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Hedge-Fund Hardball: Amid Amaranth's Crisis, Other Players Profited

On Tuesday, January 30th 2007, The Wall Street Journal published an excellent article on the Amaranth meltdown entitled Hedge Fund Hardball written by Ann Davis, Gregory Zuckerman and Henny Sender. (Toomre Capital Markets LLC previously has commented on Brian Hunter and Amaranth Advisors as summarized by this listing.) The article begins with the following section:

When Amaranth LLC collapsed in the fall, after swiftly losing more than $6 billion, it was the biggest hedge-fund failure ever. Now as investors slowly get back what's left of their money, it's becoming clear the debacle also had some big winners: other players in the high-stakes energy market who profited from a crippled rival's travails.

The final agonies of Amaranth, described by dozens of people close to the roller-coaster negotiations about its fate, began on Friday, Sept. 15. Bleeding cash and facing a Monday demand for money it didn't have, Amaranth scrambled through an intense weekend to find someone who would take over losing energy investments for a price.

It did negotiate a rescue plan, requiring it to pay nearly $2 billion to Goldman Sachs Group to take toxic trades off its hands. Strapped for cash, Amaranth aimed to get the money to do the deal by using cash collateral on deposit with its middleman for natural-gas trades, J.P. Morgan Chase & Co.

But on Monday morning, just after Amaranth had told its investors a rescue was close, J.P. Morgan said it wouldn't release the collateral. The firm was effectively responsible for making sure parties to Amaranth's trades got paid, and it said the rescue plan didn't free it of this risk, according to people familiar with its stance. J.P. Morgan's refusal killed the plan. Amaranth's situation went from dire to desperate.

Two days later, J.P. Morgan itself agreed to take over most Amaranth energy positions. With a partner, it cut a deal that turned out to be lucrative for J.P. Morgan -- earning it an estimated $725 million -- but more painful for its longtime client, Amaranth.

Hedge funds are among Wall Street's biggest customers, and the Street gives them red-carpet treatment as the fees roll in. But the Amaranth case shows how Wall Street dealt with a fund after it had traded its way into a deep hole. Information the fund revealed about its holdings as it grasped for a lifeline let other commodity-market players, Wall Street firms included, exploit its positions. As they drove prices relentlessly against Amaranth, its losses swelled, and instead of facing a big but possibly survivable setback, it collapsed.

Amaranth's case also reflects an incentive structure in the world of hedge funds that can tempt some to assume heavy risk. Typical of hedge funds -- private investment pools for the wealthy and institutions -- Amaranth took 1.5% of investors' assets as a management fee each year, plus 20% of investment gains. This 20% fee is calculated on gains recorded at year end, including gains not nailed down by closed trades. From this take, traders at many firms, such as Amaranth, are given bonuses that are largely theirs to keep, even if the paper gains later shrink or vanish.

"This results in a huge incentive for taking risk," says Luis Garicano, a University of Chicago business school professor. "When the bet goes well, the hedge-fund manager collects a lot, while when it goes badly the worst that can happen to the loser is he gets zero."

At Amaranth, star energy trader Brian Hunter won an estimated $75 million bonus after his team produced a $1.26 billion profit in 2005. Like many others at the fund, he had to keep about 30% of his pay in the fund. The fund's chief risk officer, Robert Jones, got a bonus of at least $5 million for 2005, say people familiar with the bonuses. Nicholas Maounis -- founder, majority owner and chief executive of the Amaranth management firm -- got an estimated $70 million cut of 2005 management fees, plus some of Amaranth's $200 million-plus in performance fees. He kept much of his compensation in the fund.

Asked to comment, a fund spokesman said, "It would be inadvisable for Amaranth to speak on the public record ... at this time. While no litigation has been threatened or commenced against Amaranth, regulatory inquiries continue and litigation remains possible." He said, "Mr. Maounis's No. 1 priority is the continued disposition of the Amaranth portfolio and distribution of capital to investors."

Unfortunately, the rest of this article is available on the subscription-required Wall Street Journal website and in the day's physical newspapers. However, for those readers interested in hedge funds, the capital markets and/or enterprise risk management, Toomre Capital Markets LLC highly recommends reading the entire article. The last closing paragraphs contain stunning information about how the various parties profited and lost from the Amaranth meltdown:

The three firms that were paid hundreds of millions of dollars to take over Amaranth trades -- Merrill Lynch, Citadel and J.P. Morgan -- soon reported significant profits on energy trading. J.P. Morgan made at least $725 million, partly by quickly selling many of its new positions to Citadel.

The Amaranth deal produced a "very nice increment to fixed-income trading," Mr. Dimon, J.P. Morgan's CEO, said in a speech in November. "But we did take a lot of risk."

Bill Winters, co-head of J.P. Morgan's investment bank, said at a November conference that through its hedge-fund relationships, such as trade clearing, "we have the insight into what's going on in these funds" and can "respond quickly to opportunities when they come up. Amaranth was one obvious example of that."

He added, "I imagine there will be others...where our ability to be both on the inside, but not compromised, is extremely powerful [as a way] to generate profits."

The huge, complex deal with Amaranth helped build J.P. Morgan's profile as a commodities player. This month, a magazine called Risk named the firm "Energy Derivatives House of the Year."

How much the investors in Amaranth will lose depends on when they got in. They've gotten back about $1.6 billion to date. For one investor that came in in mid-2005, money returned so far comes to 27% of what it put in and about 18% of what its stake was worth at the peak. Investors will receive somewhat more when Amaranth finishes liquidating.

Some investors have a keepsake. Amaranth once sent chess sets as year-end gifts, inscribed with a quotation from the late grandmaster Alexander Kotov: "It often happens that a player carries out a deep and complicated calculation, but fails to spot something elementary right at the first move."