Making Better Bets

It’s a near certainty that the recent travails of Amaranth Advisors will generate a lot of heat on Capitol Hill, but that’s no guarantee there will be any light. That’s because there’s a real danger that the solons could miss the true story of the Amaranth case — that there’s no story.In the past week, the world has witnessed a meltdown at a $9 billion hedge fund and nothing has happened. No banks are teetering. No small investors have lost their shirts. No markets are on the verge of collapse. No panics are sweeping global markets. As far as we know, not even a margin call has been missed yet.Which is not to minimize the significance of the story. Amaranth appears to have lost about $6 billion on some ill-advised bets in the energy markets and that’s a big pot of money whichever way one cuts it. It equals the loss that destroyed Long-Term Capital Management in 1998. In all likelihood, Amaranth’s investors are going to find themselves out a noticeable chunk of change by the time the dust has settled.Yet none of that turns out to say anything about whether more regulation should emanate from Washington as a result. At the same time Amaranth is reminding everyone of the risks lurking behind those enormous gains offered by hedge funds, the story is also a lesson in how the financial system, with help from those very same hedge funds, is growing ever better at absorbing just this kind of shock.One reason Amaranth’s travails do not appear to be rippling much beyond its neighborhood in the energy market is that, hyperventilating to the contrary, the fund was not disastrously leveraged. Published reports last week estimated Amaranth’s leverage at between three and eight times capital excluding the leverage implicit in the more exotic derivatives on its books. That has proven big enough to threaten the fund itself, but not the wider financial system. Moody’s announced on Wednesday that it would not need to downgrade the credit ratings of dealers doing business with Amaranth.Contrast that with Long-Term, arguably the most famous hedge-fund failure in history, which at its peak was leveraged as much as 30 times assets excluding derivatives. That leverage is why, eight years ago, losses equivalent to Amaranth’s sparked an emergency meeting of Wall Street’s magnates at the Federal Reserve Bank of New York and a massive bailout coordinated by a consortium of banks at the behest of the Fed. The absence of such severe leverage in this case helps explain why banking executives are on the golf links right now instead of in frantic meetings.To be sure, the analogy isn’t completely accurate. Long-Term held hard-to-liquidate positions in unusual assets, for which it was often one of the only traders, while Amaranth is helped by the relatively quotidian and easy-to-liquidate nature of its positions. Already another hedge fund, Citadel, and a major bank, JP Morgan, will take over Amaranth’s energy trading assets.Nonetheless, the relative calm in Amaranth’s wake is partly a sign that Wall Street and regulators learned some lessons from the Long-Term story. In the wake of that meltdown, agencies like the Fed and the Commodities Futures Trading Commission have been paying more attention to the hedge-fund exposure of the companies they regulate, which are the traders that are counterparties to hedge-funds’ transactions. Credit may have been relatively easy for Amaranth, as some commentators have suggested, but it certainly wasn’t nearly as easy as it had been for Long-Term.What should this mean for lawmakers and regulators? In a perfect world, nothing. There are only two reasonable justifications for additional hedge-fund regulation: to control systemic risk or to protect investors by reducing fraud. Amaranth isn’t a failure on either count. Unlike Long-Term, Amaranth is not presenting any systemic risk. And unlike other recently infamous hedge funds like Bayou Management, there is no suggestion of fraud. Amaranth merely bet poorly, very poorly, and is now paying for its mistake.What actually will happen is another matter. A fistful of congressional committees have been holding hearings on hedge funds for months, and Rep. Mike Castle of Delaware recently introduced a bill that would call for a study of the issue. By far the most sensible talk has been coming from the chairman of the Securities and Exchange Commission, Christopher Cox.He continued to impress with his acumen last week by suggesting that the SEC revisit the net wealth threshold investors must pass to put money in hedge funds. Mr. Cox argues that by increasing the threshold to $1.5 million from $1 million, regulators can ensure that hedge funds remain the preserve of investors sophisticated enough to evaluate the risks. Such an approach would also obviate the need for much, or any, further regulation.Meantime, it’s worth thinking on the bright side for a minute or two. Amaranth appears to be in no danger of dragging anyone else down with it — even the much-discussed $175 million investment of the San Diego public employee pension fund amounts to only just over 2% of that fund’s assets. It turns out that the same market that spawned big bettors like Amaranth has also spawned other big bettors who are positioned to pick up the pieces with minimal muss or fuss. That’s not a call for more regulation. It’s merely a call for some entrepreneurial trader to come up with a better bet than Amaranth did.

Making Better Bets

Making Better Bets

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