What went wrong at Amaranth Advisors
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One of the mistakes that led to Amaranth Advisors' multibillion-dollar losses on natural-gas investments is a common one in fast-shifting energy markets: confusing paper trading gains with cash profits.
The hedge fund's chief energy trader, 32-year-old Brian Hunter, misgauged when to take his chips off the table, losing roughly $5 billion in a week for a hedge fund that boasted of world-class risk-management systems. While Amaranth had traded energy for several years, its roots were in convertible-bond trading, a different, less-volatile market.
According to natural-gas investors who traded alongside Amaranth, Mr. Hunter repeatedly used borrowed money to double-down on his bets. Buying more futures contracts of the kind his fund already owned supported their price by increasing demand, propping up paper gains, these traders say. But that support only lasted as long as Amaranth and its lenders were willing to spend cash to buy more contracts. Such trades may also have masked growing weaknesses in market fundamentals, his trading peers say.
As Connecticut Attorney General Richard Blumenthal vowed to investigate the losses, the once-mighty Greenwich-based hedge fund scrambled to explain to investors how risk controls went awry, cutting assets to about $4.5 billion, from $9 billion.
Working from Calgary, Alberta, Mr. Hunter employed a routine commodities strategy, exploiting the difference between the prices of contracts for delivery of natural gas at various future points. He also was buying options to buy or sell natural gas at prices that others in the market thought unlikely but that would provide big payoffs if the prices came to pass. Both strategies are supposed to be less risky than simply betting that prices will move either up or down.
In an Aug. 29 interview, when Mr. Hunter still had big paper gains, Amaranth Chief Executive Nick Maounis said his bets were meant to minimize risk and maximize reward. "Spreads and options are of their very nature instruments for positions which are designed to allow the user to capture upside with a much clearer understanding with respect to downside exposure," he said.
Mr. Maounis was unavailable Tuesday. In a letter to investors Monday, he said the fund so far had met all demands for more cash to back trades and was unwinding natural-gas bets "to preserve investor capital." An Amaranth spokesman declined to comment. Mr. Hunter has not responded to recent interview requests.
By early September, as prices fell precipitously because of a storage glut, Mr. Hunter held bets that would pay off exponentially only if natural-gas prices rebounded, either on the prospect of a cold winter or a nasty hurricane that hit natural-gas facilities. But as evidence pointed to a meek hurricane season and mild winter, prices fell more.
Amaranth's systems didn't appear to measure correctly how much risk it faced and what steps would limit losses effectively. The risk models employed by hedge funds use historic data, but the natural-gas markets have been more volatile this year than any year since 2001, making models less useful. They also might not predict how much selling of one's stakes to get out of a position can cause prices to fall.
"It was a total failure of risk control to put your entire business at risk and not seem to know it," says Marc Freed, a managing director at Lyster Watson & Co., an advisory firm that invests in hedge funds for clients but not with Amaranth. "They were more leveraged than they realized."
Commodities trades require less margin money -- collateral to be surrendered in case of losses -- upfront than other markets. On the main exchanges, traders typically post 10 percent of their position's value, whereas in the stock market, 50 percent is common.
So say, for example, gas is trading at $7 per million British thermal units and a trader buys one contract to buy or sell 10,000 million-BTUs for $70,000. That trader posts just $7,000 to make that bet. If the price of gas goes down 10 percent, the trader has to post another 10 percent, or $7,000. The trader now has $14,000 tied up in the market, and the value of his position has dropped to $63,000.
Compound that with generous lines of credit from banks, and it is easy for commodity hedge funds to get highly leveraged quickly.
Funds like Amaranth are able to borrow three to eight times their initial capital to make bets thousands of times over. Mr. Hunter sometimes held 100,000 positions in a single contract, say traders familiar with his bets.
The volatile trading that distinguished Mr. Hunter was a departure for Amaranth. Denis Joseph, Amaranth's senior vice president for human resources until 2004, said Mr. Maounis, the CEO, sought to centralize oversight of traders and to keep big discretionary trading authority on the fund's Greenwich trading floor. After big gains in 2005, Mr. Hunter was allowed to trade from Calgary. "To have a relative newcomer ... receive so much discretion is just shocking to me," Mr. Joseph said.
Still, the fund's high returns from energy last year and earlier this year were popular with its investors. When Amaranth reported returns of roughly 12 percent in April, it told investors most of that profit was from energy trades. After Amaranth lost about 10 percent in May, or roughly $1 billion, mainly on energy trades, it told some investors that it was cutting back on leverage in the energy market, the investors say.
Mr. Hunter's bets ultimately went bad because he misjudged the movement of the difference between prices for different month contracts, known as the spread. People familiar with the trades say he bet prices for nearby-month contracts months would fall and winter contracts would rise. These people say he also presumed gas might be scarce in March if use was heavy this winter and prices would then fall off in April.
Meanwhile, Amaranth's investors are tallying up their losses. One of Morgan Stanley's funds-of-hedge-funds, a $2.3 billion fund, had about 5 percent of its investments in Amaranth, as of June 30. A spokeswoman wouldn't comment. Goldman Sachs Dynamic Opportunities Ltd., a hedge-fund vehicle listed on the London Stock Exchange since July by Goldman Sachs Group Inc., said it may post a 2.5 percent to 3 percent loss in September from its Amaranth holding. The $7.7 billion San Diego County Employees Retirement Association last year placed $175 million in Amaranth. "We're extremely disappointed," said Brian White, its chief executive.
Fortunately for its investors, Paloma Partners, a $2.2 billion Connecticut firm, withdrew its money from Amaranth in late 2004, saying firm had grown too large.
Now other institutional investors are trying to do likewise. Hedgebay Trading Corp., a secondary market for trading hedge fund stakes, was inundated with calls from burned investors wanting to sell Amaranth stakes and bottom fishers looking to buy.
"Sellers want 30 to 40 cents on the dollar, but buyers are only willing to pay 10 cents to 20 cents on the dollar," said Hedgebay founder Jared Herman.
First Published September 20, 2006 12:00 am