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Hedge-Fund Borrowing Examined by Fed, SEC, European Regulators

Date: Tuesday, January 9, 2007
Author: Rich Miller and Jesse Westbrook, Bloomberg.com

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.''

Any move to raise margins as a result of the probe may crimp the $8 billion a year in fees that securities firms collect providing hedge funds with prime-brokerage services such as lending and clearing trades. Bear Stearns Cos., one of the three largest prime brokers, generates at least 30 percent of its profit catering to hedge funds, according estimates by Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York.

Hedge funds, which use margin loans to add leverage and increase the size of their trading bets, would have a harder time making money.

Threat to Business

``Any tightening will decrease the amount of business that the banks can do,'' said Josh Galper, the New York-based managing principal at consulting firm Vodia Group LLC. ``If the hedge funds' ability to borrow on margin is decreased, they're going to be unable to produce the same returns for clients.''

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.

Goldman Meeting

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.

New York Fed spokesman Calvin Mitchell and Anja Schuchardt from Germany's Bafin declined to comment.

Expanding Market

Hedge funds worldwide manage a combined $1.3 trillion, more than double the amount they controlled five years ago, according to Hedge Fund Research Inc. in Chicago. Returns last year averaged 13 percent, led by emerging-market funds, the best annual performance since 2003.

It's common for prime brokers to relax margin requirements because the bigger the loans, the more the banks make charging interest and holding securities as collateral, said Galper at Vodia Group. He estimates that Wall Street collected about $8 billion last year lending cash and securities to hedge funds.

``That's a selling point of the banks, how much leverage they're willing to give,'' Galper said. ``If one says, `I'll give you 10-to-1 leverage,' another says, `I'll give you 12-to-1.'''

Goldman's revenue from providing prime-brokerage services jumped 22 percent in fiscal 2006 to $2.18 billion. Bear Stearns got $1.1 billion of revenue from prime brokerage and other clearing and settlement services, up 3 percent.

Hedge funds are attracting more scrutiny after Amaranth Advisors LLC's failed bets on natural gas forced the Greenwich, Connecticut-based firm to liquidate positions as lenders demanded more collateral. Amaranth's two main hedge funds lost more than $6.5 billion, or 70 percent of their assets, in September, in part because its trades were leveraged.

Next Step Uncertain

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.''

To contact the reporters on this story: Rich Miller in Washington at rmiller28@bloomberg.net ; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net .