WHEN THE Bank of England simulated a financial shock, it discovered that the problem that initially manifested itself was not the problem that ultimately threatened the system. The systemic risk “war game” was played out behind the Bank’s closed doors last October. It began early in the morning with the implosion of a small insurance company linked to a financial blow-up at a second-tier European bank. By early afternoon the imaginary crisis had spread and, suddenly, the bank staff were scrambling to save a British high street bank with more than ten million customers across the country. The lesson learnt was that, in today’s interconnected world, financial contagion is not contiguous: institutions no longer fall as sequentially as dominoes, but erupt as unpredictably as volcanoes. Inside Threadneedle Street, officials quietly continue to worry about financial dangers in a borderless world — about an obscure firm far away going bust and suddenly, unexpectedly putting a grand old British institution in jeopardy.
In this context, the $4 billion-plus losses at Amaranth Advisors, a Connecticut-based hedge fund, provide a timely case study in systemic risk.
Brian Hunter, a 32-year-old Canadian trading out of Calgary and driving around town in a grey Ferrari (or his Bentley, which, apparently, grips better in snowy weather) has single-handedly wiped out half of Amaranth’s $9 billion assets. It is hard to see how the hedge fund will recover. But he has not been a “rogue trader” in the Nick Leeson tradition, rather a feted alternative investment manager in the modern mould. The bets he made on natural gas prices were entirely legal and, until the summer, were delivering extraordinary profits to Amaranth. Mr Hunter was up $2 billion in August. When the gas price slumped contrary to his expectations, his bet suddenly became very expensive: the latest estimate is that he lost $5 billion in a week.
To be clear, Amaranth is no Long Term Capital Management. John Meriwether’s hedge fund, also based in Connecticut, collapsed in 1998. It was brought down by losses of
$4.6 billion, but the panic it created was a consequence of its enormous leverage. It borrowed huge sums to finance big volume bets on tiny movements in price. The firm had equity of $4.75 billion, but had borrowed $124.5 billion. When LTCM failed, it seemed to threaten its big Wall Street lenders.
The world has also become more sanguine about the risks posed by hedge funds since the LTCM crisis. One of the features of financial connectivity is that the market compensates for failure. In Amaranth’s case, the winners are likely to be as big as the losers. Centaurus Energy, a trader in Houston run by an ex-Enron executive, is reported to have been on the other end of Mr Hunter’s disastrous bets on natural gas and profiting handsomely from it.
Still, the extent of Amaranth’s borrowings remains unclear. The company has links to a host of blue-chip financial institutions, including Credit Suisse and Morgan Stanley. Goldman Sachs said yesterday that one of its listed hedge fund investment vehicles, Goldman Sachs Dynamic Opportunities, will report a 2.5 per cent to 3 per cent loss in September because of its exposure to Amaranth. The Connecticut hedge fund may yet have to unwind a host of other investments, including such unlikely holdings as Manchester United’s debt. Contagion, today, means problems crop up in the unlikeliest of places.
There will be longer-term repercussions for hedge funds generally. For a while now, many have smarted at the extraordinary fees demanded by hedge fund managers — typically 20 per cent of profits. When investors find they are shouldering all the losses, but the hedge fund is only sharing with them 80 per cent of the profits, there will be a squeeze on those fees. Politicians, too, will be unsettled by Amaranth, adding to the pressure that is building for hedge funds to operate more like traditional fund managers, meeting similar requirements of transparency. For Amaranth, among its other flaws, was not transparent about the risk that Mr Hunter posed to its investors: they had put their money in something called Amaranth Multi-Strategy Funds, which implied a diversification of risk. In fact, they were putting nearly all their eggs in one basket, Mr Hunter’s bet on natural gas.
As the Amaranth case shows, the Bank of England has plenty to worry about — including the fact that EU finance ministers have scheduled the next pan-European systemic risk exercise for 2009.
Energy gap
THE Government should put on hold any short term plans it has to sell its stake in British Energy. The company’s shares peaked in August with energy prices. Nuclear’s semi-fixed costs make profits sensitive to the price of gas, its chief competitor in power generation. The fall of a quarter since then reflects investors’ lack of confidence in the board’s management control.
British Energy shares dropped 8 per cent yesterday when the company implied that a further 3 per cent of output is to be lost this year because unplanned stoppages at key plant are taking longer than expected to repair.
This damage masks uncomfortable trends. Gas prices are weak and so are wholesale electricity prices. If forecasts of a mild winter in Britain prove correct, these trends could accelerate. Add those doubts over operational management and this looks a bad time to try to sell any big stake in British Energy. British Energy has fundamental work to do on its Hinkley Point B power station before the Government should give any consideration to a sale of its interest in the company.
What the Treasury owns, however, is not a conventional asset but a right to two thirds of British Energy’s cashflow. It was conceded when the company would otherwise have gone bust, in exchange for taxpayers taking the liability to decommission its reactors. The rights convert into shares worth nearly twice British Energy’s existing market value.
The Government’s interest, therefore, is not an asset but an obligation. Nuclear decommissioning represents a vast and growing liability for future taxpayers. It needs to be funded. The Treasury should sell rights in British Energy only if the price is so high that it will guarantee a sufficient cashflow to meet that obligation to the future.
