Hedge Fund's Collapse Met With a Shrug

By Steven Mufson
Washington Post Staff Writer
Wednesday, September 20, 2006

When the high-powered Long-Term Capital Management hedge fund imploded in 1998, two dozen of Wall Street's most powerful bankers and brokers assembled with the New York Federal Reserve governor to devise a $3.5 billion bailout plan to prevent a bout of panic selling in world markets.

But this week, when the Greenwich, Conn.-based hedge fund Amaranth Advisors LLC announced that it had suffered losses just as big as LTCM's, markets shrugged. There were no summit meetings at the New York Fed. J.P. Morgan & Co. and Merrill Lynch & Co. quietly took over and started selling off Amaranth's portfolio of ill-timed natural gas futures. The major damage is expected to be felt by people wealthy enough, and foolish enough, to have invested in Amaranth.

"There's no systemic risk. The market can absorb this," said Peter Fusaro, co-founder of the Energy Hedge Fund Center, which tracks 520 energy hedge funds. "It's a hiccup."

The reasons for the difference? LTCM borrowed heavily, and it lost badly on a roughly $1 trillion position in currency and Treasury markets. Its failure threatened the stability of banks, and a fire sale of its assets would have hit securities held by almost every fund and investor.

Amaranth also engaged in rash trading, hedge fund managers and commodities traders said. But it borrowed less heavily, and its positions were smaller and focused mostly in natural gas futures. As a result, the firm's downfall has made barely a ripple in broader markets.

"No one got hurt except sophisticated people," said the manager of another multibillion-dollar hedge fund, who spoke on condition of anonymity to preserve his business relationships. "They took fliers. They made money. They lost money."

They lost a lot of money, almost entirely in a natural gas market that gets tossed about by geopolitical anxieties, the vagaries of weather and the limits of an unwieldy storage system for the fuel.

To many investors, the failure of Amaranth feels more like a serious case of indigestion than a hiccup. Over the past five years, the amount of money invested in hedge funds engaged in energy trading has soared, from about $5 billion to more than $100 billion, according to some estimates. Those investors include not only wealthy individuals, but also endowments and pension funds seeking to diversify out of traditional stocks and bonds.

While most of those investors realize that trading in energy markets is risky, Amaranth's plunge is a reminder of just how risky it can be. Amaranth's co-founder and chief executive, Nicholas Maounis, said in a letter to investors that the fund was "aggressively reducing our natural gas exposure" to meet payments to creditors. He said that the fund, which was up sharply in August, would be down 35 percent for the year after the sell-off.

Amaranth's downfall also bears unsettling similarities to the failure of LTCM. Both firms engaged in spectacularly large wagers, taking up such big portions of their markets that it became difficult for them to unravel their positions. Like LTCM's Nobel Prize winners and other stars, Amaranth's partners possessed a confidence built on past success and untroubled by the possibility of failure. The company bragged on its Web site of "moving nimbly and effectively within an ever-changing investment landscape" and said that its employees "possess fearlessness with respect to complexity, learning, as well as invention, and continuously strive for perfection." Maounis, a convertible-bond trader, said he had chosen the company's name, which means "unfading" in Greek.

Yet experts in commodities trading and natural gas markets said yesterday that Amaranth, which had $9 billion in assets just three weeks ago, had been far from perfect. It had allowed one of its star traders, Calgary-based Brian Hunter, to take huge positions in natural gas. According to the Wall Street Journal, which interviewed Hunter earlier this year, the 32-year-old trader was up $2 billion for the year at the end of August.

To make that much, Hunter must have had "an unconscionably large position for this market," said a hedge fund manager with years of experience in commodity markets who spoke on condition of anonymity for business reasons. A firm such as Goldman Sachs Group, one of the biggest players in energy markets, would typically take positions less than a tenth as big as Hunter's, traders said. One veteran energy trader said Hunter's positions were often twice as big as the next biggest.

Amaranth and Hunter declined to comment for this article.

Natural gas traders said Hunter took risky positions, too. He bet that the price of winter natural gas would rise and that the price of summer gas would fall -- the opposite of what has happened. He also bet that the gap between the March 2007 natural gas price and the April 2007 would increase. Instead, it fell from about $2.60 per 1,000 cubic feet to about 80 cents.

Earlier this year, Harry Arora, a former Enron Corp. energy trader who had hired Hunter at Amaranth, had a falling out with Maounis and Hunter over the risks the firm was taking, say people familiar with the situation. Maounis, impressed that Hunter made hundreds of millions of dollars for the firm in 2005 after Hurricane Katrina sent natural gas prices soaring, made the young Canadian a co-head of commodities trading.

In addition, he let Hunter increase the size of his natural gas positions so that they became more than half of the entire firm's exposure, even though Amaranth claimed to be a "multistrategy" fund. Before Hunter's arrival, all commodities positions made up about 20 percent of Amaranth's portfolio, natural gas no more than 7 percent.

The size of the positions that Amaranth was letting Hunter take was no secret. It was disclosed to investors, such as major investment banks that included stakes in Amaranth as part of their "funds of hedge funds." Typically, the investment banks market their expertise in choosing the best hedge funds. Yet Morgan Stanley, for example, invested $126 million, or about 5 percent, of its $2.3 billion fund of hedge funds in Amaranth. Without naming Amaranth, Goldman Sachs Dynamic Opportunities Ltd., another fund of hedge funds, said yesterday that "significant" losses on an energy-related investment would shave as much as 3 percentage points off its return this month.

Amaranth's fall is almost certainly going to come under scrutiny from members of Congress who advocate federal oversight of the essentially unregulated hedge funds, especially as the $1 trillion sector opens its doors to more investors.

Just last week, New York Fed Governor Timothy F. Geithner expressed concern about the ability of hedge funds to take on a lot of leverage without disclosing it. And he warned that hedge fund failures could hurt market participants other than those investors and lenders who have chosen to do business directly with those funds. In a speech delivered in Hong Kong, Geithner said the growth in hedge funds "will force us to consider how to adapt the design and scope of the supervisory framework to achieve the protection against systemic risk that is so important to economic growth and stability."

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