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Unintentional irony watch (hedge fund edition)

by Brad Setser
September 21, 2006

Risk management standards do seem to be slipping.   Davis, Sender and Zuckerman in the Wall Street Journal: 

“The risk models employed by hedge funds use historic data, but the natural gas markets have been more volatile this year than any year since 2001, making the models less useful.  They also might not predict how much selling of one’s stakes to get out of a position can cause prices to fall.”

The models broke down because this year has been more volatile than any year since 2001?   That isn’t so long ago, except in hedge fund time …  

I suspect Mr. Geithner won’t be happy if stress tests — and risk management models — don’t look a bit further back. 

1998 might be a relevant data point.  Certainly for anyone betting on emerging markets, the yen/dollar (or the yen/ euro, since the dyanmics of an unwinding carry trade are similar) or the Treasury market.  1998 also might be a relevant data point for a few commodity markets.   

Mr. Geithner also wants – I suspect – those lending to hedge funds to assume that liquidity will dry up when their clients need it the most.  Getting out when you don’t need to is easy.  Getting out when you absolutely have to is hard.  Especially if you have a large concentrated position … 

That lesson may be relevant for another set of institutions with large positions.  A few central banks might also want to ponder the impact large, sustained purchases can have on market dynamics.  Davis, Sender and Zuckerman, again.

“According to natural gas investors who traded alongside Amaranth, Mr. Hunter repeatedly used borrowed money to double down on his bets.   Buying more futures contracts of the kind his fund already owned supported their price by increasing demand, propping up paper gains, these traders say.   But the support only lasted so long as Amaranth and its lenders were willing to spend cash to buy more contracts.   Such trades may also have masked growing weakness in market fundamentals” 

Substitute dollars, Treasury bonds and Agency bonds for “futures” and “contracts,” and substitute the PBoC (and a few others) for Amaranth … 

China is making a huge bet that Stephen Jen and Friedrich Wu are right, and the RMB isn’t really undervalued (and the dollar and euro are not overvalued against the RMB).   It is betting that the RMB wouldn’t really rise if it stopped buying.   That is a rather large gamble though.  

Especially since Chinese productivity is growing faster than US productivity (see the graphs on p. 13 of Feng Lu’s presentation), so a key “fundamental” is moving against China’s financial position …

I think Fan Gang at least understands as much.   Yu Yongding as well.   And Zhou Xiaochuan. 

The Politburo and the State Council?   I am not so sure.

26 Comments

  • Posted by FR

    Brad -
    Regarding China, have you seen
    http://www.lemonde.fr/web/article/0,1-0@2-3234,36-814866@51-628862,0.html
    which would have us believe that China is not tightening the monetary screws as some (Steve Roach) hope but is actually pursuing an effective “politique de relance” through burgeoning budggets of local govts and low interest rates

    Thus, whether the central monetary authorities and central govt “understand” or not doesn’t make a hell of a lot of difference because – according to the article cited above – they don’t have the power to intervene.

    whatever happened to Joseph Wang. I’d like to see him or some other knowledgable China hand comment.

  • Posted by Guest

    Looking at what Wu is saying in that article: “…Wu offers a laundry list of potential “growth decelerators” marring China’s outlook. It includes overheating, the widening gap between rich and poor, a fragile banking sector, rampant corruption, an aging population, worsening pollution and the risk of military conflict with Taiwan. Amid so many risks, is it really a given that China’s currency should be 20 percent or even 40 percent stronger? …Once traders look under the nation’s hood, the yuan may very well sink under the weight of China’s challenges.”

    And: “…In a July 8 [2003] ceremony on the top floor of the 22-story China Construction Bank (CCB) headquarters in Beijing, financiers drank champagne toasts to a deal that paired Morgan Stanley with CCB, one of China’s big four commercial banks, giving Morgan Stanley bragging rights as the first foreign bank to sign a direct joint venture to dispose of the mainland’s nonperforming loans. For China, it’s just the latest opportunity to leverage Western banking expertise to clean up a bad loan problem that Standard & Poor’s says will cost $500 billion to clean up…” http://www.businessweek.com/magazine/content/03_30/b3843073_mz014.htm

  • Posted by PC

    You wrote:

    “The models broke down because this year has been more volatile than any year since 2001? That isn’t so long ago, except in hedge fund time ..”

    It’s not the volatility that kills Amaranth, they were simply betting too big. Volatility won’t kill you if you have a prudent position size.

    The incentives encourages him to bet wrecklessly. I read that Hunter took home US$75 million to US$100 million in pay last year. With Other People’s Money, heads he wins and tails investors lose. Of course he would swing for the fences, wouldn’t you?

  • Posted by Joseph Wang

    FR: Just been busy, but the Le Monde article seems to be confused. The central government is increasing spending in the poorer interior to boost growth there, but growth in the interior has been really sluggish. The areas of overheating are mainly in the coastal provinces. US$13 billion or so in infrastructure development in the West is actually a pretty small amount.

    The situation with local government debt has improved greatly. Local governments can’t borrow directly, but they are funded through policy banks like the China Development Bank which gives the central control over how much local governments borrow.

    The Bloomberg article was pretty confused. There is a fun line in it that China always seems to be on the fine line between inflation and deflation. Hmmmm…. That’s a good thing right?

    A lot of reading the press is funny because when there isn’t a car accident, they take about the car accident that *could* happen if someone jams on the brakes or presses the accelerator.

  • Posted by bsetser

    I’ll stick with the basic balance of payments as my predictor of what would happen with the RMB. Lardy puts China’s 06 current account surplus at 9% of GDP. Net fDI inflows are 2-3%. That is a basic surplus of 11-12% in good times. If Chinese growth slows, the current account surplus will rise — so the basic balance of payments surplus will be above 11-12% — perhaps 13-15%.

    Note that bad loans/ bad bank balance sheets didn’t lead to large outflows from China during the 01-04 period, when most of the bad loans were on the banks balance sheets. And note that if China raised interest rates to US levels, it would reduce incentives for capital outflows (right now China is trying to discourage inflows, not discourage outflows). Wu/ Pesek didn’t convince me — they are making the same arguments lots of folks made in 03/04, and since then the banks have been cleaned up (in the sense of bad loans from the 90s have been moved to the AMCs, new loans from the current boom have yet to go bad)/ China’s basic balance of payments surplus has soared.

    Should china slow, China might be politically even less willing to allow RMB appreciation. But keeping the RMB from rising will still require –in my judgement — tons of intervention.

  • Posted by bsetser

    PC — fair point. but shouldn’t the size of your positions be stress tested against potential rises in volatility? And isn’t a return to the the most recent peak level of volatility a reasonable stress test?

    Agree tho that Hunter is up $75 to $100m no matter how much Amaranth’s investors lose this year … Harvard Management company deferred compensation to see if one year’s gains last anyone?

  • Posted by Cassandra

    “The risk models employed by hedge funds use historic data, but the natural gas markets have been more volatile this year than any year since 2001, making the models less useful. They also might not predict how much selling of one’s stakes to get out of a position can cause prices to fall.”

    Huh??!? Such a paragraph demonstrates that the the only ones with less useful information about HF’s & risk than Davis, Sender & Zuckerman themselves, are their editors at the WSJ who seemingly cannot distinguish drivel from legitimately useful (and accurate) insights.

    There is little modeling that can capture the essence of the tail risk that results from being gunned when the market smells blood other than a fiendish imagination, and Andy Grove-like paranoia. Even in the currency market – supposedly the most “liquid” market in the world where a daily 3 StdDev event is still but a few percent, “accidents” happen. Think of the YEN in Oct 1998. Go to bed it’s 133 – wake up: it’s 121, more importantly, with almost no trade in between. By next morning reflecting lots of turnover: its surfing 113.

    Large Absolute Position + Market knowledge of your position + Leverage + Position Concentration + Limited investment time horizon by large marginal participants + Agent vs. Principal Dilemma + Accelerating contra-trend Price move + Fine Print of Most Margin Agreements = Anatomy of most amusing speculative carnage.

    http://nihoncassandra.blogspot.com/

  • Posted by Emmanuel

    Call me Yasuo Hamanaka (!), but I admit to having difficulties with this “PBoC-as-hedge-fund” analogy:

    (a) If I were a hedge fund manager whose strategy consisted of passing up local investments with returns in the low double figures for Treasuries yielding less than five percent, I’d have no takers. Unfortunately, the Chinese people are being suckered in this matter, despite claims to the contrary.

    (b) China’s massive stash of reserves has geopolitical as well as economic significance. It can, by selling this stash off at fire-sale prices, detonate the US economy and probably the world economy;

    (c) It is not apparent to me that China is betting on the RMB not appreciating if it stopped borrowing. It’s more likely that they got stuck in an unhealthy pattern of “vendor financing” they have little way of getting out of now. From my POV, it’s an addiction and not a wager.

  • Posted by Emmanuel

    Oops, I meant “lending” in (c). I need to go out for some fresh air right about now.

  • Posted by Guest

    Emmanuel

    They have two positions: one debt (US Bonds) & one equity (the Chinese Economy). The positions are correlated for the moment. Neither position is “leveraged”. The equity position has been built on FDI – not foreign currency debt. The debt position has allowed them to build the value of the equity position. They know they’ll have to stop adding to the debt position, and that When they do they know they’re gonna take a hit on both positions at first. But the one that matter is their equity position. The devalued and eventually-written-down US debt position will still buy something, and more importantly yield political benefits & leverage over the US (Taiwan?, Tibet? conflict in Siberia? etc.). All the while the long-term value of their equity position which they’re nurturing is increasing. Pretty sneaky, huh?

  • Posted by Aaron Krowne

    I second what writer PC says: no market can take you out if you aren’t excessively leveraged. I point this out and survey some more of the Amaranth damage here.

    Also more comments on systemically-slipping risk management standards here.

  • Posted by PC

    Mr. Setser, you wrote:

    “PC — fair point. but shouldn’t the size of your positions be stress tested against potential rises in volatility? And isn’t a return to the the most recent peak level of volatility a reasonable stress test?”

    As a general rule of thumb, you should not risk more than 2-2.5% of your total equity on any one trade, irrespective of volatility. That’s the way you stay in the game. You are playing a game of positive expectancy and in order to realize the positive expectancy “over the long term” YOU HAVE GOT TO BE ABLE TO STAY IN THE GAME. You can’t let any one trade take you out. It’s obvious that Amaranth violated that rule.

    Also I never understood these computer models (I don’t use them myself) they use where they increase their position size when volatility is low in order to compensate for lower returns (you need high volatility to generate high returns). Given volatility is cyclical, this means the time when they have the largest position (low volatility) is exactly when things will turn. Just ask LTCM.

    Also everyone is using basically the same models which makes me wonder whether there will be any systemic risks when there is a black swan event.

  • Posted by Guest

    re: “more of the Amaranth damage”

    as Goldman is on that list, interesting that it hit a new 52 week high today – pulled back a bit, but still up on the day.

  • Posted by Guest

    PC — we are on the same page. low vol = you can have more leverage. and if vol is falling bet on it falling further … it all assumes that past vol predicts future vol — and that if it doesn’t you can cover the position.

    in some cases, the additional leverage from falling vol not just leads folks to bid up certain assets, but also reduces vol. take turkey — as everyone was going long the lira, the Turkish CB was intervening to keep TRL from rising. there was no downside pressure so vol was basically zero on TRL. And low vol on TRL/ $ = ok to take more TRL risk. am sure that there are other examples out there. that is just the one I know.

  • Posted by bsetser

    PC — we are on the same page. low vol = you can have more leverage. and if vol is falling bet on it falling further … it all assumes that past vol predicts future vol — and that if it doesn’t you can cover the position.

    in some cases, the additional leverage from falling vol not just leads folks to bid up certain assets, but also reduces vol. take turkey — as everyone was going long the lira, the Turkish CB was intervening to keep TRL from rising. there was no downside pressure so vol was basically zero on TRL. And low vol on TRL/ $ = ok to take more TRL risk. am sure that there are other examples out there. that is just the one I know.

  • Posted by bsetser

    “PBoC isn’t leveraged — ”

    Not sure I agree with that.

    The real money part of the PBoC’s balance sheet is the FX reserves held as assets against RMB cash. the leveraged part of the PBoC’s balance sheet is the FX reserves held as assets against sterilization bills. As reserve growth exceeds the base money growth, the share of the PBoC’s balance sheet that is “financed” by interest-bearing liabilities is rising …

    there is also leverage in another sense — the hot money that came in to bet on the RMB might flow back out. And those folks are basically trading against the PBoC. If the RMB goes up a lot, they win and the PBoC loses. They buy RMB at 8 (for $) and then sell the RMB back to the PBoC at say 6 … and pocket the difference. the PBoC is just left with a loss.

    right now though, the PBoC is winning — US rates are higher than Chinese rates + the RMB’s appreciation. but the PBoC can only keep on winning by in some sense continuing to double down. Chinese reserves basically doubled between mid-04 and mid-06 … and they are on track to grow by $250-300b a year for the foreseeable future even if hot money inflows stay modest. That is the problem with a close to 10% of GDP current account surplus …

  • Posted by Guest

    “The United States real estate market has entered a period of “unprecedented volatility,” and banks, insurance providers, and government housing agencies should brace for global ripple effects, Yale economist and author Robert Shiller told a conference yesterday… [Mr. Shiller] is also chief economist for MacroMarkets LLC, a company that designs financial instruments aimed at providing a hedge against real estate risk. One of the firm’s innovations is housing futures and options for 10 major U.S. cities traded on the Chicago Mercantile Exchange. The products allow investors to buy and sell housing futures and options in the same way they would invest in other commodities such as soybeans or coffee, with the idea of hedging against risk… Consumers and institutions should consider such instruments as a means of protecting themselves against volatility that shows no signs of decreasing, Mr. Shiller said… such movements can affect entire countries and, in the case of the U.S… influence the economies of other nations…” http://www.globeinvestor.com/servlet/story/GAM.20060921.RHOUSING21/GIStory/

  • Posted by Joseph Wang

    Does it make any sense at all to use a balance sheet for a central bank? I’m not sure what the liabilities of the PBC would be in this model. Suppose the value of the PBC’s dollar holdings dropped by 20%. I’m not seeing how this would be a bad thing, necessarily.

    Also, I think that the models are being caricatured. Just because one hedge fund had bad risk management doesn’t mean that most or all of them do.

  • Posted by Guest
  • Posted by Guest

    China is about to become the latest victim of “DHD” Syndrome (Dollar Hegemony Disease).

    Just as every country has before it that has taken the Fausitan deal of exporting to the U.S., accepting our IOUs as payment, then practicing the fatal fractional reserve lending/central banking lifestyle and allowing its economy to overheat and ultimately implode, COMMUNIST China will go down in a deflationary collapse.

    Japan comes right to mind as the last example of DHD syndrome.

    And this is the BEST CASE scenario. Imagine if the U.S. itself experiences debt-collapse and the concomitant decimation of “MEW” (Mortgage Equity Withdrawal, another fatal disease!), and stops buying Chinas gimcracks and geegaws.

    Or if there is a REAL oil shock.

    Or some other geopolitical event.

    Then all this discussion of the minutiae of RMB valuation moves of X-percent or PBoC raising rates 25-basis points will be rendered moot. China will go down in a sea of red flames.

    Interesting, isn’t it, that BOTH the SUPPOSED “free-market” economies of the United States and those of communist countries such as Russia and China practice identical monetary and banking shemes?

  • Posted by DF

    May be China is betting that it is heading towards a stronger deflation than in the USA … May be they do it for political reasons.
    All I see is that the roaring 90′s seem to be over, and with some delay we re finally reaching the point where globalisation, deregulation and all the related buzz finally ends.

    Now comes in the time for long trends and the death of free marketeers and Neo classical economy.

  • Posted by Anonymous

    re “The real money part of the PBoC’s balance sheet is the FX reserves held as assets against RMB cash. the leveraged part of the PBoC’s balance sheet is the FX reserves held as assets against sterilization bills.”

    What are sterilization bills?

    Thank you.

  • Posted by bsetser

    Sterilization bills are debt sold by the central bank to withdraw currency from circulation — currency that in this case has been issued when the PBoC buys dollars (and sells RMB) –

    It goes like this:

    the PBoC sells RMB (cash) for dollars (cash) in the fx market.
    The PBoC invests the dollars cash in US debt markets, buying treasuries, agencies or MBS (things that pay interest).
    But the PBoC worries that it is injecting too much cash (RMB) into the cHinese economy, so it has to withdraw some of the cash it is injecting from circulation.
    It could so sell by selling some of its stock of Chinese government debt (it buys RMB cash with RMB denominated chinese treasury bonds). That is how the Fed conducts monetary policy.
    But China’s central bank long ago sold all its of its domestic treasury bonds. So rather than selling bonds (And buying cash) it sells its own IOUs (And buys cash). Those IOUs are called sterilization bills …

    J. Wang — tis true that a central bank can absorb a capital loss, so there is a debate about what the practical implications of all this are. At the same time, central banks usually make profits that they give back to the treasury … and if Chinese domestic interest rate rise above US (or European rates) in the future — and if a revaluation has reduced the stock of PBoC assets (in RMB terms) relative to the PBoC’s liabilities, the central bank could be cash flow negative.

    Mexico and Korea are both dealing with similar problems right now …

  • Posted by Anonymous

    re sterilization bills –

    Thank you for the explanation. It will take my a while to wrap my mind around it.
    So, in effect they’re ‘killing’ their money? It seems so counter-intuitive.
    And does “China’s central bank long ago sold all its of its domestic treasury bonds” mean that the government has zero debt to service?? (??)
    Thank you.

    PS — I appreciate the “try again” posting option.

  • Posted by bsetser

    China has plenty of debt to service –

    The PBoC has to pay interest on its sterilization bills. (like the idea of sterilization bills “killing money”

    it does so out of the interest it gets on its foreign reserves.

    And since the PBoC has sold its holding of the government’s treasury bonds to the public, the government of China has to pay interest on these bonds not to the central bank but to the public, and it does so out of tax revenue/ new borrowing.

  • Posted by Anonymous

    Something about it reminds me of the Alaska ‘dividend’ … keeping the money (some of the money anyway) moving around and local. And it seems very efficient — transforming US obligations into fertilizer for China’s economy. Or maybe it WAS efficient.
    Is the public free to buy these bonds, or is their purchase restricted?
    Can foreigners buy them?