Contrast Amaranth and Goldman’s Leverage and Daily VAR
The excellent blog NakedShorts writes about The wind beneath the market's wings and the increase in both risk and leverage that Wall Street has experienced since the end of 2001. Goldman Sachs is referenced as an example. According to its latest reporting date in May 2006, Goldman had “$32 billion of equity to support $799 billion of assets”, and its daily value-at-risk (“VAR”) “is up by 136 percent (and by 21 percent since only last summer, to $92 million from $76 million).” This works out to a leverage ratio of just slightly less than 25.
Contrast these Goldman numbers with those of Amaranth Advisors, which TCM previously covered in this post and this one. According to this Bloomberg article, Amaranth Advisors reported a leverage ratio of approximately 4.3 in June 2006. Assuming that this leverage ratio remained constant, Amaranth peaked with assets just slightly less than $40 billion at the end of August 2006 (4.3 leverage times $9.25 in assets). The interesting question is what was Amaranth’s daily VAR?
As TCM has pointed out previously, daily VAR attempts to assess the magnitude of what can be lost if an unlikely event were to occur. Many market participants have adopted the convention of measuring potential losses at the 99% confidence interval. In other words, 99 times out of 100 the realized daily P&L is expected to be less than the daily VAR number (either to the upside or on the downside). Amaranth took approximately 80 trading days to make $2 billion through the end of April and approximately 20 trading days then to lose $1 billion in May 2006. Hence, its daily VAR in June has had to exceed at least $50 million. Amaranth also took twelve trading days to lose a reported $4.44 billion through September 18th or a daily average of close to $370 million. Further, when the sale of the energy book was announced on Wednesday the 20th, the losses swelled to $6 billion and the average daily loss for September expanded to $420 million per trading day!!
If the risks in the Amaranth Advisors portfolio(s) had been modeled correctly, using the 99% percentile confidence interval, the daily VAR for Amaranth had to exceed $400 million or approximately 1% of assets. Contrast this with Goldman’s VAR which was 0.012% of assets and 0.3% of equity. Did the investors in Amaranth Advisors understand that this hedge fund group was more than 10 times ($400 VAR/$9.25 billion assets = 4.3%) risky than Goldman Sachs’ 0.3%? Remember some people regard Goldman Sachs as no more than a hedge fund in disguise? It will be very interesting to eventually learn just what the daily VAR of Amaranth was throughout this debacle. Comments and thoughts are welcome.