Regulators have long been worried about the potential for hedge funds to jolt financial markets, and this summer’s subprime mortgage crisis reawakened that fear. Nonetheless, outgoing Securities and Exchange Commissioner Roel Campos says no one at the agency is pushing for further regulation. “If I had to describe the regulatory sentiment, it’s one of concern and caution. But no one sees a need for immediate action,” says Campos, who last spoke to Alpha earlier this year (“Marketing Appeal,” January 2007) about his proposal to get hedge funds to register with the SEC by letting them advertise -- what he calls a carrot-versus-stick approach. Although SEC chairman Christopher Cox has expressed some interest in the idea, Campos, who ends his five-year tenure at the commission this month, says the subprime mortgage crisis means “no one is talking about giving hedge funds more leeway.”
Of course, the SEC and other U.S. regulators want to avoid a repeat performance of 1998, when the Russian bond crisis and subsequent marketwide panic led to the near-collapse of Long-Term Capital Management, forcing the Federal Reserve Bank of New York to organize a $3.65 billion bailout by a group of banks and investment firms. Such fears are balanced, however, by a wave of antiregulatory sentiment sweeping the corridors of some federal agencies, particularly the U.S. Treasury.
“The regulatory pendulum is swinging back,” says Stanley Sporkin, a Washington attorney who spent 20 years as an SEC lawyer, including seven heading the agency’s enforcement division. “You’re seeing a rebound from the high, pro-regulatory era in early 2000, caused by the Enrons and WorldComs, because businesses are complaining they are overregulated.” Studies by the U.S. Chamber of Congress and the Committee on Capital Markets Regulation suggesting that the U.S. is losing out to markets in other countries have put additional pressure on the SEC to back off, says Sporkin, and Congress seems unsure of which direction to take.
In 2004, Campos, a Democrat, was one of the SEC commissioners, along with former chairman William Donaldson, who voted to require hedge fund advisers to register, in a bitterly contested 3-to-2 decision. Shortly after the rule took effect in 2006, a federal appeals court threw it out. Donaldson’s successor, Cox, neither appealed the decision nor asked Congress for legislation authorizing registration. Then in February of this year, the President’s Working Group on Financial Markets released an interim report stating that a light regulatory hand was sufficient for hedge funds because their counterparties, such as banks, have a significant interest in monitoring funds’ activities and risk levels themselves.
The subprime market meltdown was the first test of that theory, and the long-term effects remain unclear. Campos says the SEC is “facing a devil of a problem” regarding hedge funds and their role in the subprime crisis. But for regulators, the financial losses are less worrisome than the impenetrability of the marketplace. “Something is wrong when even the professionals don’t know the level of risk with problematic debt,” Campos says.
Congress has begun to hold hearings on the subprime credit crisis, but even if legislators force hedge funds to provide greater transparency, no one really knows what information should be required from them. Quarterly reports, for example, would probably not be much help -- as Campos points out, positions in some hedge fund portfolios change hourly.
A better approach, and one that already has some traction at the SEC, would be to require banks and other institutions that bundle subprime paper and sell it to hedge funds to make an aftermarket in the products. “If Goldman Sachs and other investment bankers sell these, they need to say they will support them when there is market turmoil,” says Campos.
Campos’s resignation leaves four SEC commissioners instead of the usual five. Of the four, Annette Nazareth is a Democratic appointee; the others, including Cox, are Republicans. Nazareth, who quietly let her term expire on June 5 and who has said she will not seek another, can remain in her post for up to 15 more months unless someone is appointed to replace her.
