Wall Street curse claims billions, again

Wall Street curse claims billions, again
By Heather Timmons
Copyright by The New York Times
Published: September 21, 2006



LONDON The big losses at the hedge fund Amaranth Advisors have their roots in a Wall Street curse that seems to strike at least once a decade: high-flying trader takes outsized risks and makes ridiculous paycheck, then implodes, possibly dragging the firm down with him.

But the events at Amaranth could be repeated much more often in coming years, veteran fund mangers say, thanks to hedge funds' recent love affair with the fast-moving commodities markets, and the "youthful aggression" of many traders.

Amaranth racked up some $5 billion of losses at the hands of a 32-year-old natural gas trader named Brian Hunter.

On Wednesday, Amaranth sold its energy portfolio - which holds what remains of its disastrous trades on price differences in the natural gas market - to J.P. Morgan and Citadel Investment Group, according to two people briefed on the negotiations. The sale leaves Amaranth, once a well-regarded $9.25 billion hedge fund, with $3.5 billion to $4 billion, a person involved in the negotiations said.

But there's a lot more aggressive new money out there in the volatile sector: Nearly $60 billion was invested by energy-related hedge funds in these markets, the Energy Hedge Fund Center estimates. Commodity indexes have $85 billion in assets, up from single digits just a few years ago.

Not all of these funds, or even most of them, have made bad bets, of course, and there is no guarantee that oil or natural gas prices will not soar again.

Still, veteran traders say the commodity markets are full of Brian Hunters: traders in their late 20s or early 30s who have never traded through severe conditions like the gasoline crisis of the 1970s, or the plunge in oil prices in the 1980s. Instead, they have watched as natural gas prices, as well as those of many other commodities, rose - unevenly, but with clear annual gains - since 2001. (The trading desk Hunter ran at Deutsche Bank suffered losses in 2003, but he maintains that he personally made money for the firm that year.)

He has not commented publicly since the losses were disclosed by Amaranth.

Where more experienced traders in commodities have pulled out of the market in recent months, or made long- term bets that these historically cyclical investments would fall, younger traders may have been convinced that the market could keep going up, say their peers. Emerging market demand for commodities and fears about petroleum supplies has created what traders refer to as a "super cycle," one that has driven prices higher, for longer, than ever.

Most people investing in commodities are "investing on the sustainability of the cycle, on things going higher," said Louis Gargour a former RAB Capital fund manager who recently founded his own fund, LNG Capital. Because so many people are buying and not selling, the short-term volatility has increased, which can particularly hurt people who are highly leveraged, as commodity traders are. "When the market retreats, it is vicious," Gargour said.

"The young guys just keep on buying and buying, and say, 'Who are you Grandpa, to say what value is?,'" said Gargour, who is 42.

Amaranth's losses came after Hunter bet that the spread between the prices of natural gas in March 2007 and April 2007 would increase because April's price would rise, but they declined instead.

While finance jobs like investment banking or equity trading are open to a vast range of ages and experience, trading in general, and commodities trading in particular, is generally staffed by young employees, which can exacerbate the big risk taking.

"Trading commodities has always been a youthful game, because it takes a certain youthful aggression" to make the bold decisions necessary, said Jay Levine, principal of enerjay, a broker and consultant. "In general, these young bucks have a certain knack of getting in and out of the market."

Commodities also appeal to younger traders because of their heavy leverage: only a limited amount of money is required upfront to trade. And because prices are very volatile, there's an element of instant gratification that also appeals. "Why sit in a stock for years waiting for it to appreciate when you can buy and sell something in hours?" Levine asked.

What younger traders often lack is a strategy to unwind their trades if the market goes against them. "Anyone that tells you they don't make a bad trade is a bold-faced liar," Levine said. What separates good managers from the bad ones is "how you recover from it, financially."

It may seem odd that Amaranth, which had several experienced risk managers on staff and bragged about its number of employees with doctorates, allowed Hunter to take such big bets without having such a strategy. But the problem is endemic to the industry, fund managers and traders say.

Hedge funds, particularly fast-growing ones, are particularly susceptible to the charms of a big risk-taker like Hunter, because they are under pressure to keep up their annual returns.

"The dirty secret of a lot of larger hedge funds is that returns fall off as assets grow," said one manager of a small hedge fund in New York who did not want to be quoted by name because he was insulting his peers. Often, "they turn into mutual funds in drag to some extent," he said, by going to multiple strategies, and taking lots of smaller positions to reduce risk. "It is harder to find valuation anomalies to put billions to work in," he said.

Having on board a trader like Hunter who has historically taken big bets and made huge profits helps to keep the returns up where they were when the fund was smaller, when he's making the right calls.

"All hedge fund managers are greedy, that's why they are in the game," said the New York manager. "If they have a 'star' they give them a lot of latitude," he said. "Often, skill and luck get confused."

Nassim Nicholas Taleb wrote "Fooled By Randomness," a book on Wall Street that claims luck has as much to do with success in the markets as skill.

"When you're a hot trader, people are afraid of not laughing at your jokes," Taleb said.

"When you make a lot of money at a firm, you can start owning the firm," he said. "That's the biggest risk when you hire someone who is very successful - you end up working for him."

Gargour adds, "No one listens to the risk managers until it is too late."

Veteran traders are bracing themselves for more implosions in the commodities sector.

"We've had a big buildup of a lot of risk, without a big blowup," Taleb said. Commodities are more vulnerable to impact from rare events than others sectors, he said, and the markets are very local, both of which increases the chance for volatility. Commodity spreads are very likely to be squeezed, "and these squeezes are very vicious," he said.

Amaranth is no different from any other hedge fund, said Taleb, who shared an office with the Amaranth founder, Nicholas Maounis, in Greenwich, Connecticut, for several years. "They're probably not much better, and they are certainly not worse," he said. "People are playing Russian roulette, and someone has to be on the losing side."