In Washington, the Wall Street moneymen are at it again, waging behind-the-scenes battles against a host of new rules to prevent another financial crisis. Some of the fiercest fights are over limits on derivatives trading, including complex derivatives linked to commodities. Regulators, legislators and judges inclined to sympathize with the industry ought to rush out and buy a copy of Barbara Dreyfuss’s “Hedge Hogs,” a wonderfully instructive tale about Amaranth Advisors, a nearly $10-billion hedge fund brought down by the recklessness and arrogance of a single commodities trader.
The rise and fall of Amaranth turns out to be just the latest chapter in a story that, in the modern era, begins with Drexel Burnham Lambert in the 1980s, extends through Barings and Long-Term Capital Management in the 1990s and on to Enron, Lehman Brothers and AIG in 2000s. It is the story of financial markets that have long since forsaken their legitimate function to efficiently allocate capital to the real economy, turning themselves instead into casinos rigged to favor traders and money managers. It is the story of senior industry executives who refuse to rein in what they know to be dangerous risk-taking because of the spectacular short-term profits it generates. And — apropos of the current battles in Washington — it is the story of regulators and legislators who allow themselves to be captured by the industry they are meant to supervise.
Few people have probably ever heard of Amaranth Advisors, and in the six years since the fund’s implosion, most of those have probably forgotten about it. Dreyfuss’s book, however, is a reminder that the only way to get to really understand these Wall Street disasters is to wait until the lawsuits and congressional hearings and administrative proceedings have played out and the normally tight-lipped bankers and traders have been forced to testify under oath. Dreyfuss, a Wall Street analyst turned investigative journalist, not only plowed through what turned out to be a treasure trove of official records and transcripts, but supplemented it with plenty of her own reporting. She manages to organize it all into a tight, riveting and understandable yarn.
“Hedge Hogs” is the story of two traders. One is Brian Hunter, a Canadian who began trading natural gas futures at Deutsche Bank, just as the market was recovering from the Enron debacle. Hunter’s career was controversial almost from the start, with bosses claiming he misrepresented the value and riskiness of his trading positions and Hunter complaining that his bonus was too small. When Amaranth went looking for commodities traders in 2004, Hunter was eager to jump, establishing himself almost immediately as the fund’s star trader. Within a year he was in a position to command a $8.5-million bonus, a $10-million retention fee and a guarantee of 15 percent of any future profits he earned. More ominously, he extracted a promise from the fund’s founder that he could move back to Calgary, where he could control his own portfolio without interference from mid-level executives or risk managers.
The other trader in Dreyfuss’s tale is John Arnold, who earned a reputation as the nation’s top natural gas trader while at Enron. As the energy company was beginning to implode, it was Arnold’s huge trading profits that allowed it to cover up its mounting losses in other areas. And as Enron slid into bankruptcy, it was Arnold who infamously negotiated a $5-million retention bonus for himself while thousands of his colleagues were losing their jobs, their pensions and their life savings.
By the spring of 2006, Arnold was running his own hedge fund when he began to notice inexplicably high prices for natural gas contracts for the following year. Anytime the price started to fall, huge buy orders would hit the market to move prices higher again. According to chatter among the traders, the buyer was Hunter, and the speculation was that, in the process of propping up the market, he had amassed a position so huge that he couldn’t sell out without triggering a dramatic drop in price. In other words, Amaranth was stuck.
In fact, it was later revealed that Amaranth at various points controlled 50, 60, even 70 percent of outstanding contracts for certain months. By manipulating the market on the way up, he had generated billions in paper profits for Amaranth and huge bonuses for himself. But by the time Amaranth’s top executives realized the risk he had taken with fully half of the fund’s capital, it was too late. Arnold and a pack of other profit-hungry traders set Amaranth up for a classic squeeze, driving down prices and forcing the company to come up with billions of dollars in additional collateral for its highly leveraged positions. In the end, it didn’t matter whether Hunter was right or wrong about spring prices — once the market turned against it, Amaranth had no choice but to sell its position at a huge loss and close its doors. Unsuspecting investors who thought they had put their money in a low-risk, diversified fund were lucky to recoup half of their original investment.
While Dreyfuss lets this tale unfold, she does an artful job of weaving in the history of the hedge fund industry and how the energy and derivatives markets came to be largely unregulated. She provides ample evidence of how these markets are routinely manipulated by a handful of trader-speculators to the detriment of energy consumers. She exposes the hypocrisy of hedge fund executives who make false and extravagant claims about their risk management. And she raises serious questions about public pension funds which have rushed to invest so much of the nation’s retirement money in high-risk, high-fee hedge funds that can no longer deliver on their marketing hype.
Almost as revealing as the story of how Amaranth got into trouble is the story of how it got out of it. After an agreement was struck to sell Hunter’s gas portfolio to Goldman Sachs at a discount of $1.85 billion below the already depressed market price, Amaranth’s prime broker and lender, J.P. Morgan Chase, refused to sign off on the deal, for no other apparent reason than that it saw an opportunity to squeeze a dying customer. In the end, Amaranth was forced to sell the portfolio at an even steeper discount to Morgan and another hedge fund. Morgan quickly flipped its stake for a $725-million profit.
As for Hunter, you might think he would have headed back to Calgary with his head bowed and his pockets empty, but that’s not the way it works on Wall Street. As Dreyfuss reports, Hunter walked away from the Amaranth wreckage with enough money to complete construction of a new $2-million house and start a new hedge fund that quickly received pledges of $800 million from outside investors. The whole cycle might have started all over again if the government had not finally charged Hunter with several counts of market manipulation in connection with his Amaranth trades.
As for Arnold, the publication Trader Monthly estimated that he personally earned between $1.5 billion and $2 billion from putting the squeeze on Amaranth, sending him to the top of the list of hedge fund traders in 2006. Three years later, Arnold made a rare appearance before commodities regulators to urge them not to impose additional curbs on commodity trading, claiming that speculators like himself had the effect of stabilizing markets and lowering energy costs for consumers.
Sound familiar? It is the same arguments the Wall Street moneymen are making today.
The Cowboy Traders Behind Wall Street’s Largest Hedge Fund Disaster
By Barbara T. Dreyfuss
Random House. 285 pp. $28