Who Says Hedge Funds Aren't Regulated?

So it came across Bloomberg this morning that the SEC (US), the New York Fed and the FSA (UK) are doing an investigation into the margin requirements of the leading hedge fund prime brokerage units:

Jan. 9 (Bloomberg) -- U.S. and European regulators, turning a spotlight on one of Wall Street's most profitable businesses, are conducting a joint probe into whether banks and securities firms set strict enough limits on loans to hedge funds.         

The U.S. Securities and Exchange Commission, the Federal Reserve Bank of New York and the Financial Services Authority in London met last month with some of the biggest lenders to the hedge-fund industry, seeking information on how they decide the amount of collateral required, SEC Commissioner Annette Nazareth said in an interview in Washington. Swiss and German authorities were also involved.                

``The purpose of the meetings was to discuss margin practices,'' Nazareth, 50, said. ``It was a fact-finding effort.''

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Officials want to know how much margin banks require hedge funds to provide up front to obtain loans and cover potential losses. They're hoping to avoid the kind of turmoil that engulfed financial markets when Long-Term Capital Management LP's losses forced the Fed to organize a rescue in 1998.         

For hedge funds, private pools of capital that speculate on everything from interest rates to weather patterns, leverage also can multiply trading losses and put stress on the financial system.       

``We are doing work on credit-risk management with the SEC,'' said David Cliffe, a spokesman for the FSA in London. ``It's looking at the prime brokers in relation to the hedge funds.'' The Swiss Banking Commission in Bern has worked with British, U.S. and German authorities on the issue, spokeswoman Tanja Kocher said.

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The meetings last month included New York-based Goldman Sachs Group Inc., Morgan Stanley, Bear Stearns, Merrill Lynch & Co., Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and Citigroup Inc.; UBS AG and Credit Suisse Group, both based in Zurich; and Frankfurt-based Deutsche Bank AG, according to a person helping to direct the examinations. All of the firms declined to comment.         

The person, who declined to be named because of the confidential nature of the discussions, said the regulators are concerned that there has been a decline in lending standards because hedge funds are such lucrative customers. The agencies plan to meet in the next couple of weeks to decide what to do with the information, the person said.         

Now doesn't this sound like, uh, regulation of hedge funds? Not to play the "I told you so" card, but here is text from a post I had written about six months ago titled "Much Ado About Nothing - the Hedge Fund Regulation Debate:"

Hedge funds are already subject to significant regulations, SEC rule or not. The SEC can ask for a hedge fund's books and records if they have basis for a concern that places investors at risk or believe a violation may have taken place. Investors can (and often do) request extensive information from hedge funds during the due diligence process, and this process can often take months for large, sophisticated institutions. Furthermore, investors who are also fiduciaries (like pension funds) have an obligation to do thorough due diligence prior to investment in order to protect the individuals who make up their constituency. Finally, the allocators and managers of risk capital, the prime brokers, can alter margin and credit requirements based upon the strength of a hedge fund's management structure, risk reporting, operating environment and returns.

So here we are, with the "Big Three" overseers of the lion's share of global hedge fund AUM examining the prime brokers and their lending practices. This is exactly the kind of regulation I was talking about when I scripted the July 16, 2006 post. Writers, politicians and many in the general public just don't seem to get it - an SEC "hedge fund rule" or not, much more powerful levers are already controlled via oversight of broker/dealers, federally chartered banks and the ability to walk into any hedge fund at any time if there are suspicions of fraud or malfeasance. Today's Bloomberg article goes on to say some stuff that really worries me:

Nazareth said it's not clear what steps, if any, the regulators may take. New York Fed President Tim Geithner described the question of margins as "very complicated'' in comments to a Nov. 29 meeting of the American Institute of Certified Public Accountants in New York.

Because hedge funds let managers participate substantially in the gains on money invested they provide an incentive to boost returns with extra leverage. Fed officials have been troubled for months by the possibility that banks may be cutting margin requirements for hedge funds too far and in some cases demand no margin at all for potential losses on over-the-counter derivatives.

``It's very hard to figure out what's right,'' Geithner, 45, said at the November meeting. ``It's maybe as hard or harder to try to figure out whether you can bring about change that may be in the broader interests of all market participants.''

When you have the President of the New York Fed saying that the issue of margin requirements is "very complicated" and that "It's hard to figure out what's right," I'd be very afraid of the potential outcome. Mr. Geithner is right - margin requirements are extremely powerful and complex tools. And they need to be examined very carefully and with the utmost care before change is enacted. And hopefully Mr. Cox of the SEC will prevail upon him and his UK-based colleagues in the FSA to proceed thoughtfully. Because abrupt changes in things like margin requirements can have very powerful (and unintended) ripple effects throughout the financial markets and, therefore, the real economy. So don't tell me hedge funds aren't regulated. They are and they always have been. The SEC and the Fed has the equivalent of "regulatory nuclear weapons" at their disposal, and this is just one of its potential manifestations. Let's hope the suitcase with the red button remains in storage for a long, long time.

Comments

[Yaser Anwar]

The imposition of additional limits on hedge funds such as: fund size limits, limits on the maximum amount that an investor may invest in a hedge fund, or limits on the number of investors in any one hedge fund, may not be an appropriate or effective means to address the perceived risks of hedge funds.

A provision that seeks to impose additional limitations on HFs may also impose unwarranted burdens on other types of private investment pools, such as mezzanine funds & structured financings, that may not raise the same concerns as hedge funds.

For example, a limit on fund size or maximum individual investments could force a mezzanine capital pool to reject or limit investment contributions. This could, in turn, limit investor opportunity and capital raising efforts that benefit small/mid-sized businesses.

Increasing concerns have been expressed about the activities of highly leveraged institutions with respect to their impact on market dynamics generally and vulnerable economies in particular. Again, I think every 3-4 years when a fund blows up, regulators get to work and like to make a lot of noise. It remains just that, noise. In a year or so, everything will be back to normal. A great man once said markets remember nothing. When LTCM blew up we heard a lot of jibber jabber, now AA *yawn*.

In my view, such activity can affect markets in some circumstances but for limited periods although, as a number of independent studies that have been undertaken so far have suggested, the activities of highly leveraged institutions do not appear to have played a significant role in precipitating the financial market crises (except in the case of LTCM. Hardly any ripples were felt in AA's situation).

Sir do you know if regulators have authorized broker-dealers, FCMs, and their unregulated affiliates to report credit risk information by counter party?

I think the reporting of this information would provide a comprehensive, periodic snapshot of unregulated broker-dealer and FCM affiliates and the financial risks they pose. Right now, there is overlap in these authorities, and the agencies will cooperate in order to eliminate duplicative requirements and multiple filings of the same information.

To constrain the leverage of both regulated and unregulated financial entities, our market-based economy relies primarily on the discipline provided by creditors, counterparties & investors. If a fund seeks to achieve greater leverage, its creditors and counterparties ordinarily will respond by increasing the cost or reducing the availability of credit to the firm.

History tells us that creditors, counter parties and investors from time to time misjudge their risks, and that sometimes they become complacent in their risk assessments in an attempt to achieve higher returns (prime example- Amaranth).