Disaster at Amaranth

As of this writing, it's not clear if the story of the staggering losses at hedge fund firm Amaranth will simply fade away, or if it will spark a new series of "those terrible hedge funds, we need more government regulation to find out what they are up to" stories in the general press. If those stories do come, I'll spend a lot more time on the issue. In the meantime, however, keep this in mind:

"'What type of regulation would prevent a hedge fund from following a particular investment strategy, or the loss incurred in the pursuit of an investment strategy that simply did not work,' said Perrie Weiner, a partner who helps manage law firm DLA Piper Rudnick Gray Cary's securities litigation practice and often deals with hedge funds."

The answer is none. There are two important issues in this specific situation:

• One, did the firm in fact do what it told its investors it was going to do, most importantly in its offering documents, but also in other communications? A simple example would be a firm that said it was going to buy common stocks, and instead speculated in energy futures (not the case here, but you get the idea).

• Two, should investors demand more specificity in such documents about what firms are allowed to do in a particular fund? The most striking thing about the Amaranth situation is that they allowed the firm to be so incredibly exposed to a move against them in a single market (i.e. natural gas). Investors might, quite rightly, begin demanding more specific, quantitative risk control guidelines be included in offering documents. These might include limiting individual (or related) positions to a certain percentage of fund capital, formalized stop-loss guidelines, etc.

Come to think of it, there actually is another big issue, and the fact that it hasn't really come up shows you that the system works. Was there any chance of a broader market breakdown or disruption because of this individual failure? You may recall that it was just this type of fear (whether or not it was justified) that caused the NY Fed to help orchestrate a private bailout of Long Term Capital Management back in 1998. In this case, despite what would appear to be a very concentrated portfolio exposure to natural gas, I haven't seen worries about derivative contracts not being honored, or other systemic concerns. In fact, it seems that non-energy parts of the portfolio were being liquidated in order to meet the collateral requirements of the gas positions. If that's the case, then the banks and others involved did the job they were supposed to do, and limited the damage to Amaranth.

Remember, when dealing with sophisticated funds and investors, regulators aren't around to stop them from losing money by making bad bets. Instead, they are around to stop those bad bets from hurting others. It seems in this case that system worked fine.