# 'Hedge Fund' Blowout Threatens World Markets



## MARKETWAVES (29 May 2005)

Decades of insane economic policies, and the stubbornness of central 
banks papering over the symptoms of a systemic crisis by providing 
ever more liquidity, have produced an impossible situation as of late 
May, after the GM/Ford credit shocks.

One of the effects of this unprecedented liquidity pumping has been 
the biggest explosion in mortgage and other private debt titles in 
history, as well as the emergence of new financial bubbles in the 
bond, housing, and commodity markets. All of these financial assets 
are again just the basis for financial bets of even larger 
proportions: "derivatives." As most of the derivatives bets are 
traded outside of official exchanges, in the form of private deals 
between two counterparties, nobody really knows the actual 
dimensions. A substantial amount of derivatives betting is done 
by "hedge funds," which are not subject to any kind of regulation or 
supervision. According to the Bank for International Settlements 
(BIS), the outstanding volume of OTC ("over-the-counter") derivatives 
alone amounts to $248 trillion, while the annual turnover of exchange-
traded derivatives is close to $900 trillion. It's a conservative 
guess to estimate the current rate of derivatives trading at $2 
quadrillion per year; that is, 50 times more than the annual economic 
activity, measured by the gross domestic product (GDP), of all 
countries on the planet. (See Glossary of terms on derivatives and 
hedge funds.)

On May 5, a big shoe dropped into this giant financial minefield. 
Standard & Poor's downgraded $453 billion in outstanding debt of 
General Motors and Ford Motor Corporation to junk. On May 8, Lyndon 
LaRouche indicated that the General Motors crisis is not only 
a "national disaster" for the United States, but could actually 
detonate the world financial-monetary system. Two days after 
LaRouche's statement, markets were shaken by the fear of an imminent 
repeat of the Long-Term Capital Management (LTCM) disaster, which 
almost destroyed the entire system in Autumn 1998. Stock and 
corporate bond markets suffered massive losses on May 10, after 
traders pointed to evidence of severe problems at several large hedge 
funds, as a direct consequence of GM's and Ford's downgrading. The 
hedge funds mentioned in this respect included Highbridge Capital, 
GLG Partners, Asam Capital Management, and Sovereign Capital. The 
London-based GLG Partners has $13 billion under management, and lists 
as the largest hedge fund in Europe and the second-largest in the 
world.

GLG issued a statement on May 10: "All the funds are fine and we have 
no concern." Highbridge Capital, that same day, wrote a letter to 
investors, noting: "It is our understanding that recent volatility in 
the structured credit markets is apparently related to the unwinding 
of an unprofitable CDO [collateralized debt obligation] tranche 
correlation trade by one or more parties.... The purpose of this 
letter is to inform our investors that Highbridge has no exposure to 
the trades." Highbridge was bought up last year by U.S. megabank JP 
Morgan Chase. Sovereign Capital, a British hedge fund, is closely 
linked to Lazard Brothers. The fund is heavily involved in East Asian 
markets, and news of the possibility of its collapse had caused panic 
among Asian bankers. Sovereign Capital's chairman, John Nash, 
formerly worked for Lazard. Since May 10, the "LTCM-word" is in 
everybody's mouth. Asam Capital Management is based in Singapore and 
reportedly has lost most of its investors' money.

Top Banks Involved
The stocks of the same large banks that participated in the 1998 LTCM 
bailout, and which are known for their giant derivatives portfolios””
including Citigroup, JP Morgan Chase, Goldman Sachs, and Deutsche 
Bank””were hit by panic selling on May 10. Behind this panic was the 
knowledge that not only have these banks engaged in dangerous 
derivatives speculation on their own accounts, but, ever desperate 
for cash to cover their own deteriorating positions, they also turned 
to the even more speculative hedge funds, placing money with existing 
funds, or even setting up their own, to engage in activities they 
didn't care to put on their own books. The combination of financial 
desperation, the Fed's liquidity binge, and the usury-limiting 
effects of low interest rates, triggered an explosion in the number 
of hedge funds in recent years, as everyone chased higher, and 
riskier, returns.

There can be no doubt that some of these banks, not only their hedge 
fund offspring, are in trouble right now. And the top banks are 
starting to point fingers at each other. Particular attention has 
been paid to Deutsche Bank. On May 17, Merrill Lynch issued a report 
noting that Deutsche Bank probably has suffered significant 
derivatives losses following the GM and Ford downgrading. The report 
states that Deutsche Bank will not be able to maintain its rosy 
performance, culminating in a pre-tax return on equity of 30% in the 
last quarter. Not only has the volume of bond emissions managed by 
Deutsche Bank dramatically declined during the second quarter, but 
the bank may have suffered reduced business from hedge funds because 
of the "recent turbulence" in the credit derivatives market, as well 
as losses in its own trading positions. "Deutsche must be taking some 
pain at present," concludes the report, which appeared just one day 
before Deutsche Bank's annual shareholder meeting in Frankfurt. 
According to Merrill Lynch, about 17% of Deutsche Bank's clients in 
its debt sales and trading business are hedge funds.

When it was named as one of the victims of the GM/Ford fall-out, 
Deutsche Bank chief financial officer Clemens BÃ¶rsig was forced to 
claim at a New York conference on May 11, that the bank "has no cash 
lending exposure to hedge funds." Deutsche Bank's "exposure is fully 
collateralized." BÃ¶rsig said that the bank's global markets unit "has 
no investments in hedge funds." The bank has a "conservative" 
approach to its business with the funds and "very strict criteria" 
for choosing clients, he added. Nevertheless, according to its own 
2004 annual report, Deutsche Bank at the end of that year held 
derivatives positions, mostly interest rate derivatives, of a nominal 
volume of $21.5 trillion. That is about ten times the GDP of the 
German economy.

'Hedging' to Death
The unprecedented downgrading to junk of almost half a trillion 
dollars in corporate debt, which doubled the total volume of U.S. 
junk bond debt, had devastating consequences for different kinds of 
derivatives bets. In particular, the downgrading hit the credit 
derivatives market, which provides insurance against bond defaults. 
In the recent period, hedge funds have sharply increased their 
exposure to a form of credit derivative known as a collateral debt 
obligation (CDO). CDOs are pools of loans, bonds, and other debt 
titles from hundreds of different corporations which are bundled and 
sold to investors in much the same way as mortgages are turned into 
mortgage-backed securities. In exchange for hefty fees, many hedge 
funds have taken to selling insurance against corporate defaults. If 
there is no default during the life of the contract, the seller 
pockets a lucrative fee, but in the event of a default, the seller 
must pay out the face value of the contract. To raise that money, the 
hedge fund must often sell its most liquid assets, and that, often, 
in the face of a falling market. Such "distress selling" by several 
hedge funds was actually observed on May 10 and subsequent days. 
Europe is extremely vulnerable to the current crisis in the credit 
derivatives market, as 50% of all CDOs are euro-denominated. The same 
kind of financial instruments led to the Parmalat collapse in Italy 
last year.

A related kind of derivatives scheme is the so-called capital 
structure arbitrage (CSA). It's one of the latest inventions in the 
derivatives casino. CSAs also involve bets on corporate debt titles, 
or the derivatives on that debt, such as CDOs. But the overall bet is 
made more complex by adding another element: the stock price of the 
respective corporation. Usually, when the prices of corporate bonds 
or their derivatives falls, the stock price of the respective 
corporation goes down as well. By combining the bond or credit 
derivative with a bet on a falling stock price, the CSA investor can 
try to "hedge" against potential losses. More convincing for hedge 
funds than the limiting of risks, is the empirical discovery that 
once a corporation runs into trouble, the stock price often plunges 
much more violently than the bond price of the same corporation. And 
that is exactly the condition under which a CDA contract generates 
profit.

Now comes the problem: By the very combination””in the same week””of 
Kirk Kerkorian's announcement for a partial General Motors takeover, 
boosting the GM stock price by almost 20%, and the downgrading of GM 
debt to junk by Standard & Poor's, crashing the GM bond price, the 
arbitrage traders suffered the worst of all possible disasters.

Nobody knows how many hedge funds have already gone under in May. 
Further complicating matters is the fact that many hedge fund 
investors, faced with all the news and rumors circulating about 
derivatives losses, are panicking, and are right now pulling out 
their money””if they can. Hedge funds often allow withdrawals of funds 
just once a quarter. The next date is July 1. But how to pay out 
investors, when cash reserves are gone and every dollar of capital is 
tied up in highly leveraged derivatives bets? To be able to meet 
redemption demands, hedge funds are forced to liquidate contracts 
under the present, extremely distressed, market conditions. This 
means piling up even more losses, which in turn””once investors 
recognize it””will further intensify withdrawals.

One indicator for the ongoing "distress selling" is the average price 
of credit-default swaps (CDS), which on May 18 hit the highest level 
since records started one year ago. For every outstanding corporate 
bond, an investor can buy a CDS contract, by which the default risk 
is transferred to the counterparty of the contract. In exchange for 
this kind of protection, the investor pays a certain fee to his 
counterparty, which works like an interest rate deduction on the 
nominal return of the bond. Within ten days leading to May 18, the 
average CDS rate has jumped up by one third, from 42 to 60 basis 
points (from .42% to .6%). The sharp increase reflects not only the 
rising fear for corporate bond defaults, but even more, a sudden drop 
in the number of hedge funds that are willing, or able, to take over 
additional default risks. The surprising rise of the U.S. dollar and 
the fall of commodity prices, including oil, are also being 
attributed to hedge fund emergency sales.

Beyond LTCM
Andrew Large, the deputy governor of the Bank of England, issued a 
strong warning on credit derivatives on May 18. Speaking at an 
international conference of financial regulators in Turkey, he 
noted, "Credit risk transfer has introduced new holders of credit 
risk, such as hedge funds and insurance companies, at a time when 
market depth is untested." Large said the growth of derivative 
instruments has "added to the risk of instability arising through 
leverage, volatility, and opacity." Regulators should therefore act 
and, in particular, search for credit concentrations.

Among the many voices warning against a repeat of the LTCM debacle or 
worse, is non other than Gerard Gennotte, former senior strategist at 
LTCM, and now working for another hedge fund called QuantMetrics 
Capital Management. In statements picked up by London's Financial 
Times on May 18, Gennotte pointed to the rising risk of a liquidity 
crisis triggered by hedge fund blowouts, which then could lead to a 
1998-style collapse. He emphasized: "You could expect something 
similar to 1998, with people starting to liquidate their positions. 
It starts with one position, but then they are afraid of getting 
withdrawals, and it spreads across strategies."

In private discussions with EIR, an international financier confirmed 
LaRouche's notion, that the downgrading of General Motors and Ford 
debt was just the beginning of a much larger crisis hitting the 
grossly over-extended global financial bubble””in particular the 
derivatives scam. The financier said that the international financial 
system is, in fact, facing a derivatives crisis "orders of magnitude 
beyond LTCM." He observed that one can be certain that the Federal 
Reserve, the President's Commission on Financial Markets (the so-
called "plunge protection team"), and the relevant departments of 
major central banks around the world, are all on "emergency red-alert 
mobilization."

Hedge funds and banks are, of course, all publicly denying reports of 
a major derivatives blow-out. Any bank or hedge fund that admitted 
such losses without first working a bail-out scheme, would instantly 
collapse. Such implausible protestations of solvency are another 
source of instability. The source further said that there is no doubt 
that the Fed and other central banks are pouring liquidity into the 
system, covertly. This would not become public until early April, at 
which point the Fed and other central banks will have to report on 
the money supply.

Regulating Hedge Funds
In response to the GM and hedge funds crises, Lyndon LaRouche issued 
a statement May 14, "On the Subject of Strategic Bankruptcy," in 
which he called for "new governmental mechanisms" for dealing with 
these "strategic bankruptcies, bankruptcies with which existing 
mechanisms of governments are essentially incompetent to deal." 
LaRouche also renewed his call, from the early 1990s, for a 
transaction tax on all derivatives trades, to regulate hedge funds. 
By such a transaction tax, government authorities, for the first 
time, could get an insight into the hedge fund activity. Currently, 
there exist about 8,000 hedge funds worldwide, managing about $1 
trillion in capital, compared to 4,500 hedge funds and $600 billion 
in capital just two years ago. When LTCM was going under in 1998, for 
every dollar of its capital, it had borrowed $30 from banks at was 
running at least $400 in derivatives bets.

Allegedly, the average leverage of hedge funds today is much lower 
than in the case of LTCM. At least one in ten existing hedge funds, 
in most cases the smaller ones, are quietly being closed down every 
year, while at the same time many more are being set up new.

A public debate on the regulation of hedge funds has already erupted 
both in Britain and Germany. On top of the fears for a systemic 
breakdown, there is the imminent concern that private equity funds 
and hedge funds are, right now, taking over or manipulating the stock 
prices of thousands of corporations in both countries. John 
Sunderland, the President of the Confederation of British Industry 
(CBI) came out with an attack on such funds, sounding similar to 
German Social Democratic Party chairman Franz MÃ¼nterfering's famous 
earlier "swarm of locusts" statements. CBI Director General Digby 
Jones raised the alarm bells concerning certain derivatives””
"contracts for differences" (CFD)””by which hedge funds are able to 
secretly build up stakes in corporations.

In Germany, the chief executive officer of Commerzbank, Klaus-Peter 
MÃ¼ller, who also heads the German banking association, raised the 
question: Why are we regulating small banks, while hedge funds, 
moving much larger capital, are not being regulated at all? 
Bundesbank board member Edgar Meister described hedge funds as 
the "white spots on the map of supervisors," which are growing at 
alarming speed. Even Rolf E. Breuer, who just resigned as supervisory 
board chairman of the Frankfurt stock exchange (Deutsche BÃ¶rse) after 
losing a power fight with the British hedge fund TCI, has now 
astonished the banking scene with a surprising conversion. The same 
person who, as head of Deutsche Bank, had praised derivatives trading 
as the shortest way to paradise on Earth, and become known in some 
circles as Germany's "Mr. Derivatives," is suddenly denouncing the 
short-term speculative investments of hedge funds, that are colliding 
with the need for long-term productive investments and therefore 
could "devastate the German economy."


Derivatives: 'Ticking Timebombs'
In an article headlined "Ticking Time Bomb in Structured Credit 
Products," Switzerland's conservative financial daily Neue ZÃ¼richer 
Zeitung on May 19 pointed to the precarious situation in the so-
called "structured credit" market. This includes the use of capital 
structure arbitrage (CSA) contracts, combined bets on the stock price 
and debt titles of the same corporation. The daily states that the 
purchase of GM stocks by Kerkorian caused a "brush fire" on the bond 
market, which then, in particular, hit funds specialized in CDAs. The 
funds faced "painful" losses when the risk premiums on GM 
bonds "exploded" and the prices of related derivatives plunged, while 
GM stocks, because of the Kerkorian move, jumped by 20%. Overall, the 
downgrading of GM, in spite of "the fact that it didn't came as a 
full surprise, triggered a chain reaction on the bond market," 
centered around collateralized debt obligations (CDO). These CDOs 
fueled the "sudden explosion" of the GM risk premium. Trying to 
escape from their CDO adventure, investors "at some point engaged in 
panic selling, which then derailed the credit derivatives market." ””

Lothar Komp 





investorsexchange@yahoogroups.com


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## markrmau (13 May 2006)

Just thought we should revisit the 'hedge fund' topic in light of the rampant speculation in commodities.

Doesn't anyone else have GRAVE concerns about these stories we hear about hedge funds basing trading decissions on momentum?

Techical analysis is suited for the average Joe Blow (no offence site owner  ) to gain an insight into what the 'smart money' is betting on - based on their opinions of the fundamentals. The thought that these larger players whose money helps map the direction of the market are also playing the dumb trend following game is just asking for a disaster (ie sudden 50% overnight moves).


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## wayneL (13 May 2006)

markrmau said:
			
		

> Just thought we should revisit the 'hedge fund' topic in light of the rampant speculation in commodities.
> 
> Doesn't anyone else have GRAVE concerns about these stories we hear about hedge funds basing trading decissions on momentum?
> 
> Techical analysis is suited for the average Joe Blow (no offence site owner  ) to gain an insight into what the 'smart money' is betting on - based on their opinions of the fundamentals. The thought that these larger players whose money helps map the direction of the market are also playing the dumb trend following game is just asking for a disaster (ie sudden 50% overnight moves).




It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend,  as discussed elsewhere.


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## RichKid (13 May 2006)

wayneL said:
			
		

> It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend,  as discussed elsewhere.




Which reminds me, time to dig up COT data to post in the gold thread, only issue is they are a week old, that's far too long in the current climate. ... I might check your blog wayne to see if you have stuff on it....


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## markrmau (13 May 2006)

Just read this:

http://www.telegraph.co.uk/money/ma...d=242&sSheet=/money/2006/05/13/ixcitytop.html



> David Threlkeld, a veteran copper trader, said the market had been "out of control" for months, allowing speculators to run roughshod over industrial producers and users. "The LME has been seduced by hedge funds, [which have] pushed prices to levels unsupported by fundamentals. There's a vacuum below and the crash could set off a chain of margin calls running through the whole commodities sector. We've got a crisis on our hands and it is a lot bigger than copper," he said.


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## nizar (13 May 2006)

wayneL said:
			
		

> It's true, and it's reflected in COT data. The big fund traders get in deeper the longer a trend develops. Extremes in what the big funds and the commercials are doing( eg if the funds are REALLY long and the commercials are REALLY short) often signals the reverse in trend,  as discussed elsewhere.




Agree

those hedge funds can go short at any time, its scary what may happen then


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## RichKid (13 May 2006)

nizar said:
			
		

> Agree
> 
> those hedge funds can go short at any time, its scary what may happen then




Where's Dr Mahathir Mohamed when you need him? We can all blame the mysterious hedge funds when things go awry. Those dastardly speculators.


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## wayneL (13 May 2006)

http://www.telegraph.co.uk/money/main.jhtm.../ixcitytop.html



> Banks face vast losses in copper mayhem
> 
> By Ambrose Evans-Pritchard (Filed: 13/05/2006)
> 
> ...


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## lesm (13 May 2006)

This article may be of interest.

By Peter Brimelow, MarketWatch
Last Update: 12:01 AM ET May 11, 2006


NEW YORK (MarketWatch) -- All eyes are on the Fed, and one respected institutional service thinks there are reasons to dislike what they're seeing.
It's nearly eight years since the Long-Term Capital Management hedge fund cratered. At that time, the Federal Reserve engineered an extraordinary bailout on the (highly debatable) theory that the financial markets would otherwise be fatally disrupted.

What would happen if there was another LTCM today?

The Connecticut-based institutional service Bridgewater Daily Observations, which itself manages over $150 billion, has been asking this disturbing question and getting a fairly disturbing answer.

In recent issues, Bridgewater pointed out that money invested in hedge funds is now five times higher than in 1998, when the LTCM debacle occurred. 
Bridgewater also tried to show through a sophisticated analysis that hedge funds do tend to march in lockstep. That means, paradoxically, that they are vulnerable to the same things: "tight credit, widening credit spreads, and falling equity markets."

Bridgewater's summary: "We estimate that an unfavorable environment, in degrees comparable to 1994, 1998, and 2000/01 will cost ...equally to about 2/3 of the S&L crisis and twice the size of the Mexican default in 1994 - i.e. it is material, but not system threatening."

That's the good news. The bad news: "'the system can withstand a moderate economic crisis (like those that occurred post-1993) but not a major one (like 1974)." 

Bridgewater estimates that losses with the current hedge fund regime would have been $80-$100 billion in the post-1993 crises, $300-$350 billion in 1974 (and $500-$600 billion in 1929).

And then there's the REALLY bad news: Bridgewater also expects a major international system crunch exactly like the collapse of the fixed exchange rate Bretton Woods system, which lead directly to the inflationary crisis of 1974. See my March 16 column (http://www.marketwatch.com/News/Story/Story.aspx?guid={B08B1127-327B-4433-9867-84EC34016FC9}&siteId=mktw)

Wednesday morning, Bridgewater's Daily Letter was headlined, "The Tremors Before the Big One" and concluded: "We believe the odds of a dollar/ U.S. debt crisis in the next twelve months are elevated (say 50 percent)."

A week earlier, Bridgewater pointed squarely at China's manipulation of its exchange rate and at new Fed Chairman Ben Bernanke's handling of the situation.

In an issue titled "Bernanke's Test begins," Bridgewater wrote: "Today's imbalances are much larger and global in scale. They have been sustained for a longer time because China, and many other countries, are not defending a declining currency with shrinking reserves. Instead, they are resisting rising currencies with increasing reserves, a much more sustainable action."

The result, according to Bridgewater: "bigger imbalances that have taken longer to build, have been sewn deeper into the economic fabric, and will take much longer to unwind, with dramatically larger financial consequences."

Bridgewater's savage summary: "...Now you've got a new, academic, waffling Fed chairman, a falling dollar, a falling bond market, rising gold and commodities prices, and an underperforming stock market all with a giant current account deficit ..." 

Its caustic conclusion: "Bernanke is rapidly losing control."


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## Smurf1976 (14 May 2006)

It is my opinion, based on observation of history, that once the Fed starts a series of interest rate rises they keep going until _something_ in the economy breaks. The only questions being what breaks, when it breaks and what the consequences are.

My only prediction as to actual events at this stage is that we're about to see a serious US Dollar rally going higher and lasting longer than most expect followed by a serious fall to new lows. That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move. I could, of course, be wrong with that observation.

To me, this implies that the Fed isn't finished raising interest rates yet (neither is the RBA) and will keep going until a genuine crisis develops. Most likely IMO that will take the form of a bond market slump very quickly leading to falls in real estate prices given the relationship between the two markets. There is increasing evidence that, in the US, this is already underway on a limited scale. After bonds fall there are then implications for commodities, gold, stocks etc.

In short, I'm bullish on yield especially bonds and property.  

(The above is my opinion only and I'm not a qualified financial advisor so do your own research before investing.)


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## rederob (14 May 2006)

Smurf1976 said:
			
		

> My only prediction as to actual events at this stage is that we're about to see a serious US Dollar rally going higher and lasting longer than most expect followed by a serious fall to new lows. That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move. I could, of course, be wrong with that observation.



Not totally disagreeing, but USD weakness has in my view a lot further to run before the upswing - there are definite cycles.
If you are right, then gold will hold steadier (not rise as sharply) during the return of dollar strength.
And if the cycles run to plan, then we are probably looking at  return of dollar weakness by last quarter, which coincidentally is gold's typically strongest period of the year.
All this analysis suggests is that gold is a great hedge to the hedge funds hegemony.


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## markrmau (14 May 2006)

Smurf1976 said:
			
		

> That's simply a contrarian view based on my observation that Dollar bears are getting a little too excited at the moment so it's time for an up move.




Interesting POV. One trigger for this scenario would be a big drop in crude this week with the IEA forecasting a drop in oil demand in 2006, and a reduction in sabre rattling over the iran nuclear issue.

This would alleviate inflation concerns, and cause a big drop in gold. I suspect copper would be slaughtered too as copper is taking on the same 'anti inflation' status as gold.


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## scsl (20 September 2006)

An interesting article on the the risky activities that hedge funds get up to. American hedge fund Amaranth's downfall was the result of letting a young (gun) trader Brian Hunter (who made the firm hundreds of millions in 2005) bet on natural gas prices and gaps - which went horribly wrong. 

Hunter's natural gas positions "became more than half of the entire firm's exposure, even though Amaranth claimed to be a "multistrategy" fund". 

However, one thing is different from previous downfalls of hedge funds. When Long-Term Capital Management hedge fund collapsed in 1998, global financial markets were under threat. Nowadays, the failure of Amaranth (which comes just a month after fellow hedge fund MotherRock was closed) has barely caused any instability - which just goes to show how large and sophisticated the hedge fund industry has become. 



> Hedge Fund's Collapse Met With a Shrug
> Amaranth's Loss in Natural Gas Gamble Not Seen as Affecting Broader Market
> 
> By Steven Mufson
> ...



Cheers,
scsl


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