Light Hedge Fund Oversight Works

Date: Monday, March 3, 2008
Author: Forbes.com

The light-touch regulatory regime for U.S. hedge funds is getting a deep-end-of-the-pool tryout courtesy of the ongoing credit crunch.

So far, so good.

A huge caveat has to be entered right here: No one knows, to switch to a baseball analogy, what inning the credit crunch is in. If we're still in the early stages, there's still the possibility hedge funds could endanger the financial markets. Moreover, just this week news reports emerged that two large funds in London were having serious problems, to cite just the latest example of hedge fund stumbles.

But the regulatory framework wasn't designed to protect hedge funds from finding trouble or even failing. Nor is it or should it be designed to insulate hedge fund investors - typically institutional investors or wealthy individuals - from losses.

As Rep. Barney Frank, D-Mass., told the Financial Times in late 2006 on the issue of hedge-fund investors: "I don't care if you ride your motorcycle without a helmet."

The real issue is whether the failure of one or more hedge funds could pose real systemic risk for global financial structures. The risk arises because hedge funds often use borrowed funds to amplify their bets and because those funds typically are loaned by large commercial or investment banks.

As it turns out, it's the more heavily regulated commercial and investment banks that have suffered the brunt of the woes brought by assets related to subprime mortgages.

Indeed, it was on the subject of bank regulation that Federal Reserve Chairman Ben S. Bernanke took some heat Thursday from members of the Senate Banking Committee. Put simply, the heavily regulated have so far fared worse than hedge funds, which are more dependent on market discipline to keep system-threatening risks in check.

It was Bernanke who in April 2007 kept step with his predecessors by publicly stating U.S. hedge funds should continue to be largely regulated by market forces.

Back then, this column took some issue with that sanguine view, as it presupposed rational and fully informed decisions by hedge fund investors and Wall Street creditors, an assumption challenged by the subprime crisis and risk-taking profile of many Wall Street banks.

"The market-discipline approach to regulating hedge funds imposes responsibilities on four sets of actors," Bernanke said last year, "hedge fund investors, creditors and other counterparties, the regulatory agencies and the hedge funds themselves."

Crucial to this framework is the idea that if you are a prime broker to a hedge fund, you know how and what the fund is investing in and you won't lend to support reckless strategies or put your own enterprise at risk.

But in the fight to win profitable hedge fund business, caution hasn't always prevailed, and risk management on Wall Street, generally speaking, has a ways to go to be broadly effective.

Here's how the U.S. Government Accountability Office put it in a recently released report on hedge funds:

"Several factors may limit the effectiveness of market discipline or illustrate failures to properly exercise it. For example, because most large hedge funds use multiple prime brokers as service providers, no one broker may have all the data necessary to assess total leverage of a hedge fund client. Further, if the risk controls of creditors and counterparties are inadequate, their actions may not prevent hedge funds from taking excessive risk."

Meanwhile, another sort of market discipline seems at work in the hedge fund world, which previously enjoyed a simply astronomical rate of growth and offered many of its denizens the ability to earn vast sums.

Consider these numbers from the GAO: from 1998 to 2007, the number of funds grew from more than 3,000 to more than 9,000. Global assets under management grew from more than $200 billion to more than $2 trillion.

But now news reports say institutions and wealthy investors are less likely to trip over each other in the rush to hand hedge funds their investment dollars. That makes sense, since overall returns for many hedge funds are down.

Perhaps the next dose of market discipline will be felt by hedge funds' generous fee structures.

Neal Lipschutz is senior vice president and managing editor of Dow Jones Newswires.