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A Safety Board for Hedge Funds

Date: Monday, November 17, 2008
Author: Joe Nocera, Executive Suite Blogs.nytimes.com

Although it received almost no mention in the media, a panel of academic witnesses preceded the five hedge fund billionaires who appeared Thursday before the House Committee on Oversight and Government Reform, which is led by Representative Henry A. Waxman. One of the specialists was Andrew W. Lo, the M.I.T. professor who is both an expert on, and participant in, the hedge fund industry.

In the course of his testimony — most of which centered on the need for regulators to have access to hedge fund data that would allow them to assess the risk — he trotted out what I think is a very intriguing idea. He would like to see the government set up a small agency, modeled along the lines of the National Transportation Safety Board, that would investigate hedge fund blow-ups in the same fashion the N.T.S.B. investigates airline crashes.

Here is how he described the idea in his written testimony:

The most pressing regulatory change with respect to the financial system is to provide the public with information regarding those institutions that have “blown up,” i.e. failed in one sense or another. This could be accomplished by establishing an independent investigatory agency or department patterned after the National Transportation Safety Board, e.g., a “Capital Markets Safety Board,” in which a dedicated and experienced team of forensic accountants, lawyers and financial engineers sift through the wreckage of every failed financial institution and produces a publicly available report documenting the details of each failure and providing recommendations for avoiding such fates in the future.

The board, he later explained, would have several purposes. It would report to the public, just as the N.T.S.B. does, about what had gone wrong — a level of transparency that simply does not exist today. (Do we really understand the details of what brought down the hedge fund Amaranth last year, for instance?) Thus it would help stem some of the “confusion and fear” (Mr. Lo’s words) when a hedge fund goes bust. Mr. Lo also believes that the agency should have a dedicated “team of public relations professionals” whose job it would be “to establish clear and regular lines with the public.”

In addition, the agency would help inform regulators about what constituted excess risk, and when it ought to step in to prevent blowups. In other words, it would allow the government to better understand what causes failures — just as the N.T.S.B. has helped the government understand what causes airline crashes. In so doing, the N.T.S.B. has made it possible for federal aviation officials to pass regulations that have greatly improved airline safety.

This idea seems so sensible I do not know why anybody has not suggested it before. My column this week is about the Waxman hearing as well as another hearing this week, at Barney Frank’s Financial Services Committee. Your feedback is welcome on the column — and also on Mr. Lo’s nifty idea.