Hedge funds an accident waiting to happen

Benj Gallander and Ben Stadelmann
Friday, October 6, 2006

It’s been a couple of weeks since the Amaranth hedge fund pulled a Chernobyl, and many in the financial community are congratulating themselves on how well the fallout has been contained.

Unlike the collapse of the Long Term Capital fund in 1998 that threw Wall Street into a panic and spurred Federal Reserve chairman Alan Greenspan to perform a daring rescue mission, his successor Ben Bernanke’s repose has not been disturbed. That Warren Buffett guy, who has warned for years about derivatives being “financial instruments of mass destruction” must be a big worrywart.

Still, there were a few people left scratching their heads as to why their investments were being affected by a losing gamble on natural gas. Cinram Income Fund, which manufactures CDs and DVDs, saw about $65 million knocked off its market capitalization as investors speculated that Amaranth would have to unload its 15 percent stake in the firm.

Counsel Corp., which owns shopping malls, saw its shares drop about 25 percent. Amaranth is Counsel’s largest shareholder, with about one-third of the shares outstanding.

Brian Hunter, the math whiz at Amaranth who devised the trading strategy responsible for the debacle, has been a lightning rod for blame. He’s been dubbed a nefarious rogue trader, yet no evidence has emerged that he was trading secretly in contravention to the policies of his employer.

Far from it: he was doing exactly what had been done earlier to make colossal profits, $1.3 billion (US) in 2005 and another $2.2 billion in the first eight months of 2006. Easy come, easy go.

And of course, if Mr. Hunter managed to lose $6 billion, it means that some other bright sparks engineered to gain a similar amount and are out comparing Ferraris and Bentleys, reflecting dreamily about how many digits will be on this year’s bonus cheque.

To some, this is proof positive that the market is efficient. Poppycock!!

Does anyone seriously believe the incredible runup in petroleum prices would have been possible without the massive participation of speculative hedge funds? Or that prices would be dropping so fast now on commodities across the board if these nervous funds were not running for the hills and liquidating positions?

Where’s the much ballyhooed “terrorism premium”? Has the unquenchable thirst from India and China suddenly been slaked?

Hedge funds are just another herd. But if investors who got sucked into tech funds in the 1990s were quiet lemmings, hedge traders are more like clever rats who won’t hesitate to turn on their own. Amaranth’s founder, Nick Maounis, explained that when the firm tried to reduce exposure, competitive traders who smelled vulnerability refused to provide liquidity.

“We did not expect that the market would move so aggressively against our positions,” he stated. That sort of dewy eyed naivete strains belief.

For our part, we continue to believe that 9,000 hedge funds managing more than $1.2 trillion in assets is an accident waiting to happen. Sure, the industry can chew up the odd flameout without so much as indigestion, but if the Byzantine interconnections brought down a group of them, the entire pyramid could reach a tipping point and destabilize.

In such a scenario, they will not fall like an orderly row of dominoes, but the damage would be haphazard, unpredictable and extreme.

Mr. Buffett used Mark Twain’s metaphor of a cat carried by the tail to describe the potential mayhem, but we’ll take our literary cue from Victor Hugo’s last wonderful novel, Quatrevingt-Treize, which in a terrifying scene describes the effect of a cannon loose on the deck of a ship in the English Channel.

“A cannon that breaks its moorings suddenly becomes some strange, supernatural beast. It is a machine transformed into a monster. That short mass on wheels moves like a billiard-ball, rolls with the rolling of the ship, plunges with the pitching, goes, comes, stops, seems to meditate, starts on its course again, shoots like an arrow from one end of the vessel to the other, whirls around, slips away, dodges, rears, bangs, crashes, kills, exterminates.”

The likelihood of such an evil turn of events is, fortunately, fairly small. But as Maounis ruefully noted, the odds of Amaranth’s trading models going so wrong were “highly improbable.”

“But,” he added, “sometimes even the highly improbable happens.”

We can only hope that Mr. Bernanke will not be called upon to capture any loose cannons.