk, and this is something that risk managers should be aware of. However, I’ve discussed before if the NAB had paid attention to it they could have avoided worst parts of the FX options debacle. VAR is a useful measure of risk, but its not everything.

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9 Responses to Amaranth: Was it failure of risk management or a failure caused by risk management?

  1. ozrisk says:

    Steve,
    I would agree. The hedge funds, by nature, are risk taking institutions so these sorts of events can be expected to occur from time to time.
    In particular, it is important that they do occur from time to time to remind everyone that they are risky investments and that, while they may give you spectacular returns (as Amaranth did the previous year) these returns should not blind you to the simple fact tht they are bought with high risk.

  2. I was horrified when I discovered that many VAR models are just based on an automatically fitted statistical distribution to the last n years data (rather than having some thought about whether conditions have changed since the data). But there are so many variables that often that’s all you can do.

    But when (as many hedge funds) you’re trying to exploit the very edges of the distribution, that’s when the weird things will happen.

  3. Steve says:

    Yes the question is what else do you use, what asumptions can you make when you have perhaps 100 driving variables in your monte carlo.

  4. hammer says:

    What Nick Manouis said about “We viewed the probability of market movements such as those that took place in September as highly remote” is absolutely and patently false. The markets did not move that much and certainly would have been in a two standard deviation move for the market. What killed them was the size of the position. It was the largest natural gas position EVER taken. The infamous Mar07/Apr07 spread went from a peak of $2.60/MMBtu to around $0.50/MMBtu. If that were the only position they had (which it was not since they had other Mar/Apr spreads, bullish volatlity plays and dated year-on-year spreads on) the would have had to have on 300,000 spreads on to lose $6.5 billion. All the regulation in the world is not going to prevent STUPIDY! Talk about lack of diversification, lack of liquidity planning, and total lack of understanding risk management. My guess is that they knew of this risk and since it was a successful strategy they told the risk managers to shut up and let the revenue generators make the money and pay for your salaries. No matter parameters their risk management guys used they would have found this was an unacceptable risk. The faults lies in Nick Manouis for not understanding this gravity of the situation and not controlling his risk. Brian Hunter the maligned trader was just a puppet that found one trade that worked in the past and went to the max. After all he got paid $75MM last year using the same strategy, so what if he lost he’d only be out of a job.

  5. JC says:

    Steve
    These guys shouldn’t have ever been running a hedge fund becasue they clearly didn’t understand risk. Traders need to figure out if their positions could be liquidiated without it being an issue in itself. If your positions are so big that liquidztion itself becomes a problem, you shouldn’t be trading.

  6. ozrisk says:

    hammer,
    As you alude to, for the trader in all these situations there is a definite one sided risk – the worst he / she can do is lose his / her job. The best is to make a huge bonus – which is why strong risk mangement is so important.
    I would not (necessarily) agree that this was a stupid position to run, though – if the fund was being advertised as high risk and highly leveraged then there should be no problem beyond the credit risk with the counterparties. If it was being advertised as stable, though then perhaps civil or criminal action will result.
    It would be a stupid position for a bank to run, but people should be aware that hedge funds are different and should be treated as such.

  7. […] the US, we have statements that we had 1 in 10000 year events occurring every day for 3 days, the collapse of Amaranth, and of course LTCM. In all of these cases we had people believing that their models actually […]

  8. So, have we learned anything yet from these examples? Fast forward and compare the Amaranth and LTCM situations to the current FNM, FRE, AIG situations and entire market crisis of late 2008. It becomes apparent that these things are destined to keep happening on a grander scale. Each time there are many to blame, and the regulators say silly things like they’ll fix it so it “never happens again.” I heard one of them say that on television recently, then I realized that television is entertainment and not investment advice.

  9. […] in their occurrence. In 2006, it was the completely unexpected failure of Amaranth which some have appropriately attributed to the underlying failure of risk management. And less than a decade earlier, it was the collapse […]

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