Safety Net of Hedge Fund Regulation Encourages Perverse Risk-Taking

by: Roger Ehrenberg

I have long been a champion of light-touch regulation for hedge funds, focusing on the burden of investors to do their homework with the proviso that information provided needs to be truthful, straight-forward and timely. I have also been a proponent of letting funds fail, as I scarcely hiccuped in the wake of the $9 billion Amaranth implosion.

That said, no argument I've seen for light-touch regulation is any more compelling than that I read in this weekend's Wall Street Journal penned by Allan Meltzer of Carnegie Mellon. His punch line:

Congress is about to propose new regulations for hedge funds. German Chancellor Angela Merkel has the same bad idea, meanwhile the British Financial Service Authority, currently worrying about excessive debt issued to finance acquisitions by private-equity firms, may be next in line. But whatever the perceived problem, more regulation is not the answer. It is far better to change some incentives for excessive risk-taking. The old saying is true: Capitalism without failure is like religion without sin. The answer to excessive risk-taking is "let 'em fail."

All I can say is: Amen, brother. You've got it. Think back to all the perverse behaviors that were prompted by ill-conceived market regulation. The S&L crisis. The Great Depression. The hyper-inflation of the 1970s. And now the quasi-Federally guaranteed home loan entities. And this list goes on and on.

But the S&L crisis along with Fannie Mae are probably the best analogies for the hedge fund industry. There was an implicit "safety net" that protected investors in these sectors and companies, leading to perverse risk-taking by both the entities and the financing sources backing those entities. After all, if the Federal Government is implicitly backing up any crisis, then they are effectively underwriting a free put option, the premium of which is used to gamble on the upside.

It is the same thing as hedge fund managers themselves exhibiting negatively-skewed returns with high kurtosis, which is akin to writing options and hoping they don't pay off. The net result: a steady stream of out-performance followed by a colossal bust. And at that point the managers can simply move on and try again. Just look at Brian Hunter. Who would have thought that he was employable after his little fiasco? Anyway, Mr. Meltzer goes on to say some other pretty interesting stuff that warrants mention:

Regulation will not solve the problem of risk-taking that has returned many times, under many different regulatory regimes. If there is a current problem of excessive risk-taking, it arises from financing long-term investments with short-term borrowing. This is an often-repeated problem in financial history that ends badly for many of the risk-takers, especially if the economy experiences a recession.

This is clearly what happened during the S&L crisis, where so many S&Ls held long-dated mortgage assets funded by short-term money market instruments. And when the yield curve inverted, they were toast. Or, rather, the U.S. taxpayer was toast. And Fannie Mae? Declining credit standards, but again due to the put option issued by Uncle Sam. Mr. Market is very, very smart. It will consistently go to the place that maximizes the expected value of those in power. And what about the appropriate role of financial regulators?

The responsibility of financial market regulators is to the market, not to financial firms. Sometimes risk-takers have to be allowed to fail. At the same time, announcement of policy -- and acting in accordance -- has great advantages. Financial firms can understand the rule: no bailouts, period. That will induce firms to hold more relatively safe assets and to take fewer risks. Incentives achieve what regulation cannot. They focus a manager's attention on the firm's self-interest. The Fed is responsible for aligning self-interest with the public interest.

I absolutely, positively guarantee that Mr. Meltzer is right. Financial firms will adapt. Because they will have to maximize their own self-interest. And this is adaptation for the right reason, not because of some ill-conceived regulation arising from political posturing or a tussle for headlines. And, finally, the punch line:

A strategy for reducing risk is overdue. Instead of burdensome regulation, the Federal Reserve and other regulators should develop a strategy, announce it and follow it whenever the next round of failures appears. Bailouts encourage excessive risk-taking; failures encourage prudent risk taking.

I wish I had written this Op-Ed because it is so right. It's hard to argue with its conclusions. Turning the market on itself, giving it clear parameters within which to operate and letting it run will both spur innovation and foster prudent risk-taking. And isn't this what we really want from our financial institutions, be they banks, investment banks, asset managers or hedge funds? I'd say so.

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