15 Nov 2006 - Tammer Kamel

The dust having settled from the Amaranth fiasco allows for comparison with another hedge fund failure from a few years earlier. Comparing LTCM and Amaranth offers some interesting insights into the evolution of an industry.

Some things change…

Amaranth, it appears, lost $6 billion. LTCM, the most notorious hedge fund in history only managed to lose $4 billion. Yet Amaranth got no more than two or three days press coverage before their infamy waned. To this day, LTCM is referenced again and again in the media and in 1998 enjoyed front page attention for weeks; that at a time when most people didn’t know what a hedge fund was. That a $6 billion dollar hedge fund loss is a one cycle story is a sign of the matured hedge fund industry. No longer does the public (and the media) use a single hedge fund as a proxy for the industry. Some hedge funds screw up. Others make money. In 1998, LTCM was prima facie evidence that hedge funds (as a class) are dangerous, reckless, evil, obscenely risky and to be avoided at all costs. Today, the world has figured out that some hedge funds are good investments, some bad, and a few disastrous. Much like any investment. But no one is making grand inductions about hedge funds from the Amaranth case.

Of course, LTCM’s extra notoriety might stem from having taken the global financial system to the brink of failure. Amaranth can not make a similar claim. But this is also symptomatic of the differences between the modern world and the one LTCM operated in. Pre 1998, hedge funds like LTCM were worshipped by investors “lucky” enough to be granted an audience. The management of LTCM (and the handful of their contemporaries that were around at the time) could make the most arrogant of modern managers look downright humble. From inception in 1994 to failure in 1998, LTCM wrote the rules for not only for their investors, but their creditors too.. The rule of investing was simple: Hand over the money and ask no questions. Ever. The rules between LTCM and their counter parties were also simple: Counter party to take the absolute minimum in margin and to not complain about it. And so they did. And as a direct result of this, as the firm lost hundreds of million of dollars through August of 1998, major Wall Street banks watched as the effective leverage they were providing drifted to beyond 100 times. As the fund teetered on the edge of bankruptcy, the New York Fed was forced to poke the banks into a rescue operation because LTCM’s failure threatened to incite a dangerous liquidation gyre.

How times have changed! Investors demand (and receive) just about any information they want from hedge funds. And counter parties call all the shots with respect to collateral and margin requirements. Investment banks have made a science out of managing their hedge fund obligors: There is simply no way a modern fixed income fund would be able to take risk à la LTCM. They couldn’t even get close. Today, only investors take hedge fund risk, banks do not. This was not the case 10 years ago.

…and some stay the same

Audacity however, seems to transcend hedge fund epochs. The ultimate reason LTCM lost $4.4 billion was because the managers convinced themselves they could simply not get it wrong. A delusion which was reinforced by a few years of success. Sound a bit like another fund? The myth of Icarus was surely conceived by an ancient Greek hedge fund investor.