'Implicit' Hedge Fund Regulation: The Right Direction

by: Roger Ehrenberg

This week's article in the Financial Times chronicling concerns over hedge fund collateral has only reinforced a theme that I've pounded on for the past six months: HEDGE FUNDS ARE ALREADY REGULATED.

Why this realization is only now coming to the fore in mainstream media and, potentially, in our regulatory bodies is beyond me, but thankfully it seems to be here. Now, this is an issue worth thinking about. And it is properly being addressed to the banks and prime brokers extending credit to hedge funds, in their capacity as entities regulated by the Federal Reserve and the OCC:

US, UK and European regulators have expressed concern in recent meetings that investment banks may be allowing hedge funds to increase their borrowing capacity using collateral that could lose its value rapidly in a financial crisis.

The regulators have asked banking executives in the meetings on Wall Street to detail exactly how they use portfolio netting, a practice that allows hedge funds to use relatively illiquid securities such as credit default and total return swaps as collateral to reduce overall margin requirements.

The fear among some regulators and outside observers is that in a big market dislocation the funds might be unable to sell those securities, increasing the likelihood of widespread defaults.

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One Wall Street executive acknowledged that regulators had a "legitimate concern" that such agreements might not be enforceable in the face of a hedge fund collapse. However, he did not believe regulators would find that banks were taking on excessive risk.

The questions are part of a broad new effort by the New York Federal Reserve, the Securities and Exchange Commission, the Office of the Comptroller of the Currency, the UK's Financial Services Authority and European regulatory bodies to understand better how much exposure large banks have to hedge funds and whether that could present a significant risk to the financial system in the event of a market disruption.

So far, detailed discussions have been held with a group of five of the largest Wall Street securities firms that some time ago agreed to volunteer for a "consolidated supervised entities programme". Members of the programme are among the most active in lending to hedge funds.

Officials have found that some firms have been extending credit on less liquid instruments but relatively little credit is being extended under these circumstances - and at higher cost to borrowers, regulators say.

This is great stuff. This is the way it should work. Regulators spending time interviewing the market participants in order to gain a deep understanding of the issues. They then develop cooperative relationships with the top players in the market in order to standardize data collection, have early visibility into trends across the industry, and have a direct line into senior management should urgent questions or concerns arise. This is a process for intelligent, fact-based oversight outside the reach of political agendas and perverse motives. What a breath of fresh air.

And the issue they've targeted, the appropriateness of collateral practices, seems particularly timely in light of the frothy markets and ever-tightening credit spreads (the FT is on a roll - they also had a story on this issue recently). The credit markets appear priced for perfection, and we know what happens when most large players are caught leaning one way: inevitable pain and suffering ensues. Selling premium seems like a good way to generate returns; I mean, the real economy is strong, earnings are strong, corporate balance sheets are healthy (except those that have been LBO-ed in the private equity frenzy), so what could go wrong? Oh, I don't know, maybe Iran, Iraq, terrorism, return of Russian stateism, and about 300 other things? Naaaaah. And this same motivation is what can drive, shall we say, more liberal collateral lending practices in the prime brokerage community?

This would seem to be a logical extension of tightness in the credit derivatives market, but somehow I'm not getting this vibe. Banks have gotten much, much smarter in the wake of LTCM and other hedge fund meltdowns. Risk controls have, in fact, gotten much more sophisticated and robust. This doesn't mean that someone won't drop a several hundred large in some purportedly 10-sigma outcome (ha!), but I really don't think that banks are going hog wild lending to hedge funds. The risk/return is just not skewed in their favor by making stupid loans with crappy collateral. They don't have to do this to mint money. I mean, they've still got stock lending, right?

Anyway, I am just happy to see the bodies that should be doing the overseeing actually doing it without the assistance of Congress or like bodies in the UK. Let's hope this favorable trend continues for the good of the hedge fund community, the financial markets and investors everywhere.