Hedge funds begin to show up on U.S. financial regulators' radars

Date: Monday, February 12, 2007
Author: Carrie Johnson & Jeffrey Birnbaum, Washington Post

For years, hedge funds barely registered on the Washington agenda, and that was just the way their managers liked it.

These investment pools designed for wealthy individuals flourished in the shadows: They collected more than US$1 trillion; seized control of underperforming companies; and increasingly drew money from gigantic pension funds, including those of government employees.

But now they are so large and numerous -- there could be as many as 9,000 hedge funds -- that federal regulators, state authorities and lawmakers are clamoring to learn more about them, including whether fraud and risky trading flourish in their secretive operations.

This week, the Securities and Exchange Commission (SEC) staff confirmed that it was conducting a sweeping inquiry into whether hedge funds are misusing information they receive from investment banks to get a jump on trades and sweeten their profits. Last week, federal prosecutors in New York charged a fund manager with criminal securities fraud, saying it cost investors US$88 million. And German officials put hedge fund risks at the top of the agenda of the Group of Seven meeting that concludes Saturday in Essen, Germany.

"All over the place, there are signals of rising regulatory concern," said Damon Silvers, who tracks the issue as an associate general counsel at the AFL-CIO. "It's certainly not an issue that's going away. If anything, it's escalating."

The last time a major coalition of federal agencies said anything on the subject was in 1999, after a star-studded hedge fund named Long-Term Capital Management nearly collapsed and shook the financial markets. Back then, the agencies rejected direct regulation of the funds, a position the U.S. government continues to hold.

Federal scrutiny, if not action, has increased significantly, however. High-ranking Treasury Department officials held 15 meetings over three days last year with representatives from prominent hedge funds, investors, lawyers and others to gather information about hedge funds' operations. Next week, the President's Working Group on Financial Markets -- comprising leaders from the Treasury, the Federal Reserve Board, the SEC and the Commodity Futures Trading Commission -- will meet and consider issuing a statement that highlights the importance of the funds to the market and the risks, insiders say. For now, federal officials say the best way to police hedge funds is to ensure that banks, which handle billions of dollars of the funds' business in loans and trades, are aware of the risks they face. Market analysts add that it is unlikely that the collapse of one large hedge fund would topple the market. But under certain scenarios, an over-leveraged fund could set off a string of events that could bring a large investment bank to its knees, touching off a dangerous chain reaction.