A collapse, a coup and the markets

21 Sep 2006


Global financial markets have shrugged off the collapse of a large US hedge fund and the military coup in Thailand. Have such developments lost their shock value? By Rex Mathew.

One of the biggest ever investment fund collapse and a military coup in a significant emerging Asian country would have caused more than a few shivers in the global financial markets a few years back. But this week, the markets shrugged-off the bad news from hedge fund Amaranth Partners and the coup in Thailand that happened the same day.

Other than some initial flutters, the two events did not have much of an impact on markets. Have such developments lost their shock value for the normally skittish stock markets?

The Amaranth collapse
In the late '90s when hedge fund Long Term Capital Management (LTCM) went under after trading losses $3 billion, the US government had to intervene and prompt major Wall Street firms to bail it out with fund infusions. This week, Amaranth Advisors LLC — one of the top-20 hedge funds in the US — said it had lost nearly $5 billion in oil futures and the markets were hardly perturbed.

Amaranth lost heavily on its natural gas futures positions when petroleum prices started declining. The fund had emerged one of the biggest traders in natural gas for the last couple of years and had made substantial profits by trading in the commodity. After touching record highs, natural gas prices dropped substantially this year. But the drop in prices was not the sole reason for Amaranth's collapse.

Demand for natural gas in the US is seasonal and is at its peak during winter when houses need heating. The "spread" or gap between peak-season and off-season prices of natural gas has been increasing for the last couple of years. Amaranth was betting that the spread would continue to go up, but this year the spread contracted.

But how can a fund with $9.5 billion in assets lose $4.6 billion in just one week? Like many hedge funds, Amaranth was also heavily leveraged. Some reports say Amaranth's natural gas positions were leveraged five times — in other words only 20 per cent of its own money was used with the rest being financed by brokers.

This heavy leveraging led to margin calls from brokers as Amaranth's positions sank deep into losses. The fund was forced to liquidate its other assets, including equities, to satisfy the margin calls and meet liabilities. Since it had to dump these assets at whatever prices it could get, total losses went up by another $1.4 billion to $6 billion!

The modest decline in global indices on Tuesday was mostly a result of this slump sale by Amaranth and selling by others on hopes of a wider fallout. Even the Indian indices saw a very sharp fall in the last hour of trade that day and there was talk of hedge funds selling. Once the slight pressure from the slump sale was over, the markets focused on other important developments like the US Fed meet to consider interest rates.

High profile collapses in the past had seen a media frenzy surrounding the central character responsible — like Nick Leeson of Barings Bank. The opaque nature of hedge funds has robbed us of such fun in the case of Amaranth. The fund manager who was in charge of energy trading at Amaranth, reportedly all of 32 years old and who would have been a perfect media target in earlier days, has simply vanished.

Unlike banks and widely held investment funds, the collapse of hedge funds affects only a few large investors as these funds do not accept investments from the public. Though some of the larger US pension funds and listed investment funds invest in hedge funds, their exposure — as a percentage of total assets — to hedge funds is not substantial enough to cause a crisis.

A loss of $6 billion is huge in absolute terms, but insignificant — just half a per cent — for the US hedge fund industry which has an estimated $1.2 trillion in assets under management. In contrast, LTCM's $3-billion loss appeared substantial in the late '90s when the hedge fund industry was much smaller.

It would be another matter if a number of large funds face heavy losses over a short period. That could trigger a sharp sell-off and precipitate a crisis across most global markets.

The Thai coup
The military coup in Thailand did lead to some initial weakness in other Asian markets yesterday. But they recovered later in the day and have rallied today. After remaining shut yesterday, the Thai stock exchange reopened today and the main index has lost just one per cent. The Thai Baht (Rs1.22) did weaken considerably yesterday, but there was no panic.

Political uncertainty is something, which financial markets generally loathe and a military coup is regarded as the worst kind of political crisis. But in this case, most analysts do not expect much of an impact on the Thai economy. Some even opine that the coup may actually turn out to be positive development for the economy and the markets.

Rumours of a coup in Thailand have been doing the rounds for the last few weeks. Opposition to former prime minister Taksin Shinawatra, one of the richest men in Thailand, had been mounting on corruption charges. So when the coup finally happened, it was almost like a peaceful non-event. It also helped that the coup was bloodless and Thailand was back to business after pausing only for a day at the site of tanks rumbling across the capital.

The coup has indeed ended the political stalemate in Thailand, which would have paralysed the government and dented economic growth. The coup leaders have promised an early return to democracy and general elections may be held within a year. Though political freedom would be curtailed, economic policy is not expected to change.

Markets love democracies as long as they come with a stable and transparent economic environment. If these are absent markets would take any other system which facilitates economic growth. In the case of Thailand, the coup has so far not worsened the situation, which had anyway not been ideal. On the contrary, the coup holds the promise of a more stable future with the promise of fresh elections without much delay.

The situation would have been completely different had the generals announced highly restrictive economic policies, without any intention to return to democracy.

Economic interests and fortunes of the countries in the region are interlinked and a shock in Thailand would have impacted the other Asean neighbours.

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