Once in Morgan's hands, Amaranth's losing trades became winners overnight

How the Wreck
From Amaranth
Was Contained

J.P. Morgan and Citadel
Swooped In, Assumed Risk,
Proving Markets' Resilience

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By Gregory Zuckerman
The Wall Street Journal
Thursday, October 5, 2006

As Amaranth Advisors scrambled to unload its sinking energy investments last month, here is what potential bidders saw:

There were thousands of complicated contracts at the Connecticut hedge fund to buy and sell natural gas, power generation and oil in increasingly jittery markets across the globe. Though some were regulated by futures exchanges, others were one-on-one deals with two dozen or so banks and other investors. Some were in markets with relatively few buyers and sellers, making them vulnerable to big price moves.

In other words, this multibillion-dollar transaction looked like it wouldn't be easy to accomplish quickly without causing broader market turmoil. Yet J.P. Morgan Chase & Co. and hedge fund Citadel Investment Group LLC managed to smoothly assume Amaranth's energy portfolio in under 48 hours.

How they did it illustrates the global markets' resilience to massive blowups at a time when some other hedge funds are struggling.

The transaction was a two-step process, people familiar with it said. J.P. Morgan's bankers and Citadel's portfolio managers first raced to estimate the value of Amaranth's investments -- a difficult task, given the illiquidity of some of the markets the hedge fund focused on. Derivative trades -- contracts whose value rises and falls based on an underlying asset's price -- aren't like stocks and bonds. How much is an asset worth if there is a paucity of investors regularly trading it?

Then they spent a furious day persuading those two dozen or so counterparties to rip up their derivative-trade contracts with the struggling hedge fund and sign agreements with the new owners, and then transfer the portfolio to them. Along the way, J.P. Morgan and Citadel hashed out their own agreement to share the deal's risk and potential upside.

The frenzy began in mid-September, when Amaranth realized its losses were so deep that it needed to unload its energy investments to meet demands for additional collateral to back its investments and to avoid a credit cutoff. The firm eventually reported losing upward of $6 billion of its $9 billion or so under management, mostly from bad natural-gas bets. If it couldn't get rid of the energy investments, Amaranth might have been forced to close its doors immediately.

By Sept. 17, the firm had invited several parties, including some investment banks, to bid for its energy holdings. There was limited interest, in part because of how complicated and large the investments were. Citadel and J.P. Morgan, however, were amenable. Both have gotten more involved in energy trading in recent years, despite the market's ups and downs.

Some of Amaranth's derivative trades wagered that prices for natural-gas futures contracts for March 2007 would be much higher than those for April 2007. Other such so-called spread bets involved other months' prices.

As Citadel and J.P. Morgan examined these investments and others, their value was continuing to plummet. The team had to quickly assess the risk of further losses. The spread trades weren't working out, for example, because natural-gas prices were weakening amid a glut of reserves.

Citadel and J.P. Morgan employed their risk-management systems to estimate the investments' value. Their conclusion: Once transferred from Amaranth, the trades would be more valuable than the market assumed. The new owners would be able to hold them until they proved to be winners, in part because each was bigger than Amaranth and so could afford to wait. J.P. Morgan and Citadel also felt they could hedge, or reduce the risk of the trades, through other investments.

Working with Amaranth's traders, they concluded that enough collateral remained to back the investments, so they could be assumed. The collateral totaled $2 billion, people familiar with the situation said. Along with the investments, that money was transferred to J.P. Morgan and Citadel.

To reduce some of their risk, the partners immediately moved to sell some of the investments after concluding that the energy market wasn't buckling, despite worries about ripple effects from Amaranth's woes. Willing buyers quickly emerged. Some were J.P. Morgan's investor clients. Others were traders on the other side of Amaranth's bets eager to cash out and pocket their winnings.

Within days, the firms had sold enough of the portfolio to shift more than 50% of its risk to others, according to someone close to the matter.

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