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Amaranth’s Anomaly -or- When Hedge Models Go Awry
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(September 24, 2006) Chevron announced on September 6th a potential 15 billion barrel oil discovery deep in the Gulf of Mexico. That same day a total rout in prices of oil, metals, and natural gas began. Soon thereafter, a hedge fund died of natural gas causes.
The collapse of the Amaranth Investors hedge fund is a tremendous story. Somewhere, actual professional writers are negotiating contracts for books to be written about it. This story has so many angles to pursue, lessons to convey, morals to illuminate, and human and market dramas to exploit.

Unfortunately, what you will get here is just an outline, with a cheap ending tacked on.

To begin: September of 2006 so far has seen a tremendous tumble in commodity prices, further correction in gold prices, more evidence of a weakening housing market, gasoline down 50c a gallon or so at your local pump, the Dow back near its record highs of 2000, and a substantial correction in natural gas prices running concurrently with the $5 billion in natural gas market trading losses sustained by one 32-year old Brian Hunter, former math whiz and trading genius employed by a once highly-regarded Connecticut hedge fund known as Amaranth Investors.

The fund’s losses came from a complicated web of long and short positions that Mr. Hunter was trading in both near-term and distant contracts for delivery of natural gas. There is evidence that the enormous magnitude of his maneuvers in some of the more thinly-traded contract months were simply out of proportion to the liquidity that can be sustained in some of the less-traded contract.

At any rate, the market which he had played so skillfully for over a year started to go against him. As the behavior of the natural gas market began to deviate from the norm that Mr. Hunter had so carefully modeled, there are indications that he ‘doubled down’ rather than abandoning losing positions. The natural gas market continued to behave contrary to his models, and in five short days the fund was out some $5 billion.

As in the collapse of the Long Term Capital Management hedge fund, the Amaranth debacle was a case of experienced market geniuses, who thought they had it all figured out, but were ambushed by an unanticipated alignment of market events. Despite their supreme confidence that every possibility had been factored into their computer model, the impossible, or at least, the unimaginable happened, and a fortune was lost.

The problems at Amaranth Investors seemed to catch everyone’s attention. The New York Times Business Day section on September 19 ran an article by Gretchen Morgenson and Jenny Anderson headlined, “A Hedge Fund’s Losses Shakes Wall Street.”

Their article led with this sentence:

“Enormous losses at one of the nation’s largest hedge funds resurrected worries yesterday that major bets by these secretive, unregulated investment partnerships could create widespread financial disruptions.”

The Wall Street Journal ran successive multiple stories on 9/19 and 9/20 about the young Mr. Hunter, his background, and how he was able to single-handedly cost the Amaranth Investors funds $5 billion in one week of unfortunate natural gas trading. The whole fund was only worth some $9.5 billion to start with, with sort of begs the question: What was so ‘hedged’ about it, if one 32-year old trader could slice its net worth in half in five days?

As James Hardy pointed out in a commentary posted by the Times of London, entitled, “Hunter Brought Down by Big Game,”

“For Amaranth, among its other flaws, was not transparent about the risk that Mr.Hunter posed to its investors: they had put their money in something called Amaranth Multi-Strategy Funds, which implied a diversification of risk. In fact, they were putting nearly all their eggs in one basket, Mr Hunter’s bet on natural gas.”

So what is a hedge fund? Basically, a hedge fund is a pool of money put together by qualified investors (i.e., rich people who can afford to take complete risks) and put under the control of a group of traders and/or analysts, usually of a mathematical background, and often armed with enormously complicated computer programs designed to exploit anomalies in various markets to the benefit of the fund’s investors and operators.

The ‘hedge’ label implies a promise that the fund is market-neutral, without bias except towards the goal of profits. Hedge funds are free to trade anything, anywhere -long or short or both, stocks, bonds, mutual funds, commodities, currencies, futures, options and the whole range of exotic derivatives upon derivatives continually being invented for the sophisticated and nimble trader. Such funds operate, according to “The Dark Side of Debt” in the Economist of 9/23, in a “computer-enhanced frenzy of creativity…in today’s caffeine-fueled dealing rooms…”

Of course, biases against hedge funds abound. Because they are run by young hotshots (Mr. Hunter supposedly took home nearly $100 million in 2005), and benefit the enormously rich, and are so large and powerful in their effects on markets, hedge funds are naturally objects of suspicion. And increasingly, hedge funds are targets for government regulators who may not understand them, but are not adverse to attempting to promulgate rules to fence them in.

Predictably, the New York Times op-ed pages on Sunday, September 24th, call for some good old-fashioned regulations to rein in these financial cowboys. Their editorial, entitled “Regulating Hedge Funds,” stated that hedge funds, shamefully “unregulated,” have “infiltrated every corner of every market,” making markets “vulnerable to a debilitating chain reaction.”

All true enough, of course. But life is not risk-free, and it is not desirable, or even possible, to control financial activities among consenting adults, no matter how mysterious and exotic such behavior may appear. But according to the NY Times, “…regulators need to act now to translate their various calls for hedge-fund oversight into enforceable concrete rules and, in some instances, into concrete proposals for Congress to enact.”

The NYT editorial concludes with a rhetorical question: “Policy makers know that hedge funds cannot adequately police themselves. What are they waiting for?”

For good or for ill, that is a question that Elliot Spitzer and a host of other ambitious bureaucrats and politicians are asking themselves right now. The desirability and efficacy of some sort of oversight and regulation of these complicated markets is a given among those who with a straight face can say, “I’m from the government and I’m here to help you.”

By trusting one trader with a staggering amount of loot, Amaranth Investors cost itself quite a fortune. But trading is a zero-sum game. Amaranth’s lost $5 or $6 billion did not disappear off the face of the Earth. That money was in no sense ‘lost’ to the good devices of the human race. It was simply transferred to more fortunate or capable traders or, possibly, hedge-fund operators.

Saskia Scholtes of the Financial Times, in her article of 9/24/06 entitled “Lessons of the Amaranth Meltdown” points out that investors in Amaranth included Morgan Stanley, Credit Suisse, Deutsche Bank and Goldman Sachs. Her rhetorical questions are much more pertinent than that of the NY Times:

“How were all these supposedly sophisticated, expert investors persuaded to put their clients’ money into a fund with such a perilous risk position? Where was the due diligence?”

Indeed. Even so, it's hard to shed tears for the likes of Morgan Stanley and Goldman Sachs, who after all are big boys who have been around the block - they can take it. But reportedly the San Diego County Pension Fund also has a stake in Amaranth.

So to the retirees and expected future retirees of San Diego County, what can you say, except, “Welcome to the NFL.

 

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