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Amaranth Advisors Situation Shows Importance Of Due Diligence And Transparency

email this aricle - Amaranth Advisors Situation Shows Importance Of Due Diligence And Transparency - New York - 21 September 2006 print this article - Amaranth Advisors Situation Shows Importance Of Due Diligence And Transparency - New York - 21 September 2006
Standard & Poor's Ratings Services said today that the limited fallout in financial markets after the recent enormous trading losses at Amaranth Advisors funds is encouraging for several reasons. First, the magnitude of losses at this large fund did not bring it to default on any obligations to brokers. Second, the implosion of such large trading positions did not lead to any generalized systemic issues for capital markets. Third, adherence to some fairly basic and fundamental risk management principles could have averted the problems. The lesson to be learned is that with robust due diligence on risk management practices on the part of stakeholders, and some minimal transparency on the part of funds, unwanted risk can be avoided.

We can speculate about how a fund could sustain such heavy draw-downs in a short time and not entirely implode, as did LTCM in 1998. Amaranth was able to meet its margin calls and begin to arrange for a more or less orderly resolution. Obviously, it had sufficient capital and liquidity to continue to operate. Whether it survives or is forced to liquidate is still an open question, but that would not constitute a default. A new development is that there were interested purchasers of the energy assets. A consortium led by JP Morgan Chase & Co. purchased the assets, presumably at advantageous prices to themselves. This alleviates liquidity issues Amaranth might face. Other explanations might be that those who financed their trading books, the prime brokers, are on the whole much more disciplined about their borrowers. Their due diligence and understanding of their hedge-fund clients has improved since the LTCM days. They understand the collateral they have and are better at collecting on margin calls, so they can be less trigger happy and apt to retract their financing when troubles occur. This provides funds more time to work out their trading positions in a more orderly fashion. That such a large loss does not lead to default is comforting in the context of ratings for hedge funds, as it extends the track record of low default rates for the industry.

Capital markets remained generally calm. The problems at Amaranth may have been so localized to a small corner of the natural gas markets that the ripple effects on other players and other markets were necessarily small. Nevertheless, the fact that not many others had the same trades on and so did not need to liquidate simultaneously also helped.

Very important to us as well is the realization that fairly standard risk management principles could have prevented the issues from occurring. In our analysis of hedge funds, we rely on a clear articulation of risk appetite by management, together with reports that corroborate that that is being adhered to. Therefore, if a stated fund strategy is to be a diversified, multistrategy fund, then reports showing a concentration of capital allocated to energy trading would be a red flag. Extraordinary volatility of performance not typical of multistrategy funds, and not correlated to other multistrategy funds in the marketplace, is another red flag. In addition, one of the issues we look at is the tension between profit maximization and according too much power to a "star" trader, in particular if he resides in a remote location without the full risk management infrastructure. These are all risk management principles articulated in our criteria for rating hedge funds.

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