The Wall Street Journal’s big story this morning on how Citadel and J.P. Morgan bought out Amaranth’s energy positions and then flipped them back onto the market is a great uncovering hidden value tale. It’s also a good illustration about how risk tolerance differs for different market actors—Citadel and JP Morgan could tolerate holding the troubled Amaranth positions in part because their size allowed them to make additional investments to hedge against the risk. The best ‘graphs are toward the end of the story.
Citadel and J.P. Morgan employed their risk-management systems to estimate the investments' value. Their conclusion: Once transferred from Amaranth, the trades would be more valuable than the market assumed. The new owners would be able to hold them until they proved to be winners, in part because each was bigger than Amaranth and so could afford to wait. J.P. Morgan and Citadel also felt they could hedge, or reduce the risk of the trades, through other investments.
Working with Amaranth's traders, they concluded that enough collateral remained to back the investments, so they could be assumed. The collateral totaled $2 billion, people familiar with the situation said. Along with the investments, that money was transferred to J.P. Morgan and Citadel.
To reduce some of their risk, the partners immediately moved to sell some of the investments after concluding that the energy market wasn't buckling, despite worries about ripple effects from Amaranth's woes. Willing buyers quickly emerged. Some were J.P. Morgan's investor clients. Others were traders on the other side of Amaranth's bets eager to cash out and pocket their winnings.
Within days, the firms had sold enough of the portfolio to shift more than 50% of its risk to others, according to someone close to the matter.
Both Citadel and JP Morgan are generally being treated as knights in shining armor who rescued Amaranth investors (and perhaps the broader commodities markets) from even worse losses. But we're sure somewhere in the back of his brain Amaranth energy trader Brian Hunter must have watched those traders flipping his investments and thought "sharks in the water."
How the Wreck From Amaranth Was Contained [Wall Street Journal]