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Here's a nifty business: Lend a hedge fund gobs of money so it can place huge bets. Make your own trades based on your knowledge of the hedge fund manager's strategy and your hunch that he's out on a limb. Then, when the fund blows up, swoop in and buy remnants of the business for pennies on the dollar.
In a nutshell, that characterizes Wall Street's relationship with Amaranth Advisors, the Greenwich (Conn.) hedge fund that lost some 65% of its $9.2 billion in assets when its natural gas trades went south. As of Sept. 27, Amaranth's investors were pressing for total liquidation. The fund's major losses took place in mid-September, but Wall Street traders on the other side of Amaranth's bet on higher gas prices were prepared for the fall. Amaranth "got trounced," says Bill Gruzynski, portfolio manager for Emerald Strategies, a managed futures firm in Chicago. "People started to smell blood and pushed the market against them."
Banks won't divulge much in the way of numbers, but it looks as though Amaranth's loss was Wall Street's gain. "Plenty of people knew [Amaranth] had this position, and anyone trading on the other side said: 'If we knock the price down and force them to sell, we [can] profit from the short sell,"' explains a manager of a large fund of hedge funds. Short-selling is a bet that the price of an asset will fall. "This," he says, "is what the world does to each other all day long in the futures business."
Amaranth's traders lost money because they expected natural gas to climb. When prices turned, producers dumped supplies on the market, accelerating the rout. Since Amaranth leveraged up its futures bets even more by borrowing money, losses came fast. "You're overleveraged, everyone knows it, and they move against you," says Jay Gould, a securities lawyer at Pillsbury Winthrop Shaw Pittman.
Then, with Amaranth in meltdown mode, banks moved in to see what assets they could get on the cheap. Amaranth "shopped their portfolio around widely," says one securities firm spokesman. There were several bidders for what was left of Amaranth's energy trading portfolio; ultimately, JPMorgan Chase & Co. (JPM
) and Citadel Investment Group in Chicago won out. Citigroup (C
) is still in negotiations to buy other pieces of the business.
The list of players with ties to Amaranth reads like a Wall Street who's who. From wealth management to lending, the very biggest banks kept plenty of tabs on Amaranth and had an opportunity to decode its tactics. Even if some banks suffer losses in their fund of funds investments, their other operations might benefit. Says Mitchell E. Nichter, a securities lawyer and partner with Paul, Hastings, Janofsky & Walker in San Francisco: "Wall Street is willing to absorb losses as a cost of doing business."ORDERLY EXITS
While it's no solace to Amaranth investors, the fallout of this fund, unlike the 1998 Long-Term Capital Management debacle, has been fairly well contained. Even though Amaranth was bigger in dollar terms, banks' exposures to LTCM were more concentrated. And investors were allowed to yank funds early, perpetuating a run on the fund.
Since the LTCM days, banks have grown increasingly adept at using derivatives to hedge their investment exposures. What's more, contracts with lenders and investors lock up money longer, preventing a domino effect. And the explosion of hedge funds since 1998 -- tripling to some $1.2 trillion in assets worldwide -- has allowed Wall Street to diversify its risks better. "The industry is definitely evolving and becoming more institutional," says Karan Sampson, director of hedge funds at Greenwich Associates, a research and consulting firm for the industry. "It's no longer just a portfolio manager and a trader." Explains Nichter: "Every time [banks] run into a situation they hadn't thought of before, they tighten up their risk-monitoring process." By Mara Der Hovanesian