Introducing a new product, "Insurance"

[This item first appeared here on September 25, 2006. As usual, just over three years ago, the folks at The Economist were early in sounding an alarm that few heard.]

The boys at The Economist are once again sounding the alarm over hedge funds, derivatives, and now dark matter. No, not the chimerical good will and brand value used by some supply-siders to rationalize away the huge trade deficit - the dark matter in this case is debt. As in the current cover story, The Dark Side of Debt.

There are three stories in the current issue about the new dark matter that is driving the world economy - there may be more than three, as the entire magazine has not yet been reviewed. Surprisingly, all three are in the public area of the website, available to passersby at no charge. The cover story starts the ball rolling, wondering what a low-interest rate world hath wrought.

Thanks to the low cost of debt, private lenders, such as hedge funds, are extending vast amounts of credit to leveraged buy-out firms and other private borrowers. Forsaking the sunlit uplands of global finance, the market for capital is plunging into the shadows.

For the financiers, that is an irresistibly lucrative place to be. In thinly traded, lightly regulated and untransparent markets, the bold can make an awful lot of money—and they can lose it on an even more extravagant scale. A bunch of investors is $6 billion or so poorer this week, after it emerged that Amaranth Advisors, a hedge fund that had some $9 billion under management, suffered catastrophic losses in a few weeks on the back of falling natural-gas prices.

Not usually one to question the prose of others, the "a bunch of investors is poorer" phrase did give momentary pause. It would appear that the staff at The Economist are so concerned about lightly regulated credit creation and leveraged speculation that they're starting to talk like Americans.

The Amaranth blow-up has everyone a bit unsettled these days, many now expecting another hedge fund to drop and who knows what else. From little more than 500 hedge funds in 1990 with less than $50 billion under management, today almost 9,000 shops have been set up to oversee more than $1 trillion.

Are there more Amaranths out there waiting to fess up to their clients about a bet that's gone bad. In the Finance and Economics section of the current issue, this account of the recent Flare-up at Amaranth is provided.

How did it happen? Brian Hunter, the 32-year-old Canadian energy trader, had made a fortune for Amaranth in 2005 when he bet that natural-gas futures would rise and then benefited from surging gas prices after Hurricane Katrina. Last year Trader Monthly ranked him the 29th highest-earning member of his profession, estimating his annual income at $75m to $100m. He was named head of Amaranth's energy-trading operations in the spring. This summer no big storms materialised and the same sort of positions—highly leveraged and insufficiently hedged, analysts say—left the fund exposed to falling prices. Natural-gas futures prices have dropped by two-thirds in the past nine months.

“I've never seen a hedge fund so highly leveraged in energy,” says Peter Fusaro of the Energy Hedge Fund Centre. He reckons that the fund held about 10% of the global market in natural-gas futures. “Somebody was not monitoring this correctly.”

As its losses mounted, last weekend Amaranth quietly summoned a group of investment banks to its Connecticut headquarters to try to sort out the financial mess. With teams from each firm ensconced in separate rooms, officials from Amaranth shuttled between them, seeking to sell off positions, craft bridging loans and possibly negotiate a takeover. By the end of the weekend, enough had been done to prevent panic. Unlike at LTCM, the Federal Reserve did not have to intervene. To help cover its losses, Amaranth also sold a big chunk of its leveraged loans. They were snapped up, mostly by buyers in Europe.

A prerequisite for high leverage is plentiful credit. It's near impossible to make big bets without someone standing behind you, like at a craps table, ready to help you raise the bet with each lucky roll. Sometimes you wonder who's being more reckless, the borrower or the lender.

It is all explained in the feature story Shadows of Debt in which is it learned that even if there were regulators looking after this sort of thing with more than a passing interest, and even if the regulators knew where to look, they still couldn't keep up with the "innovations" that hedge funds and their bankers are driving.

Indeed, the market has changed so fast that regulators are not sure if it is spinning out of control. On one hand, innovations in the credit markets have helped to provide a remarkable period of stability in the world's financial system. In recent years, markets have lived through the end of the internet bubble, the collapse of Enron, the terror attacks of September 11th 2001, debt downgrades in the car industry and a stampede out of risky assets in May and June. Any one of these might once have triggered a financial crisis. But none did.
...
Regulators worry that some of the complex financial instruments conjured up around the lending and borrowing of money—worth trillions of dollars—may sow the seeds of the next financial crisis.

The president of the New York Federal Reserve, Timothy Geithner, can be clearly counted in the worried camp. He's taken notice of the rapidly evolving world of hedge funds and has been speaking out lately. In a speech in Hong Kong last week, he wondered if maybe a few smaller crises would be better than one big one.

"The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by, and complicate the management of, very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the larger ones."

Of course people have been warning about this sort of thing for years now and nothing bad has yet happened - surely people just worry too much.

By far, the most dangerous innovations in credit creation in recent years have been the variety of insurance products now offered for sale by hedge funs, many of which promise to make the buyer of the insurance whole again should something bad happen to whatever happens to be the hot speculation of the day.

For years now, credit default and interest rate swaps have beckoned yield starved investors to carry riskier loans and place riskier bets. The simple math of better returns far exceeding the added cost of the insurance has been manna from heaven for both lenders and borrowers - all presumably part of the technology-driven wealth creation that the Chicago Fed writes glowingly about regarding housing, and that applies to other hedge fund activities as well.

More febrile still has been the popularity of newfangled derivatives with difficult names, such as credit-default swaps (CDSs). These are as complex as they sound. But they are also among the past decade's most important financial innovations—and a cause of both regulatory hand-clapping and hand-wringing. The International Swaps and Derivatives Association said on September 19th that the notional amount outstanding of credit derivatives rose by 52% in the first six months of the year to $26 trillion (see chart 3). That number would be far smaller if banks' positions were netted out for offsetting exposures. But less than a decade ago, the credit-swaps market barely existed.

Credit derivatives, which behave a bit like insurance contracts, allow investors to buy or sell cover against default by a borrower, and the price moves depending on perceptions about the borrower's creditworthiness. Increasingly, they are being pooled into collateralised debt obligations (CDOs), another form of investment vehicle that is growing as fast as a hedge-fund manager's bank balance.

Such products, known as “structured credit”, encourage liquidity, partly because they can be created out of thin air. They also allow banks to sell on the risk of loans turning bad, possibly enabling them to lend more. Robert McAdie, head of credit research at Barclays Capital, says the change has been profound—and for the better. After the dotcom boom, when heavily indebted telecoms firms were on their knees, banks had almost no way to hedge themselves. Now they do: “The use of credit derivatives has totally liberalised the debt market,” he says. “It has created an enormous shift in the risk profile of banks. It allows them to hedge against their risk and manage their regulatory and economic capital more efficiently.”

Hedges and hedge funds
On the other hand, a recent paper by researchers at the European Central Bank says part of the problem with CDSs is that they are used for speculation, as well as hedging. “We have introduced a new product, “insurance”, that appears to be used by people not looking for insurance. It is not the instrument[s] which [are] causing liquidity concerns but the way market participants may be using them.”

On September 11th, in its semi-annual Global Financial Stability Report, the IMF warned that such “structured credit products” were one of its main concerns, especially if financial markets take a turn for the worse and liquidity dries up.

The problem, broadly identified by many regulators, is that not a lot is known about how structured-credit products behave in unusual conditions. Even if they normally mitigate risks, they might suddenly magnify them when financial conditions seriously deteriorate. The products have been developed in a decade when interest rates have been low, the appetite for risk high and liquidity ample. It is easy to assume they are always a benign influence. But it is hard to know how they will react when hard times return.

It all seems almost too good to be true - insurance for speculators. Insurance products that allow individuals and companies to take on as much risk as their models allow using borrowed money to increase their leverage to the extent that their models allow, secure in the knowledge that if something does go wrong, it won't be that big a deal.

A stock market crash, the collapse of Enron, September 11th, junk bonds from GM and Ford, Refco, the emerging market meltdown in May, and most recently plunging energy prices. All of these potential crises turned out to be just another bump in the road - the road to ever greater riches for those willing to borrow money and place a bet, purchasing some insurance just in case.

What could go wrong?