Hedge-fund hardball: How Amaranth was devoured by its banker, MorganChase

Hedge-Fund Hardball

Amid Amaranth's Crisis,
Other Players Profited

Goldman Offered Deal;
J.P. Morgan Balked,
Then Did One Itself

By Ann Davis, Gregory Zuckerman, and Henny Sender
The Wall Street Journal
Tuesday, January 30, 2007

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."

.... Volatile Market

The 32-year-old Mr. Hunter's specialty was natural-gas futures -- contracts for delivery on a future date -- and options. This is a highly volatile market, where the price can move swiftly on changes in gas available in storage and on shifts in the weather -- or a weather forecast.

If Mr. Hunter thought prices in, say, March would be higher than what other traders expected, he could buy contracts for March delivery cheaply. If his view of April prices was lower than the market's, he could go the other way. Or he could bet on the spread between a pair of months. For example, if there's a cold winter, gas can suddenly get scarce in March, sending prices skyrocketing. Things shift in April, as the heating season winds down. The March-April spread is one many gas traders bet on, but it can be such a perilous bet that some call it "the widowmaker."

Mr. Hunter bet big. He sometimes held 30% of contracts for gas delivery in certain months, say people who saw the trading data. His team, operating largely out of Calgary, Alberta, made a stunning $1.5 billion in six weeks last spring, mostly on energy trades. But gains that big in a single market can portend swings just as fast the other way, and in May that's what happened. His bets on gas prices years into the future backfired and dealt the fund a sudden loss of about 10%.

That triggered demands for more collateral from J.P. Morgan. It was Amaranth's natural-gas clearing broker, a firm that executes a client's trades on an exchange and stands behind the client's obligations in case it can't pay. Clearing brokers give futures traders confidence they'll be paid if they are owed money when a contract expires.

For taking this risk, the firms demand collateral, known as "margin," in an amount of cash reflecting a portfolio's possible one-day price move. The margin demand fluctuates daily with how well or badly the positions did that day.

Amaranth told its investors the May loss was "a humbling experience that has led us to recalibrate how we assess risk." To reduce its exposure, it paid investment bank Morgan Stanley to take over part of its energy portfolio. Yet officials at the New York Mercantile Exchange, where many energy contracts trade, were concerned enough that they discussed what a failure by a player as big as Amaranth might do to the market.

The regulators took comfort in the stability of J.P. Morgan. The bank at times advised Amaranth to reduce its natural-gas exposure, says someone familiar with the bank's operations. But the clearing operation focused chiefly on whether the fund met margin requirements, as Amaranth always did.

According to a person involved in the discussions, Amaranth's Mr. Maounis told his energy team to reduce its exposure but warned them not to do so precipitously, lest the firm suffer another major loss. Amaranth's positions were so big they couldn't be unwound fast without moving the market.

But Amaranth allowed the portion of the fund invested in energy to grow, as the energy bets started to pay off again. By July, Amaranth was 56% in energy, up from 34% in April. In the last week of August, the value of the fund's assets reached $9.2 billion, up about 27% since Jan. 1.

One of Mr. Hunter's bets anticipated relatively cheap gas in September. But in the last half hour of trading Aug. 29, the price of the expiring contract for September delivery jumped. The surge wiped out hundreds of millions of dollars in Amaranth's gains. The fund told Nymex it suspected someone had manipulated prices. Regulators are looking at it.

Then in early September, widely watched weather-forecasting centers made two predictions: that the hurricane season would pass without major storms, and that the winter would be mild. The forecasts too slammed Mr. Hunter. He was betting on a gas shortage and price spike at some point after October. Worse, contracts for winter delivery fell by more than those for early-fall delivery, hitting him where his bets were concentrated. By the end of Friday, Sept. 15, Amaranth was down more than $2 billion from its August value.

.... Margin Calls

The losses automatically raised J.P. Morgan's margin demands. One of the ways Amaranth had met past demands was selling nonenergy investments to raise cash. But now it turned out some couldn't be liquidated instantly, say people involved. Amaranth suddenly faced a risk of not having enough cash for Monday's margin demand. If it didn't, creditors could foreclose on its assets and it might lose them.

Amaranth called Wall Street banks in search of solutions. It asked Goldman Sachs if the bank, a major player in both energy markets and hedge funds, would take over much of Amaranth's energy portfolio. The fund tried a different tack with others, trying to raise money by selling a piece of the fund-management firm, Amaranth Advisors LLC.

Firms prefer to do negotiations like these secretly and one at a time, to avoid revealing too much to too many rivals or signaling vulnerability. But Amaranth's Greenwich, Conn., office that weekend was a revolving door. Morgan Stanley representatives spotted someone from Merrill Lynch & Co. in the parking lot. Rumors flew.

On Saturday, Goldman offered to do a deal designed to eliminate most of Amaranth's energy risk -- in return for a $1.7 billion cash payment from the fund -- say people familiar with the negotiations. Amaranth managers were insulted. Mr. Hunter had figured the fund could get out of these problematic trades for about $800 million.

Amaranth kept shopping. It called John Arnold of Centaurus Energy, a Houston hedge fund that was Mr. Hunter's biggest rival. No deal.

With others they talked to, some Amaranth traders claimed Mr. Arnold was driving gas prices against Amaranth, according to someone who was approached. Their pitch was: We've got one guy in the market trading against us. If you take over our positions and hold onto them, you can make a billion dollars.

.... A Deal With Merrill

Later that Saturday, Amaranth managed to make a partial deal. It got Merrill Lynch to assume about a quarter of its natural-gas exposure, in return for a payment of approximately $250 million, say people familiar with the matter. Merrill won't comment.

Amaranth officials figured that Goldman Sachs now would reduce its price, since Merrill was taking some of the exposure. Instead, Goldman executives fumed, say people familiar with their reaction; Goldman had wanted to negotiate exclusively, not have competitors poring over Amaranth's books.

Rather than reduce its price, Goldman upped it, to $1.85 billion. The deal it envisioned would use derivative contracts to assume most of the risk of Amaranth's main remaining energy investments. Goldman would do trades that partially offset energy trades on Amaranth's books, with the aim of neutralizing them. The deal would leave a lot of positions on Amaranth's accounts at J.P. Morgan, which remained responsible for their execution.

Some at J.P. Morgan, including Chief Executive James Dimon, had grown concerned about Amaranth. Late Sunday, J.P. Morgan called in its top energy trader, George "Beau" Taylor, to review Amaranth's positions. Informed that an Amaranth-Goldman deal was imminent, J.P. Morgan said it might make an offer itself, but then said it needed more time.

In Greenwich, Mr. Maounis was in turmoil, sometimes losing composure and in tears, according to people familiar with the matter. Late that night he accepted the deal with Goldman.

On Monday morning, the sleep-deprived fund chief issued a letter to investors, telling them that half of the money the fund had at its peak 2½ weeks earlier was gone. Instead of being up 27% for the year, it might be down more than 35%. But his letter gave an assurance. It said a deal to get the fund out of natural gas was "near completion."

The letter didn't mention that a key player still needed to sign off: J.P. Morgan. The clearing broker held an estimated $1 billion to $2 billion of Amaranth's money in a margin account, cash that Amaranth intended to use to pay Goldman.

Amaranth held a conference call intended to close the Goldman deal. But as officials from Goldman and Nymex listened, J.P. Morgan refused to release Amaranth's collateral -- scotching the deal.

The bank said it believed the complex transaction wouldn't eliminate its risk. J.P. Morgan would still be the clearing broker for Amaranth's energy positions. And although Goldman and Amaranth claimed that the risk in those positions would be drastically reduced by Goldman's offsetting trades, J.P. Morgan would be the clearing broker for those new trades too. The firm said it needed to analyze how the deal worked. It also argued that it had a right, and perhaps a duty, to hold onto the margin money until its obligations were resolved.

"We would have been absolutely willing to facilitate a deal that would have removed unwanted Amaranth credit exposure from our risk profile," a J.P. Morgan spokesman said.

In the energy market, it was now open season on Amaranth. All weekend others had been dumping natural-gas positions on after-hours trading platforms, having either heard rumors about Amaranth or been invited to review its books. On Monday, with word of the fund's distress out in the open, traders sold certain gas investments even faster, in anticipation of a forced liquidation of Amaranth's portfolio.

For instance, Mr. Hunter had bet that the spread between March-delivery gas contracts and April contracts -- the "widowmaker" bet -- would widen. The burst of trading made it shrink, to 75 cents per million-BTU gas contract from $1.15 on Friday, according to NaturalGasAnalytics.net. On Monday alone Amaranth's losses deepened by several hundred million dollars.

That morning Amaranth got a call from Kenneth Griffin, founder of Citadel Investment Group. Mr. Griffin had built Citadel into a $13 billion hedge-fund behemoth estimated to be responsible for 3% of daily trading on the New York Stock Exchange. Even so, his group suffered some losses during Mr. Hunter's 2005 winning streak. Mr. Griffin proposed taking over most of Amaranth's energy portfolio.

That portfolio now was in worse shape because of Monday's losses. The more it deteriorated, the more cash an outsider would demand to take it off Amaranth's hands. The Citadel deal would have cost Amaranth more than $2 billion, say people familiar with the bid. And the fund couldn't pay, with its collateral hung up at J.P. Morgan.

Mr. Griffin considered giving the hedge fund time to pay by granting it a bridge loan, taking other Amaranth assets as collateral. He dropped the idea when lawyers warned that Citadel might have a hard time collecting if Amaranth ended up in bankruptcy.

With the Citadel plan shaky, J.P. Morgan got back in the game. In conjunction with Citadel, J.P. Morgan, which itself is a big hedge-fund player, began new talks with its now-very-vulnerable clearing client. The end result was a broader deal than the scuttled Goldman one: J.P. Morgan and Citadel would jointly assume Amaranth's entire remaining energy portfolio.

Amaranth would have to eat losses of about $800 million its portfolio had incurred from Friday night through Tuesday as others exploited its weakness. J.P. Morgan and Citadel wanted $1.6 billion to take over most remaining gas trading positions and some $300 million to assume options to buy or sell gas. As a topper, they asked for $250 million for taking over miscellaneous commodity investments. Mr. Hunter thought the price for taking over the miscellaneous positions should be no more than $50 million, says someone involved in the talks.

Amaranth capitulated. After an all-night session, the deal was signed at 5:30 a.m. Wednesday. Amaranth's total payments to Merrill Lynch, J.P. Morgan, and Citadel, plus the last few days' market losses, came to about $3.2 billion.

Now that J.P. Morgan was in on the deal, getting access to the Amaranth cash that J.P. Morgan held as collateral was no longer a problem.

His business in tatters, Amaranth's Mr. Maounis, 43, discussed selling what was left of his fund-management firm to Citigroup Inc. Dean Barr, an official of Citigroup's Alternative Investments group, was interested but wouldn't buy unless Mr. Maounis stepped down as the firm's chief, says someone familiar with the talks. Ultimately, negotiations foundered over other issues.

So Amaranth began liquidating its remaining holdings. Mr. Hunter flew back to Calgary and settled into a new house he had been building. He is now talking about launching a hedge fund of his own. Mr. Maounis also is exploring starting a new hedge-fund business.

.... 'Very Nice Increment'

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."

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