It's been a couple of weeks since the Chernobyl at the Amaranth Advisors hedge fund, and many in the financial community are congratulating themselves on how well the radioactive fallout has been contained.
Unlike what happened when the collapse of the Long Term Capital Management fund in 1998 threw Wall Street into a panic and spurred U.S. Federal Reserve Board chairman Alan Greenspan to perform a daring rescue mission, his successor Ben Bernanke's repose has not been disturbed by the Amaranth debacle. Warren Buffett, that billionaire investor who has warned for years that derivatives are "financial instruments of mass destruction" must be a worrywart.
Still, there were a few people scratching their heads as to why their investments were affected by Amaranth's losing gamble on natural gas. Cinram Income Fund, which makes CDs and DVDs, saw about $65-million knocked off its market capitalization, as investors speculated that Amaranth would have to unload its 15-per-cent stake in the company. Counsel Corp., which owns shopping malls, saw its shares fall about 25 per cent. Amaranth is Counsel's largest shareholder, with about one-third of the shares outstanding.
Brian Hunter, the math whiz at Amaranth who devised the trading strategy responsible for the meltdown, has been a lightning rod for blame. He's been dubbed a nefarious rogue trader, yet no evidence has emerged that he was trading secretly in contravention to policies of his employer. Far from it, he was doing exactly what had been done earlier to make huge profits, $1.3-billion (U.S.) in 2005 and $2.2-billion in the first eight months of 2006. Easy come, easy go. And of course, if Mr. Hunter managed to lose $6-billion, it means some other bright sparks gained a similar amount, and are out comparing Ferraris and Bentleys, and reflecting about how many digits will be on this year's bonus cheque.
To some, this is proof positive that the market is efficient. Poppycock! Does anyone seriously believe the incredible runup in petroleum prices would have been possible without the massive participation of speculative hedge funds? Or that prices would be dropping so fast now on commodities across the board if these nervous funds were not running for the hills and liquidating positions? Where's the much-ballyhooed "terrorism premium"? Has the unquenchable thirst from India and China suddenly been slaked?
Hedge funds are just another herd. But if investors who got sucked into technology funds in the 1990s were quiet lemmings, hedge traders are more like clever rats, who won't hesitate to turn on their own. Amaranth's founder, Nick Maounis, explained that when the company tried to reduce exposure, competitive traders who smelled vulnerability refused to provide liquidity. "We did not expect that the market would move so aggressively against our positions," he said in a conference call with investors. That sort of dewy eyed naiveté strains belief.
For our part, we continue to believe that 9,000 hedge funds managing more than $1.2-trillion (U.S.) in assets is an accident waiting to happen. Sure, the industry can chew up the odd flameout without so much as indigestion. But if the Byzantine interconnections brought down a group of them, the entire pyramid could reach a tipping point and destabilize. In such a scenario, they will not fall like an orderly row of dominoes, but the damage would be haphazard, unpredictable and extreme.
Mr. Buffett used Mark Twain's metaphor of a cat carried by the tail to describe the potential mayhem, but we'll take our literary cue from Victor Hugo's last novel, Quatrevingt-Treize, which in a terrifying scene describes the effect of a cannon loose on the deck of a ship in the English Channel.
"A cannon that breaks its moorings suddenly becomes some strange, supernatural beast. It is a machine transformed into a monster. That short mass on wheels moves like a billiard-ball, rolls with the rolling of the ship, plunges with the pitching, goes, comes, stops, seems to meditate, starts on its course again, shoots like an arrow from one end of the vessel to the other, whirls around, slips away, dodges, rears, bangs, crashes, kills, exterminates."
The chance of such a bad turn of events is fortunately small. The odds of Amaranth's trading models going so wrong were "highly improbable," Mr. Maounis noted ruefully, but "sometimes even the highly improbable happens."
We can only hope that Mr. Bernanke will not be called upon to capture any loose cannons.
Benj Gallander and Ben Stadelmann are co-editors of Contra the Heard Investment Letter. This column first appeared on GlobeinvestorGOLD.com.