Amaranth May Make Goldman, Morgan Biggest Winners

Date: Monday, September 25, 2006
Author: Christine Harper and Adrian Cox, Bloomberg.com

Goldman Sachs Group Inc. and Morgan Stanley, the Wall Street giants that sell more of everything from stocks and bonds to risk-analysis software to the burgeoning hedge fund industry, may be the biggest winners after Amaranth Advisors LLC said it lost $6 billion on natural-gas trades.

Amaranth, the Greenwich, Connecticut-based firm that saw more than 60 percent of its assets vanish this month, is a debacle that so far hasn't disrupted any markets or prevented the biggest so-called prime brokers, such as Goldman and Morgan Stanley, from continuing to reap a bonanza in 2006 from winners and losers alike.

Securities firms are poised to earn about $8 billion on prime brokerage to the $1.2 trillion of mostly unregistered pools of capital that let managers participate substantially in the gain or loss of the money invested. Goldman and Morgan Stanley will collect the most fees, as well as market insights, for providing services to hedge funds, according to Celent LLC, the Boston-based firm founded in 1999 to provide research and consulting advice to financial-services companies.

``It looks like there has been no fallout for the prime brokers,'' said Michael Holland, who manages $4 billion at New York-based Holland & Co. Amaranth ``makes those businesses look much more attractive rather than less attractive.''

That wasn't so apparent eight years ago, when Long-Term Capital Management LP collapsed on inauspicious trades after banks allowed the hedge fund to leverage its $2.3 billion of capital into a portfolio of about $125 billion of securities. The New York Federal Reserve organized a $4 billion bailout and regulators urged Wall Street to limit lending and monitor the risks that its clients are taking.

Limited Fallout

As a result, there hasn't been any fallout from Amaranth, whose founder Nicholas Maounis insists his firm will remain solvent. Amaranth borrowed about $4.50 for every dollar of its own equity at stake, according to documents it distributed to investors. By comparison, Long-Term Capital borrowed about $25 for every dollar in equity before it started losing money.

The 43-year-old Maounis said in a Sept. 20 letter to investors that the firm has been able to meet its margin calls, meaning deposits with brokers haven't fallen below the minimum required to cover its bets.

``The controls and the understanding are much better than they were 10 years ago,'' said Thomas Tesauro, co-head of equity finance and prime brokerage at New York-based Citigroup Inc., which competes with Morgan Stanley and Goldman.

Investor Losses

The losers were the institutions that invested in Amaranth's funds. They include Geneva-based Union Bancaire Privee, San Diego County's retirement fund, Bermuda-based insurer Max Re Capital Ltd., Arden Asset Management in New York, and the pension fund of 3M Co., the St. Paul, Minnesota-based maker of Post-it Notes and electronics and cleaning products. Funds managed by Goldman, Morgan Stanley, Credit Suisse Group and Deutsche Bank AG also had money with Amaranth.

Morgan Stanley Chief Financial Officer David Sidwell, speaking in an interview last week, said ``we don't see any material impact'' from Amaranth's losses. Goldman Sachs Hedge Fund Partners LLC, a U.S. registered fund of funds, and Goldman Sachs Dynamic Opportunities Ltd., a London-listed fund of funds, reported that returns may be affected by Amaranth's losses. Andrea Raphael, a spokeswoman in New York, declined to comment.

The prime brokers, which not only made loans but also handled trades, helped prevent contagion beyond the commodity markets by taking on Amaranth's positions in other assets, said Larry Leibowitz, UBS AG's Stamford, Connecticut-based chief operating officer for U.S. equities.

``They moved in quickly to provide liquidity,'' Leibowitz said. ``It takes a large broker with sophisticated risk- management programs to do this sort of thing.''

Stable Markets

To be sure, it was easier for Amaranth to raise money by selling other investments because stock and bond markets weren't declining like they were in 1998, when Long-Term Capital tried to unwind trades, said one head of a U.S. prime broker who declined to be identified.

The Dow Jones Industrial Average was up 7.9 percent in the year until Sept. 18, when Amaranth's losses were first disclosed. By contrast, the Dow average was down 1 percent when Long-Term Capital disclosed its losses in a letter to investors.

Losses for prime brokers, including Goldman and Morgan Stanley, probably will be confined to forfeited fees from sponsoring Amaranth, said an industry executive, who declined to be identified. Hedge fund clients typically pay prime brokers a fee of as much as 0.6 percent of their assets for providing services such as lending shares and cash and clearing and settling trades. That would translate into about $36 million in fees, based on the $6 billion of value erased from Amaranth's funds this month.

Stress Testing

``If anyone has in place the controls to make sure that this type of risk doesn't threaten the overall institution, it's the big investment banks,'' said Ian Cooper, a finance professor at the London Business School. Morgan Stanley is the biggest securities firm with a market value of $77 billion. Goldman is No. 2, with almost $76 billion. ``I would be willing to bet quite a large amount of money that we'll go through this minor blip with everything functioning well.''

Banks and securities firms have made improvements in judging potential losses on securities that clients buy, and in turn how much clients have to deposit as a guarantee for loans, Moody's Investors Service analyst Peter Nerby wrote in a report on Sept. 20. He also highlighted stress-testing and netting agreements, where firms limit their losses by offsetting loss-making transactions against profitable ones.

Fueling Profits

Hedge funds have provided the fuel for five years of rising earnings at the investment banks, as revenue from prime brokerage and trading derivatives and commodities outpaced fees paid by companies for underwriting and mergers advice. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in interest rates or the weather.

Revenue at Goldman's securities-services division rose 25 percent to $1.68 billion in the first nine months of this fiscal year. Morgan Stanley, which doesn't break out results for prime brokerage, said its unit had a record third quarter.

Bear Stearns Cos., the third-ranked prime broker, said revenue from providing clearing services climbed 2.3 percent in the first three quarters of fiscal 2006 to $823 million.

``They're the guys in the middle and they control the market,'' said James Ellman, who manages more than $100 million at San Francisco-based Seacliff Capital LLC, including shares of Morgan Stanley and Bear Stearns.

SEC Scrutiny

Amaranth's losses will prompt a review of lending agreements, risk-taking and documentation of the contracts with hedge funds, prime brokers said.

The U.S. Securities and Exchange Commission expects prime brokers to alert regulators to potential misconduct by hedge fund clients, Linda Thomsen, the agency's director of enforcement, said in a Sept. 22 interview.

``Broker-dealers frequently report suspicious activities by their retail customers,'' Thomsen said. ``They should be just as willing to report suspicious activities when the customers are hedge funds.''

Hedge funds have been reducing the information they provide to the SEC after a U.S. court ruled in June that the agency can't enforce a rule requiring more disclosure by the industry. Since the decision, 106 hedge funds withdrew registrations. In all, 2,479 of the roughly 7,000 U.S.-based funds remain enlisted with the SEC and subject to spot-checks.

More Nervousness

Amaranth ``was huge and a big prime-brokerage client to a lot of firms,'' said Glen Dailey, who ran Bank of America Corp.'s hedge fund brokerage division for 11 years before joining Jefferies Group Inc. in New York. ``You're going to have risk people that are a lot more nervous now.''

The losses may dissuade some brokers that are offering more liberal lending terms and cut-rate fees to break the hammerlock of Goldman, Morgan Stanley and Bear Stearns, said Richard Bove, an analyst at Punk, Ziegel & Co. in Pinellas Park, Florida. He has a ``market perform'' rating on New York-based Goldman, Morgan Stanley and Bear Stearns.

``You've got all of these companies coming into the business,'' Bove said. ``Is this a wake-up call and will these guys rethink what they're doing? The answer is absolutely yes.''

Citigroup's Tesauro said the biggest U.S. bank won't change its approach to risk and lending. ``This isn't going to slow our momentum at all,'' he said.

`Vicious Competition'

Officials at competitors including Frankfurt-based Deutsche Bank, Zurich-based UBS and Credit Suisse, New York-based Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and Merrill Lynch & Co., and Bank of America of Charlotte, North Carolina, declined to comment.

Les Satlow, who helps manage $380 million at Cabot Money Management in Salem, Massachusetts, said investment banks probably won't change their risk-management practices after dodging Amaranth's plunge.

``Competition for the business is vicious and it does open the possibility, just like in lending, that the banks will not take appropriate measures to limit their risk,'' Satlow said. ``I don't think anything prompts change unless it results in a huge loss of money.''

As the industry's biggest energy traders, Goldman and Morgan Stanley already may have chalked up gains from Amaranth's wrong- way bets that natural-gas prices would rise, Holland said. Trading oil, natural gas and other commodities generates about $1.5 billion in revenue for both firms, estimates Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York.

`Significant Money'

``There is a very good chance that people like Goldman Sachs were on the other side of those trades and made some significant money,'' Holland said.

Amaranth's prime brokers had a privileged vantage point and ``probably made a ton of money on these trades,'' Seacliff's Ellman said. Amaranth had about eight prime brokers and has declined to identify them.

Funds managed by Amaranth plunged 65 percent this month as of Sept. 19 because of bets in the natural-gas market, Maounis wrote in a letter to investors. The price of natural gas dropped 23 percent since the start of the month on the New York Mercantile Exchange.

The trader responsible for Amaranth's natural-gas investments was Brian Hunter, 32, co-head of the firm's global energy and commodities unit. As of June 30, energy trades accounted for about half the capital of the Amaranth funds.

Amaranth ``is very much a one-off where the strategy has gone wrong for one individual trader rather than any kind of systemic problem,'' said Gordon McAra, a spokesman for the London-based Alternative Investment Management Association.

To contact the reporters on this story: Christine Harper in New York at charper@bloomberg.net ; Adrian Cox in London at acox2@bloomberg.net