In autumn 2008, Citadel seemed about as big a threat to the global financial system as a hedge fund could get. Ken Griffin’s firm had counterparties across the financial world and was big and highly leveraged—the three red flags of systemic importance most often cited by regulators looking to avoid another financial meltdown.
Citadel’s tentacles extended to more of Wall Street than the typical hedge fund, given its market making, stock loans and administration businesses. With $20 billion under management as of mid-2008, the firm was the 12th-largest American hedge fund. And Citadel was purposely heavily indebted, with gross leverage in January 2008 of 8.2 times capital.
Arguably, these reasons are what gave traction in the crisis days to wild, unsubstantiated rumors, all denied by Citadel, that the Federal Bureau of Investigation had been poring over the firm’s books and that the Federal Reserve was engineering some sort of bailout of its portfolio (the Fed did question counterparties about their exposure to Citadel, as well as other firms).
But if the rumors held credence for speculators and regulators, they didn’t for Griffin. He argued for more transparency in derivatives trading before the House Committee on Oversight and Government Reform on November 13, 2008, but defiantly testified that it was not his belief “that we need greater government regulation of hedge funds with respect to the systemic risks they create,” contradicting the testimony of George Soros, Jim Simons, John Paulson, and Phil Falcone.
Griffin’s firm would ultimately lose some of its famous swagger, and more regulation of the opaque hedge fund industry would come. But Citadel, despite its problems, did not adversely affect the financial markets in its darkest days.
Fast-forward to 2011, and Citadel, like other brand-name money managers, is again in the conversation, thanks to the Dodd-Frank Act and the Financial Stability Oversight Council (pronounced F-SOCK) that it created.
In July 2010, the Dodd-Frank Act broadened Washington’s oversight of the financial industry from a focus on individual players to the system as a whole, hoping to avoid the regulatory myopia that contributed to the crash. Central to that effort is the FSOC, which has the “authority to require that a nonbank financial company be supervised by the Board of Governors of the Federal Reserve System and be subject to prudential standards if the Council determines that material financial distress at such a firm, or the nature, scope, size, scale, concentration, interconnectedness, or mix of the activities of the firm, could pose a threat to the financial stability of the United States.”
The FSOC did not respond to requests for comment, but draft rules up for public feedback emphasize six major factors in the determination: size, lack of substitutes for the financial services and products the company provides, interconnectedness with other financial firms, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny.
The new rules could mean substantial burdens for hedge funds. If a firm is deemed systemically important and in trouble, the FSOC’s “prudential” oversight could mean a government takeover: the forced reduction of leverage, sale of some assets or even liquidation if problems aren’t resolved.
In public, the hedge fund industry supports being monitored. Its lobbyists have filed polite letters to leaders of the new regulator, including Tim Geithner, its chairman and Treasury secretary; Ben Bernanke, chairman of the Fed; and Mary Schapiro, chairman of the Securities and Exchange Commission. “We support robust reporting…to ensure that regulators have the information they need to assess all financial market participants, including hedge funds,” wrote Richard Baker, president and CEO of the Managed Funds Association, on February 25.
Behind the scenes, however, hedge funds are strenuously arguing that even the biggest funds are not close to being systemically important. According to an FSOC filing, the MFA sent a high-powered group to make the point by meeting with Fed staffers on February 17, including Michael Waldorf of $36 billion Paulson & Co., Scott Bernstein of $10 billion Caxton Associates, and Brian Gunderson of GPC Associates, a lobbyist for $16.8 billion Elliott Management (none would comment).
One prominent hedge fund lawyer has even challenged the legality of FSOC’s oversight. Thomas Vartanian of Dechert, who has worked for Citadel and Paulson, wrote in a comment letter that the mandate is “entirely defective” and should be withdrawn. He argues that Dodd-Frank created FSOC but did not authorize it to “promulgate substantive rules” about hedge funds or other nonbank institutions. Plus, he argues, the new FSOC draft rules mostly summarize previous feedback instead of providing real insights on how the council will determine and regulate risky firms.
Hedge fund lobbyists, obviously, are not attacking the legitimacy of the council, but argue that hedge funds should not be considered systemically important. “We believe that, in light of the structure of hedge funds and the market and regulatory changes regarding counterparty risk management, leverage and use of collateral…should lead to the conclusion that it is highly unlikely that any hedge fund is systemically significant at this time,” wrote the MFA’s Baker in his February FSOC letter. (Cautiously, he adds: “We recognize, however, that circumstances can change and that there is a possibility that a hedge fund may, in the future, become systemically significant.”)
That “not now” group necessarily includes the largest, $58.9 billion Bridgewater Associates, which is not highly levered, as well as the now-$11 billion Citadel, which has been operating with net leverage of between three and five times during the past 12 months, according to an individual close to the firm. Also, the firm’s nontraditional business lines are legally and financially separated from its hedge fund unit.
The Alternative Investment Management Association, an international hedge fund lobbying group, has a similar line. “Lots of academic and regulatory analysis has been done on this topic, and there is no convincing evidence to support claims that hedge funds create new or unique systemic risks,” says Todd Groome, AIMA’s chairman, who notes that no groups of hedge funds are risky and no hedge fund closures during the financial crisis caused stress on their counterparties or the market. “They arguably decrease such risks due to their diverse and often countercyclical market behavior.”
Some industry observers disagree. “When the straw that breaks the camel’s back lands on the pile, I guess you can argue that none of the other straws were at fault,” says Andrew Lo, director of MIT’s Laboratory for Financial Engineering and FSOC proponent, in response to AIMA’s contentions on hedge funds and the financial crisis. “This seems to be a rather disingenuous claim.”
“Hedge funds certainly weren’t the only ones involved in the financial crisis,” says Lo. “But given the leverage, size and active nature of the hedge fund industry, they certainly participated on the way up and were among the first to get hit with losses on the way down.”
Lo also points to the quant meltdown of August 2007 as evidence of hedge funds’ systemic risk. His November 2007 paper on the subject said a leverage ratio of almost 9 to 1 was needed in 2007 to yield an expected return comparable to 1998 levels for contrarian strategies. That exacerbated the “cascade effect” of the quant fund unwind that ultimately spread more broadly to other types of portfolios.
Those that shaped the FSOC rules firmly believe that hedge funds should be watched. “It doesn’t make sense to say hedge funds can never be a problem,” says Michael Barr, a major architect of Dodd-Frank while at Treasury and now a professor at the University of Michigan Law School. “Look at the impact of a relatively small fund like Long-Term Capital Management on the markets at the time it collapsed or the lack of transparency about the positions hedge funds were taking during the recent financial crisis. That lack of transparency contributed to the financial panic once the crisis hit.”
A Brookings Institution study, “Identifying and Regulating Systemically Important Financial Institutions,” said that funds’ “combination of size and leverage could generate sufficiently large credit exposures for other SIFIs to merit inclusion...or they might exacerbate other potential sources of risk, including contagion.”
Merits aside, the FSOC will look at hedge funds. The council has the ability to ask for virtually whatever information it wants, especially using the new Office of Financial Research and regular reporting through the SEC’s new Form PF.
According to a draft proposal now up for comment, the confidential Form PF would be completed quarterly by investment advisors with $1 billion or more under management and annually by those managing between $150 million (the new SEC mandatory registration threshold) and $1 billion. The rule would be effective as of December 15, 2011. The form would have to be done separately by billion-dollar-plus firms for individual hedge funds with assets of more than $500 million.
The MFA plans to suggest several improvements to the proposal. It would like to see mechanisms for better coordination of international surveys of systemic risk from the United States, Hong Kong, and the UK, and the adjustment of overly broad questions in the draft survey, such as those that require monthly information, which effectively triple the calculations needed for each quarterly report.
“It may be more effective to start smaller and add questions once the FSOC learns more about our industry. Excessive data could actually make it more difficult to detect systemic risk,” says Darcy Bradbury, managing director of the D.E. Shaw Group and chair of the MFA, which, she says, is “working with the SEC to ensure the scope of Form PF is focused on gathering the data that will most effectively aid in the anticipation and prevention of systemic risk.”
Heather Slavkin, a senior legal and policy adviser for the AFL-CIO Office of Investment, says quarterly reporting for fast-trading hedge funds would give regulators an out-of-date assessment. “The disclosures need to be more robust and more frequent if they’re going to get anything valuable out of it,” she says.
The industry is expecting Form PF to be a hassle. Consultants and service providers plan to take advantage by shepherding funds through the process. “A lot of it is intuitive—what to put in which box—but with all of the attribution that is required, it is going to be difficult to make sure you’ve accounted for 100% of your portfolio, no more, no less,” says Michael Rosen, CEO of reporting platform RiskONE. As the proposal stands, Rosen says lots of assumptions will have to be made for calculations like value at risk without the space for nuanced explanations.
Even with reporting done, the criteria could change. “Which firms will be targeted and what that will mean for their strategies remain very open questions,” says Margaret Paradis, a hedge fund specialist at law firm Morris, Manning & Martin.
Regardless, recent data on hedge fund size and leverage—two of the most important criteria—support the idea that few if any hedge funds will be designated as systemically important, at least soon.
According to AR’s Billion Dollar Club, the largest 225 American hedge fund firms managed $1.3 trillion as of January 1. As the MFA noted in its comment letter, the global mutual fund industry managed $23.7 trillion in assets, and the top 50 U.S. bank holding companies had $14.4 trillion in assets as of September 30, 2010.
On leverage, a recent Columbia University study—cited by the MFA as consistent with others—found that the debt-to-equity ratio for the hedge fund industry was 1.5 as of October 2009, with an average ratio of 2.1 from December 2004 to October 2009, and a high of 2.6. That compares with the leverage of investment banks over the same period of 14.2 and the entire financial sector of 9.4. (Leverage for the largest hedge funds wasn’t available.)
That survey was unique, as there is no consistently updated public accounting of hedge fund leverage. What little information is available typically relates to equity hedge funds, which tend to use much lower leverage than strategies employed by quant or macro funds. According to a Morgan Stanley March 2011 report on U.S. hedge funds, equity long/short funds ended February at 1.52 times leverage, noting that “median gross leverage has continued to trend with the historical average.”
By comparison, in August 1998, Long-Term Capital Management—which engaged in such high-leverage strategies as statistical arbitrage—had borrowed nearly $125 billion against capital of $4.8 billion, according to the President’s Working Group on Financial Markets, the FSOC precursor. That’s a leverage ratio of 25 to 1.
Other clues to how Washington will assess systemic risk come from a leaked internal FSOC study obtained by Bloomberg. The draft report notes how an “exodus of hedge-fund investors could ‘cause activity in some markets to freeze,’ ” but also divides nonbank firms into eight categories, one of which is hedge funds. That’s calmed some hedge funds that were concerned the government might treat them the same as banks.
A co-author of the Brookings study on the council’s oversight mandate, Robert Litan of the Kauffman Foundation, says there’s little to do but wait to see: “It’s too early to say what hedge funds the FSOC might designate as systemically important, what regulatory measures they might impose on such institutions, and whether any of these steps will prove effective.”
