Shrugging off Amaranth
Despite the meltdown of a major hedge fund, it's business as usual - and that could set the market up for a bigger blowup, says Fortune's Andy Serwer.
By Andy Serwer, Fortune senior editor-at-large

(Fortune Magazine) -- The good news is that Wall Street survived a Big One. The financial markets easily withstood what many had long predicted: the blowup of a major hedge fund.

Aside from scores of badly singed institutions and superwealthy investors, the recent Amaranth debacle - triggered by a 32-year-old trader who made reckless bets on natural-gas futures and cost the $9 billion fund some $6 billion - caused nary a ripple on Wall Street. As Fortune went to press, Amaranth announced it was liquidating its assets - and stocks were hitting multiyear highs, bonds were rallying, and even energy markets were orderly. But don't get too comfortable.

Proponents say that this is proof positive that calls for regulation of the sprawling and secretive hedge fund world are off base. The business, they say, heals itself. When Amaranth was melting down, bidding by its hedge fund brethren for nonenergy holdings - such as loans and convertibles - that it sold to cover its losses was so competitive they were barely discounted.

That wasn't the case when it came to the company's hugely compromised natural-gas position, but the giant Chicago hedge fund Citadel, along with J.P. Morgan (Charts), stepped up and bought the stake and restored order there too.

In a matter of two weeks the crisis was mostly over - with no emergency meetings of the Fed or round-the-clock gatherings of Wall Street titans. All this despite the fact that Amaranth's cash losses were significantly larger than the $4 billion that vaporized when Long-Term Capital Management went bust in 1998. It seems almost too good to be true.

One explanation for the lack of chaos is that, because hedge funds have mushroomed into a $1.2 trillion industry, the pricing of some financial exotica is more efficient. But LTCM was much more highly leveraged than Amaranth. The notional value of LTCM's assets (the value of its leveraged positions) was close to $1.25 trillion. LTCM's brain trust may have felt compelled to leverage to the max to compete with then-soaring equity markets. Today if a hedge fund manager can return five percentage points above cash, that's considered acceptable - ergo, there's less lust for leverage.

Not that Amaranth's tale doesn't include the usual greed-fueled bumbling. Investors, including fund of fund operations from the likes of Goldman (Charts) and Lehman (Charts) and pensions from San Diego County and 3M (Charts), were chasing performance as Amaranth rode the flaming-hot natural-gas market. Too few questions were asked by those investors.

And while Amaranth chief Nicholas Maounis points to "unpredictable market events" as the primary cause of the meltdown, it seems clear that he failed to provide, from his office in Greenwich, Conn., sufficient oversight of his trader in Calgary, Canada. Maounis, 43, is said by some on Wall Street to love golf as much as serving his clients. (A check of a USGA Web site shows he has a 13 handicap.)

What are the lessons to be learned? Brett Barth, a founder of BBR, a New York money manager that oversees some $2.5 billion, sees some positives. "Hedge fund investors are going to demand more transparency," says Barth, who didn't place money with Amaranth. "There's going to be less 'Trust me' and more 'Show me.'"

This may be especially true in the case of so-called multistrategy funds, says Barth. These mammoth fund complexes, some with $10 billion of equity, employ a range of investing styles - for instance, U.S. long/short equity, commodities funds, and quantitative funds. The investor sends in his check, and the fund divvies it up into these subfunds at its discretion. Which team is running how much of your money? In some cases, it's tough to tell. Could all be with a cowboy in Calgary.

It would be a mistake to declare that the hedge fund business is now less risky, or suitable for unlimited pension fund investment, or even fully capable of self-regulation. The potential downside to Amaranth's muffled implosion is that it might suggest that hedge funds are underleveraged. I'm talking about a little voice in some manager's head saying, "By golly, Amaranth wasn't so bad! We can borrow more to jack up our returns." The thing is, Amaranth was a Big One. But it wasn't necessarily the Big One.

Watch Andy Serwer on CNN's "American Morning" and "In the Money."