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White House ponders: Are some hedge funds too big to fail? |
Date: Wednesday, April 8, 2009
Author: Ronald D. Orol, MarketWatch.com
WASHINGTON (MarketWatch) -- When
the $9.2 billion Connecticut hedge fund Amaranth Advisors collapsed in
2006, securities attorneys jumped all over each other to express
gleefully how the markets absorbed such a mega-fund failure.
In fact, the markets did soak up the implosion fairly well.
In fact, the markets did soak up the implosion fairly well.
However, two and a half years later, policymakers aren't so sure the
volatile and fragile markets of 2009 could handle another mega-hedge
fund collapse.
In an effort to limit the fallout from any future major
hedge fund collapse -- or private equity implosion -- Treasury
Secretary Timothy Geithner proposed on March 26 a framework for
regulatory reform that not only included registration of hedge funds
managers, but also called for new rules for buyout shops, venture
capital and insurance companies.
Nevertheless, Geithner's proposal leaves more questions than answers.
"Why should taxpayers pay for hedge-fund failures?" asked Georgia State
University Business School Professor Vikas Agarwal who argues that
already disgruntled taxpayers and legislators are sure to take issue
with a government bailout of a major hedge fund.
New regulation of hedge funds would require legislation from Capitol
Hill, or new rules from the Securities and Exchange Commission.
Geithner made it clear he believes that a group of large non-bank
investment firms are systematically significant and need to be
regulated more thoroughly than they are now because their collapse
could have a catastrophic impact on the markets overall. Such
regulation would likely involve limits on leverage, lending, access to
credit, as well as restrictions on investment activities, such as how
much investing these firms can do in the unregulated over-the-counter
market.
However, Geithner's plan may seek to use U.S. taxpayer dollars, leading
to political concerns. Government bailouts of mega-hedge funds or
buyout shops may be needed to stem systemic economic failures, but such
an approach would likely raise the ire of the retail public, already
apprehensive about the world of hedge funds and private equity.
How to unwind?
Possibly the most controversial aspect of Geithner's plan for hedge
funds focuses on how regulators could unwind systemically significant
non-bank institutions by bypassing traditional bankruptcy proceedings
that might pose a threat to the workings of the financial system as a
whole.
His measure called for the creation of a resolution authority that
could help unwind systemically significant banks, but the entity would
likely also oversee the winding-down of mega-hedge funds and other
super-sized alternative investment vehicles whose pending collapse
would ripple catastrophically through the markets.
The resolution authority could be housed at the Federal Reserve or a
brand-new entity designed for the purpose; it could also be set up by a
new interagency panel that delegates authority to different agencies.
But the most obvious agency to put such authority would be at the
Federal Deposit Insurance Corp., which already routinely winds down
failed banks through its deposit insurance fund.
Here's how the FDIC program works: The agency charges banks fees to
build up its deposit insurance fund, which are used to pay depositors
of failed institutions.
Keeping with this system, the FDIC could be required to set up a
similar insurance fund or funds for large hedge funds, buyout shops and
insurance companies.
However, placing the authority with the FDIC raises questions. Bankers
complain that they already are being charged heavily to wind-down
failed banks. They don't want their fees to help unwind systemically
significant hedge funds.
"It would be unfair to pull resources from the banking industry to
resolve non-banks," said Edward Yingling, president of the American
Bankers Association.
FDIC Chairwoman Sheila Bair recently told a gathering of bankers not to
worry: Should the FDIC be imbued with broader resolution authority,
alternative investment companies would be regulated separately from
banks.
The funding issue - industry or tax-payer funded?
Presumably, that would mean these systemically significant non-bank
institutions would pay fees to set up their own insurance funds, said
Columbia Law School Professor John Coffee.
The fees would be used to pay off counterparties of a mega-collapsing
hedge fund in the same way U.S. government cash infusions into troubled
American International Group Inc. (AIG![]()
AIG)
were used to make sure that the insurance company stayed afloat while
its credit default swap trading partners, in the U.S. and Europe, were
paid to exit their positions. However, to stem political discontent, a
hedge fund's counterparty banks are likely to receive only a percentage
of their total investment.
American International Group Inc
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Fees from large hedge funds could be put into a hedge fund pool, while
separate insurance funds could be set up for systemically significant
buyout shops and venture capital companies.
Hedge funds that trade heavily in credit default swaps are increasingly
being required to use established clearinghouses to complete their
trades. Large funds, which already pay administrative fees to operate
clearinghouses, could also be required to pay additional fees to
support a resolution fund.
Perhaps only large risky funds that trade heavily in CDSs and use a
large amount of leverage would be required to pay the fee, said one
Washington securities attorney.
However, it may turn out that the fees aren't enough.
Columbia's Coffee contended that, if the hedge fund insurance fund were
used up, the FDIC should be required to draw down capital from its bank
insurance fund as a contingency to avoid a catastrophic collapse of a
mega-hedge fund.
"You could have two hedge fund failures and it could take out the entire fund," Coffee said.
Already, the FDIC is having a difficult time making sure it has enough
deposit insurance funds. The agency had $18.9 billion as of Dec. 31,
while it estimates that $65 billion will be needed to pay out to
depositors of failed banks through 2013. Legislation moving on the Hill
would temporarily increase the FDIC's borrowing authority from Treasury
from $30 billion to $500 billion until the end of 2010.
Such authority could be used in case of hedge-fund collapses, but it
would raise political concerns. "A large hedge-fund collapse could
require international counterparty settlements that would be
controversial if paid for by U.S. taxpayers," said Georgia State's
Agarwal.
Beefed up disclosure
Geithner's plan calls for legislation that would require many hedge
funds, buyout shops and venture capital firms to register with the
agency and open up their books to periodic SEC examinations.
An overturned 2004 SEC rule allowed hedge funds exemptions if managers
required their investors to keep their money with the fund for at least
two-years. The SEC set up the exemption to make sure only hedge funds
needed to register, exempting private equity shops with their long-term
investors. However, with Geithner's broader plan, which seeks to
capture hedge funds, private equity companies and venture capital
firms, don't expect any exemptions this time around. "There is nowhere
to hide," Agarwal said.
It is unclear how stringent hedge-fund rules would be. In addition to
opening up their books to the SEC, hedge-fund managers could be subject
to costly anti-money laundering rules requiring managers to respond to
a request by the Fed for information within 120 days of the request.
After the financial crisis expanded in late 2008, the SEC installed a
temporary regulation requiring hedge funds to report their short
positions every week on a confidential basis until Aug. 1, 2009.
However, Geithner is expected to push for expanded hedge-fund reporting
requirements, including a provision requiring disclosure of the
leverage they have.
Regarding capital requirements, some European regulators are pressing
to require all hedge funds to be regulated like banks by maintaining
significant capital on hand. Geithner is not looking for this
limitation. Nevertheless, hedge-fund attorneys are pressing to make
sure such a condition is not required.
"That would have a huge cost," said Kevin Scanlan, partner at Dechert
LLP. "The cost would be in lost opportunities for hedge funds." 
Ronald D. Orol is a MarketWatch reporter, based in Washington.
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