August 16, 2006
The Long-Term Consequences of The Long-Term Bailout
By Brady Willett & Todd Alway

As the horse of ‘innovation’ leaps miles ahead of the mule that is regulation, the path for the average investor grows treacherous.

After the collapse of Long-Term Capital Management (LTCM) the regulatory bodies had a window of opportunity to enact substantial change. To be sure, as LTCM’s massive positions put the fear of God into counterparties and volatility in the financial markets erupted, all the regulatory bodies needed to do was watch LTCM burn and then utter the word ‘regulation’. Almost everyone would have signed-on, and those that tried not to would have been looked at as if they had something to hide.

Unfortunately, instead of exacting change the powers that be opted to gather the relevant parties into a room and help orchestrate a bailout. It may be unsettling to think that the world’s most sophisticated financial apparatus is, from time to time, held together by a bunch of bankers sitting in a room arguing about what to do about defaulted trades.  But in 1998 this is exactly what happened. 

On the surface, calls for the regulation of private investment might seem rather draconian.  After all, if rich people want to privately pool their money and make leveraged bets on a roulette wheel, so be it.  However, when these leveraged and largely secretive bets cause ripples throughout the entire public financial system, regulatory oversight might be required to ensure that market integrity is not at risk. For that matter, regulation appears all the more necessary the more the net consequence of these “private” gambles threatens to spill outside the symbolic casino.  Where the casino can threaten to bust the real economy rather than just one of its players, it would be negligent to advocate otherwise.

In sum, given the knowledge that hedge fund assets are growing rapidly, and that the typical investor exposed to hedge funds is less and less well-heeled, the need for hedge fund regulation would appear to be greater today than ever before.  Unfortunately no significant new regulatory efforts are in the pipeline.  Rather, and to put it bluntly, the hedge funds - whose performance is arguably no better than the average mutual fund (See
Malkiel & Saha) and whose managers are paid dramatically more than others - have won the fight versus regulators.  If only the Federal Reserve Board had watched LTCM burn…

The SEC Tried to Corral the Hedge Fund Monster

In early 2003 Oppenheimer offered clients a hedge fund product for as little as $25,000 down.  By late 2003 the SEC had drafted its hedge fund ‘registration’ plan. On the surface hedge fund registration seemed like a quick win for the SEC. After all, nearly all hedge fund managers met the criteria of an investment advisor, and with the advent of new products (i.e. funds of hedge funds) it was obvious that one of the loopholes commonly used by hedge funds to avoid compliance with the Investment Advisors Act – that hedge funds “do not hold themselves out generally to the public as an investment adviser” – was breaking down.

But alas, with ‘registration’ recently overturned in court and the SEC announcing last week that they will not appeal, nearly 3-years of regulatory effort has been for not. During these three years the number of active hedge funds has more than doubled to approximately 9,000 (Hedge Fund Association) and assets under management have more than doubled to an estimated $1.2 trillion (Strategic Financial Solutions LLC). As the Wall Street Journal recently put it, “Though they [hedge funds] control just 5% of all U.S. assets under management, they account for about 30% of all U.S. stock-trading volume.” Some estimates are even higher, speculating that more than 50% of U.S. stock-trading volume is done by hedge funds. Needless to say, what was once a select group of wealthy individuals making bets on relatively isolated spins of the roulette wheel is today a diverse and growing pool of capital, making investment decisions that can dictate the direction of the financial markets.

The point to be made about the SEC’s failed registration plan is that it was convoluted and full of loopholes from the start.  When the rule went into effect in February approximately 2,000 funds fell under the requirements and registered. Thousands of funds found ways around it, some simply by extending the investment lock-up period.

The Myopic Non-Registration Crowd

Most notable in the non-regulation crowd is Phil Goldstein, the hedge fund manager who successfully led the ‘registration’ court challenge against the SEC.  Seemingly oblivious to the fact that pension funds, endowment funds, and many smaller investors (via fund of funds) have been courted by and have invested in hedge funds, the Financial Times notes, “Like most hedge fund managers, Mr. Goldstein believes they [hedge funds] should not be regulated because they are private and do not solicit money from the public.” Mr. Goldstein adds, “As long as we're not doing anything illegal or unethical, why not leave us alone?” The latter statement by Goldstein begs the question: how do we know if hedge funds are doing anything illegal or unethical unless we monitor their activities more closely?

With the rapid growth in hedge funds since 2001 and the SEC’s regulatory attack on private funds since 2003, Goldstein’s ‘just leave us alone’ view has boiled to the surface regularly – and every time it does the investor can not help but shake their head.  For example, in a December 2005 Wall Street Journal commentary entitled ‘Who Is Watching The Watchdog’, John Berlau writes, “The SEC can go after private equity, venture capital and hedge funds if fraud occurs…”. But John, how do we know if fraud is taking place unless we monitor the activities of hedge funds more closely?  Mr. Berlau continues:

“…But there has been has been a widespread consensus that these [hedge fund] investors don't need the additional protection of the registration process, and that it is essential for the capital markets that these entities be able to move quickly.” (Emphasis added)

In other words, Mr. Berlau and many others (including Greenspan) believe that that the SEC should go after fraud and that the hedge fund registration process provides investors with ‘additional protection’. But these same individuals do not see the obvious correlation - that registration itself would help limit fraud!

“The Commission’s inability to examine hedge fund advisers has the direct effect of putting the Commission in a “wait and see” posture vis-à-vis fraud and other misconduct. The Commission typically is able to take action with respect to such fraud…only after significant losses have occurred.”   Implications of the Growth of Hedge Funds.  SEC.  September 2003.

As for the argument that registration/regulation would not limit fraud (something no one can do with a straight face), in Europe hedge fund fraud is nearly non-existent largely because the regulatory bodies have some simple standards in place. For example, hedge funds must register with the Financial Service Authority before they can start taking clients, the FSA conducts background checks on managers, and in Britain potential managers have to meet minimum competency requirements.  As Christopher Fawcett, chairman of
AIMA, put it, “You can't have been a librarian and then decide you want to open a hedge fund”. In the US a librarian’s pet monkey can start a fund so long as they can attract capital. Do the basic regulatory efforts in Europe yield results? A quote from CNN speaks for itself: “in the 15 years AIMA has existed, there has only been one documented case of hedge fund fraud. Contrast that with the U.S., where the SEC has brought fraud charges in 20 hedge fund cases in the last year alone”.

Notwithstanding Mr. Goldstein’s and Mr. Berlau’s efforts, hedge funds have generally had to do very little to fight off the regulatory powers. Indeed, with bailout artists like Fed McDonough, and non-regulation backers like Greenspan chiming in that regulation would simply force funds to move elsewhere (would this really be a negative development?), the industry has been allowed to grow unchecked.

That Was Then…

We essentially saw only two likely scenarios since we were convinced that the private sector group could not get itself in a room to work out a possible solution. Either there would be a failure of LTCM or the Federal Reserve Bank of New York would play its traditional role in this type of situation. We knew that our intervention would put the prestige of the Bank on the line…”
Fed McDonough, FOMC Meeting.  September 29, 1998

While the LTCM bailout may have been a success insofar as the short term liquidity needs of the markets were concerned, it was nonetheless one of the worst regulatory failures in history.  Quite frankly, by taking on the role of intermediary instead of allowing LTCM to fail, the Fed unwittingly created the condition wherein risk taking by hedge funds will be monitored almost exclusively ‘in house’.  Playing the roulette wheel ‘in house’ is fine, but with the savings of millions of Americans increasingly at stake blind faith in the ability of self-regulation is, to say the very least, risky. 

Accordingly, the point worth stressing is that LTCM was the first real warning that the hedge fund race track should never have been permitted to be constructed in an unregulated form.  But instead of heeding the LTCM wake-up call, the regulators pressed the snooze button -- ignoring the ominous fact that one firm could threaten the entire financial marketplace.

As for those that argue that free markets should be left to their own devices and/or that hedge funds and counterparties can self-regulate their activities just as effectively as say the SEC, they must ask the question of whether these markets are in fact capable of operating as freely and efficiently as they suggest. The Fed may have no real choice but to intervene when the collapse of one cog threatens the entire financial machine.  There are simply too many spillover effects for the Fed to maintain a laissez faire attitude after a market player has made an unsound decision.   In such an environment – and all the players know that this is the environment – there is little moral hazard associate with risk taking.  This being the case, can we expect the markets to operate efficiently or with a due regard for market risk?  

This Is Now

With the courts overturning SEC registration and reports of hedge funds controlling major movements in markets across the globe, it is quickly becoming apparent that the hedge fund raceway has become too large and too interconnected in the financial markets for anyone to attempt any significant regulatory affront.  The ECB admitted as much in its most recent Financial Stability Review, arguing that hedge funds posed “a major risk for financial stability, which warrants close monitoring, despite the essential lack of any possible remedies”. A ‘major risk’ without a remedy is a risk indeed.

Added to the ‘herding’ risk that the ECB focused on is the speculation that hedge funds are not only broadening their client base but their counterparty and lender base as well. In a recent report in the Financial Times, Gillian Tett notes that in recent weeks “an investment bank has reportedly been trying to sell several billion dollars worth of the loans it has extended to hedge funds.” The cornerstone of self-regulation is that those parties that lend money to and trade with hedge funds enact tough standards to ensure that monies can be repaid and/or that all trades can be covered. How stringent would these standards be if the lenders immediately become sellers of the loans? For that matter, and as Mr. Tett aptly asks, when the next hedge funds collapses “who would be left on the hook?”    

It is going to take another LTCM before the regulatory window of opportunity opens.  The hope is that by then the working group on financial markets will be more concerned with the long-term integrity of the financial markets than about orchestrating another band-aid bailout. Why will it take another LTCM before the regulators can win the fight?  Because following the LTCM bailout and nearly 8-years of relatively smooth hedge fund operations, the non-regulatory crowd has brainwashed investors into the idea that it is not speed that kills, but roadblocks.  Look at it this way, doing background checks on potential hedge fund managers would benefit potential investors, it would appease some of the stresses regulators are dealing with, and it would have negated some of the fraud of recent years. In other words, a simple background check is a plus for everyone involved!...except hedge funds.

So what should happen next time? Put it this way, LTCM should have been allowed to burn.  The Fed had the choice 8-years ago: regulate or bailout. They chose the latter, and that has made all the difference.


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