Toomre Capital Markets LLC

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WSJ: What Went Wrong at Amaranth

The Wall Street Journal on September 20, 2006 has posted an excellent article entitled What Went Wrong at Amaranth written by Ann Davis, Henry Sender and Gregory Zuckerman. Unfortunately, the WSJ is a $$$ subscription site and the full content of the article cannot be reproduced here. TCM nonetheless recommends all those readers that are interested in the Amaranth story read this WSJ article. The article starts as follows:

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 that involved profiting from small discrepancies in stocks and bonds.

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.

The phrase “repeatedly used borrowed money to double down on this bets” is frightening, especially for a hedge fund that touted its risk controls and measured approach to multiple-strategy investing. Apparently, Amaranth’s head energy trader, Mr. Brian Hunter, was focused on two primary strategies as the hedge fund assets shrunk from about $9.2 billion to approximately $4.5 billion. The first exploited the difference between the prices of natural gas contracts for delivery at various future points, in particular the “shoulder” months of March and April 2007, 2008 and 2009. The second strategy involved the purchase and sale of “out-of-the-money” options that would provide big payoffs if the price of natural gas were to shift by a significant amount.

Both strategies are supposed to be less risky than simply betting that volatile natural-gas prices will move either up or down.

In an interview on Aug. 29, when Mr. Hunter was still flying high with big paper gains, Amaranth founder and Chief Executive Nick Maounis contended that the natural-gas bets were designed to have minimal risk and maximum 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.

The article continues to explain that by early September, Mr. Hunter has become something of a contrarian. As gas prices declined, Amaranth reportedly held and even increased its bets that natural gas prices would rebound, either due to the prospect of a cold winter (increasing demand for natural gas for volumetric heating) or a hurricane or two would hit natural gas production facilities like Hurricane Katrina and Rita did in 2005 (thereby decreasing supply in the short term). Alas, prices fell even further as the passage time pointed to a meek 2006 hurricane season and NOAA issued a report indicating a more mild winter forecast due to “El Nino” effects in the Pacific Ocean. Other articles have suggested that natural gas prices also fell due to the increased inventories of natural gas in new or expanded storage facilities.

As Susan Mangiero writes about in the blog Pension Risk Matters, Amaranth Advisors seems to have devoted considerable resources to monitor, measure and manage risk (the 3 M’s of Enterprise Risk Management (“ERM”)). According to the WSJ article,

What Amaranth's systems hadn't measured correctly is how much downside risk it faced and what steps would be effective to limit losses. The risk models employed by hedge funds use historic data to figure out how much money a fund can make or lose from its positions across a wide swath of the markets. But the natural-gas markets have been more volatile this year than any year since 2001, so models might not accurately predict the possibility of big moves. They also might not predict how much selling of one's stakes to get out of a position can cause prices to fall and obliterate paper gains.

"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 investment advisory firm that invests in hedge funds on behalf of clients but had no money with Amaranth. "They were more leveraged than they realized."

Toomre Capital Markets is truly stupefied by how a supposedly sophisticated firm like Amaranth Advisors could fail in such a basic risk management function. Were not stress tests run regularly to assess what might happen if the natural gas “spread” trade were to go against the firm? After all, more than 50% of the firm’s capital was tied up in energy investments according to previous reports. Did no one model the “risk of ruin”? What happened to prudent standards such as money management and investment concentration? How the heck then was Mr. Hunter allowed to put on such concentrated spread trades that reportedly “lost a combined 30% last week.” Inquiring minds really would like to know about the who, what, when and why of the Amaranth Advisors story. Comments and thoughts are welcome.