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.”********************
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.********************
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.
