Hedge fund managers are an easy target — especially in the U.S. When times are good and hedge funds are making mountains of money, Washington lawmakers want them to pay more taxes. When public pension plans start plowing billions into hedge funds, legislators turn their attention to investor protection and forcing managers to register. And during economic crises, hedge funds become a scapegoat inside the Beltway.
Such was the case a decade ago, when John Meriwether and his band of rocket scientists at Long-Term Capital Management nearly brought down the world’s financial system with their hugely leveraged bets on more than $100 billion in debt, equity and derivative instruments. The collapse of LTCM — which had to be bailed out in September 1998 by a consortium of Wall Street firms that agreed to put up $3.5 billion at the behest of the Federal Reserve Bank of New York — led to the first major regulatory review of the then-nascent hedge fund industry and its role in the capital markets. Although no direct new regulation resulted, the review laid the groundwork for the Securities and Exchange Commission to approve in 2004 a rule change (later overturned in the courts) that required hedge funds to register.
In the current economic crisis, hedge funds have played a fairly minor role. This mess started in the U.S. subprime mortgage market in early 2007 and quickly spread to other areas of the housing sector, eventually engulfing almost the entire U.S. financial services industry, as the banks that had gorged on high-risk loans were forced to take massive write-offs. For their part, hedge fund managers are quick to point out that it was the near bankruptcy of Bear Stearns Cos., which was bought by JPMorgan Chase & Co. in March in a deal brokered by Treasury Secretary Henry Paulson Jr., and the actual bankruptcy of Lehman Brothers Holdings, which filed for Chapter 11 on September 15, that left the global financial system in ruins.
However true, none of this may matter. Though hedge funds have not been a big cause of the problem, they undoubtedly will be deeply affected by the solutions coming out of Washington. “The pendulum may swing back toward greater regulation of hedge funds, and capital markets more broadly,” says Sandra Urie, president and CEO of Cambridge Associates, a Boston-based consulting firm that advises endowments, foundations and other institutional investors on their investments. Urie is also vice chairman of the Investors’ Committee of the President’s Working Group on Financial Markets, which was set up in the wake of the 1987 crash and has been working with regulators and market participants during this crisis to try to restore confidence. Hedge funds continue to be easy to demonize. “And I sense a lot of that coming out of Washington right now,” Urie says.
In 2009 hedge fund registration is all but inevitable. The big question is whether Congress will require that it be done through the SEC, the Federal Reserve System or some other regulatory body. Congress is also likely to make hedge funds pay higher taxes by eliminating their ability to keep profits offshore and possibly forcing managers to treat them as ordinary income.
The next crucial fight for hedge funds will be over more general reform of capital markets regulations. The stakes are high, as some of the issues in question — in particular, short-selling and leverage — are central to hedge funds’ investment strategies.
“Now the focus is going to be more on systemic risk and preserving market integrity,” says Eric Vincent, chairman of the Managed Funds Association, the hedge fund industry’s main lobbying group in Washington. Vincent is also president of Ospraie Management, a New York–based, $4 billion commodities hedge fund firm that has suffered its own knocks. In September the firm began liquidating its flagship Ospraie Fund, which was down nearly 40 percent for the year.
Washington itself is in transition. President-elect Barack Obama has made it clear that he won’t follow in President George W. Bush’s footsteps when it comes to economic policy. Timothy Geithner, Obama’s nominee to replace Paulson at the Treasury, was a strong proponent of reforming the credit derivatives market during his five years as president of the New York Fed. Lawrence Summers, who will be Obama’s top economic adviser as head of the National Economic Council, was deputy Treasury secretary in 1998 during the collapse of LTCM (Geithner was at Treasury then too, as undersecretary for international affairs). Summers also has an insider’s perspective on hedge funds, having spent the past two years working part-time as a managing director at D.E. Shaw & Co., advising the $36 billion multistrategy giant on portfolio management and new strategic initiatives.
Although their asset base is shrinking — at the end of October it was an estimated $1.6 trillion globally, down from nearly $2 trillion at the start of 2008 — hedge fund managers remain key participants in the markets. They are also among the biggest users of many of the instruments and practices under the most regulatory scrutiny, including over-the-counter credit derivatives and leverage. Although hedge funds in the past have shied away from the spotlight, this time they want to help shape the debate.
“As important market participants, we would want a seat at the table,” says Vincent.
Hedge funds were offered something like that in November, when managers Philip Falcone, Kenneth Griffin, John Paulson, James Simons and George Soros were called to testify before the House Committee on Oversight and Government Reform as part of a series of hearings held by committee chairman Henry Waxman on the financial crisis. The hearing was possibly the largest assemblage of wealth ever seen in Congress — the five men topped Alpha ’s most recent list of best-paid hedge fund managers, each earning at least $1.5 billion in 2007 — and is a clear sign of the scrutiny that lies ahead for the industry.
Although many of the major power brokers on Capitol Hill haven’t changed, their ability to get legislation passed has gotten a huge boost now that Democrats will have control of the White House and solid majorities in both houses of Congress. As chairman of the House Financial Services Committee, Massachusetts Representative Barney Frank will be leading the charge on market reform in the House, and he will have an ally in California Democrat Waxman, the new chairman of the Committee on Energy and Commerce. Frank’s counterpart on the Senate Banking, Housing and Urban Affairs Committee, Connecticut Democrat Christopher Dodd, will probably take a more moderate stance (his state is home to some of the world’s biggest hedge fund firms). Iowa Republican Charles Grassley, the ranking minority member on the Senate Finance Committee, has no such conflict. He has already said he will reintroduce legislation requiring registration (see sidebar story, Pension Protection).
One of the top priorities of legislators and regulators will be the OTC derivatives market, which despite its $530 trillion notional value has been largely exempt from regulatory oversight. Credit default swaps, in particular, have become a cause of great concern — both in terms of the risk of big swap counterparties going bankrupt à la Lehman and how the purchase of CDSs by hedge funds and other investors may have contributed to the downfall of some banks and financial firms.
Most of the recent focus has been on creating a centralized clearinghouse, which would reduce counterparty risk as well as create a more orderly and transparent market. Since his appointment to the New York Fed in 2003, Geithner has urged participants in the CDS market to identify the problems and develop their own solutions — like the clearinghouse being offered by Citadel Investment Group and the Chicago Mercantile Exchange. But as Treasury secretary he is unlikely to be satisfied with a purely private sector approach.
One question that needs to be addressed: Which regulator will have jurisdiction?
The last major effort to regulate OTC derivatives began in 1998 — before the troubles at LTCM — when the Commodity Futures Trading Commission undertook a controversial study of that market. The result was a bitter turf war with the SEC, fears of regulation and uncertainty as to the future of the industry. Although further U.S. regulatory oversight of OTC derivatives was ultimately rejected, many market participants say the uncertainty led to London’s Canary Wharf, not Wall Street, benefiting from the boom in structured finance.
“It breaks my heart when I go to Canary Wharf and I look at the thousands and thousands of highly paid jobs in London in the derivatives markets that belong in America,” Citadel founder Griffin told Congress in November.
Griffin’s lament echoes the U.S. hedge fund industry’s longtime argument against regulation: that it will send financial innovation overseas. That reasoning isn’t likely to carry much weight with Congressman Frank, who has indicated he intends to seek more regulation of credit default swaps. Getting a jump on the issue, Frank’s fellow Massachusetts representative Edward Markey in October reintroduced legislation he had first proposed in 1994 to enhance oversight of derivatives by the SEC. Markey’s new bill includes reporting requirements for hedge funds.
In late November, Democratic Senator Tom Harkin, chairman of the Committee on Agriculture, Nutrition and Forestry, introduced the Derivatives Trading Integrity Act of 2008, which would amend the Commodity Exchange Act to require all contracts and transactions with respect to commodities (including credit derivatives and swap contracts) be carried out on a regulated exchange. His proposal would grant the CFTC sole regulatory authority over CDSs and could set off another turf war with the SEC.
Of course, the future of the SEC is itself up in the air. Chairman Christopher Cox has said he will step down in January, rather than serve out his term. William Donaldson, who as SEC chairman from 2003 to 2005 pushed for hedge fund registration, is among those on the Obama transition team charged with finding Cox’s replacement. The president-elect has not ruled out combining the SEC with another regulator, such as the CFTC, or folding it into a new superregulator as part of a broad restructuring like the one proposed by Treasury Secretary Paulson last spring.
Whatever happens, hedge fund managers are worried about a potential repeat of the decision by the SEC in September, at the height of the banking crisis, to temporarily restrict short-selling of financial stocks. With no warning the rules of the game changed, and a lot of money was lost as a consequence, as hedge fund managers scrambled to cover their shorts and close their positions. Potentially even worse was the SEC’s initial demand, later withdrawn, that hedge funds publicly disclose their short positions as they do their long-only holdings. Hedge funds have been in talks with the SEC about short-selling, including the possibility of introducing circuit breakers during periods of stress that would limit it.
Another area of potential reform is in the use of leverage. In the U.S. there are no rules directly limiting how much leverage hedge funds can use. (Hedge fund leverage is limited indirectly by Regulation T, a Federal Reserve Board rule that stipulates how much can be lent against certain securities.) Unlike mutual funds, broker-dealers and commercial banks, hedge funds are exempt from regulatory capital restrictions. As a 1999 President’s Working Group report explains: “Hedge funds are limited in their use of leverage only by the willingness of their creditors and counterparties to provide such leverage.”
Congress could pass new laws that would put direct limits on hedge fund borrowing. They could also seek to place stricter parameters on leverage by banks and other financial institutions, which would have a knock-on effect on how much capital hedge funds can borrow. But even if regulators were to do nothing, the transformation by investment banks into more heavily regulated commercial banks means that they will have less available capital on their balance sheets to provide their hedge fund clients.
With so much in flux, one thing is clear. The largely hands-off approach to market regulation that began with President Bill Clinton’s administration and accelerated under the Bush presidency ended the moment that Treasury Secretary Paulson stepped in to help rescue Bear Stearns last March. For hedge funds the world will never be the same.
