Saturday, June 30, 2007

Amaranth and the shame of it all

The Senate staff report ‘Excessive speculation in the natural gas market”, (http://hsgac.senate.gov/_files/062507Report.pdf), is an interesting read not about excessive speculation but about greed and inaction by just about all parties involved. Some may ague that greed and excessive speculation are the same, but I want to focus on the action of players not policy implications.

The failure of Amaranth is a shameful story of no one standing up and asking the important question of why one firm was holding such large positions in the natural gas markets. The implication of what may be called excessive speculation are hard to answer, but the number of people asleep at the wheel concerning why one firm had so much open interest in some contract months are almost too numerous to list in this case. While the Senate report tries to spark their writing of the story with pithy quotes about speculations, the facts of in-action speak for themselves without any help.

The Amaranth traders did not understand the risks of the sizeable positions that they were holding. It would have been nice to hear more about whet they were thinking in this report. This was not even an attempted squeeze but a bold bet on natural gas spreads which did not materialize. Given the size of the positions, it was a one way road to liquidity hell when they could not unravel their positions. What were these traders thinking when they controlled so much of the open interest in some contracts? Did they really think these trades were appropriately sized? You have to assume that others knew the relative size of the positions and would take their pound of flesh at the appropriate time.

Where were the firm’s so-called risk managers? The report suggests that a 12 member team of weak-kneed milk-toast professionals oversaw these risks. At best, they may have fought with the traders on some of these issues, but they were not strong enough to make a difference. Where was the compliance officer who was reported to be in discussions with NYMEX on position limit issues? He is supposed to stand between regulators and exchanges and the traders make sure that the firm is following the rules, yet we see consistent problems with position limits. Where were the managing partners of the firm? This was supposed to be a multi-strategy firm which started as a convertible bond firm and morphed into an energy trading powerhouse. Didn’t they realize the concentration of their bets? All of these people where focused on the profits. If the traders were making money today, who cares what may happen in the future.

Where was the oversight of the firm by investors? Some due diligence. Didn’t they notice that all of the profits were being generated by energy trading for what was supposed to a multi-strategy firm? If the firm is posting good numbers, I guess it does not matter how it is being done. Do you cut the manger who is laying the golden egg if he is not following his style?

Where were the NYMEX officials? Were they afraid of losing business to ICE? NYMEX continually increased position limits for Amaranth and did not take aggressive action against Amaranth when they controlled the back month open interest in the natural gas markets. They action was too little too late. The number of contracts Amaranth held was staggering. At times, it was over 50% of some contract markets. If they couldn’t make Amaranth liquidate or reduce positions, why didn’t they push the CFTC? The threat of lost business to ICE which did not have reporting and position limits was too much was enough to have them cave under pressure from a large trader.

Where was the CFTC? Granted there is limited staff and resources, which is a key problem, but the size of the Amaranth positions would have raised almost any eyebrow of those who were following trade flows. Given the commitment of traders report, it would seem possible that some regulator would have been pushing the NYMEX for action. If not in this situation, what would it take for the CFTC to do something? Would more resources solve this type of inaction?

The futures markets are useful but who is going to play if there is the perception that the market is one-sided or controlled by a single player. This is not an issue of international competitiveness but keeping a market reasonably fair. That may be hard to do if one party controls open interest even if their speculation is unsuccessful.

While I am a strong advocate of limited regulation in futures markets, this is a shameful display of greed and inaction by too may parties to be left unchecked. Unfortunately, you cannot legislate good sense. Markets loses may be able to teach that lesson. Nevertheless, the government can work to increase transparency in markets so that other will at least know of this type of folly.

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