Sic Semper Tyrannis

Ok, so this has been bugging me for a while: commentators have actually been saying that "the market worked" in the case of Amaranth (or things to that effect). Nothing to see here, move right along, get back to investing in the stock market, yadda yadda (yes, they "yadda-yadda'd" a hedge fund collapse!)...

Follow up:

A little bit of review and epilogue to the story: Amaranth was a $9 billion hedge fund that, a couple weeks ago, was on the wrong side of a highly-leveraged natural gas bet when energy came off its summer highs, hitting it with $6.4 billion in losses and in effect collapsing it. Lots of people and institutions lost money (including state and corporate pension plans). The big banks swooped in and assumed many of Amaranth's defunct positions at firesale prices -- the chief beneficiary being JP Morgan (as they have publicly stated in their latest financial release).

If you've been following this story and are thinking even remotely like me on the topic, then you might wonder what it would look like if the market didn't work.

Instant armageddon, perhaps?

A mushroom cloud over Wall Street?

Given the extremity of 9/11, I'm not sure what imaginable calamity would even qualify.

My point (which Ted Butler has recently echoed) is that this was not a normal occurrence, and the market did not work fine.

In the normal workings of the market, investment banks don't swoop in and take over trading contracts through back-room deals. I can't stress this enough. In the normal market, positions are bought and sold on the exchange. That is the financial system. The type of wheeling and dealing that occurred post-Amaranth was completely ad hoc -- the exact opposite of "systemic", and hence, not a function of the system.

So the system didn't work -- we just got damn lucky. Imagine if Amaranth had to actually liquidate its positions on the open market, using the normal mechanisms (like, say, you and I have to): the prices of its "long" assets would crash, possibly causing a chain reaction whereby other, even less-leveraged participants would become insolvent as well. So this was not good at all, and we shouldn't be patting ourselves on the back for being "good capitalists". In fact we were quite reckless.

Especially considering that this situation isn't new. Come to think of it, neither is this kind of spin. People have always said the same thing about the LTCM collapse, even with the benefit of considerable hindsight. That is the conventional wisdom: "the system handled it".

What happened then? Schematically, the same thing: a hedge fund got on the wrong side of massively over-leveraged bets), and the creditor and counter-party banks got together and worked everything out in backroom deals. The Fed was involved in this, by the way: it is said they "orchestrated" the "private" bail-out... though no one has explained what exactly this means.

[Historical note: the bail-out wasn't actually "private", since apparently the Fed forgave or accepted cash for a 400-tonne gold liability owed it by LTCM. That would explain why they got involved with LTCM but not Amaranth -- it is unlikely the banks themselves needed any convincing from the Fed to renegotiate LTCM's contracts, especially considering they run the Fed.]

So essentially what we have is this: as long as the entire system doesn't collapse, people will say it "works fine". And they'll actually be believing it!

I would suggest there is a major flaw in this logic: that maybe one day a problem will come along that the system won't be able to handle, even with backroom deals. Like, say, if all the key participants are already themselves over-extended (e.g. if they already have their hands full suing each other over defunct mortgage-backed securities).

Anyway, when and if that improbable situation occurs, the blase attitude towards the warning signs we've had for well over a decade might be regretted. If any of the people involved have a conscience, that is.