- The Washington Times - Wednesday, October 3, 2007

ANALYSIS/OPINION:

Could a financial H-bomb be ticking? If so, the “h” is for hedge, as in hedge funds. And the explosive ingredients include: an absence of regulation; large amounts of debt with relatively little cash leveraged into securing many multiples of assets; the demand for returns and profits well above market averages; and the size of the securitization market in which mortgages, credit-card and other derivative forms of debt are bought and sold in the form of asset-backed collateral paper in part as a means of reducing risk.

We know the history of crashes from 1929, 1987 and the dot-com meltdown to the savings-and-loan crisis of the 1980s, which forced a hugely expensive government rescue. Today, alarm bells are sounding. The collapse of the sub-prime mortgage markets is one sign of potential danger.

Hedge funds began life some 60 years ago. Over the last decade these funds have exploded in size and value. Their number ranges between 5,000 and 9,000. The total asset value under management is estimated between $1.5 trillion to $2 trillion, with substantial holdings in both equity (stock) and debt (bond) markets. Many hedge funds have produced double-digit returns or more to investors and managers, adding new members to the Forbes list of the 400 richest Americans.

Hedge funds are unregulated. Hence, the Federal Reserve’s Regulation T does not apply. That regulation prohibits any investor from borrowing more than 50 percent of the value of a public security being purchased. Hedge funds have such no restrictions and leverage factors of 8, 9 or 10 or more to 1 as the ratio between assets and actual cash on hand are common across the industry.

Hedge funds are only open to “qualified investors or purchasers” who must have a total net worth of more than $1million ($5 million for purchasers). And no more than 100 such investors can participate in any single fund without being subject to some form of regulation. This keeps the universe of hedge-fund investors small while the volume of activity is huge.

Hedge-fund managers typically receive an annual management fee of 2 percent, plus 20 percent or more of the profits above the original investment. Those profits are called “carried interest” and are taxed at a rate of 15 percent as capital gains, not 39 percent as earned income that traditional financial managers, investment advisers and fiduciaries pay. In 1998, Long-Term Capital Management (LTCM), a Connecticut-based hedge fund, bet wrongly against the Russian ruble, triggering a crisis that might have collapsed financial markets. Russia devalued the ruble and defaulted on its debt. At that point, LTCM held about $4.8 billion in cash and net assets of about $125 billion, so, it was leveraged at 25 to 1. LTCM could not remotely cover its losses. So the liability shifted to its key investors, some of the biggest banks in the world.

In a series of crisis management meetings presided over by the Federal Reserve Bank of New York and its canny president, William McDonough, enough money was raised to prevent an unraveling of financial markets because the size of LTCM’s default. Now suppose the defaulter was not merely one hedge fund but several with liabilities running into the hundreds of billions or even trillions of dollars that could not be covered. Could an LTCM meltdown happen again? You bet. And the recent collapse of several multibillion-dollar acquisitions by hedge funds has set off tremors in the financial community.

Inherently, hedge funds can be sound and attractive investment vehicles. But with globally interconnected markets and the size of the securitization market, excess leverage and debt remain a real vulnerability. To provide some protection against that vulnerability, Congress may have to act. Sen. Chuck Schumer of New York and Rep. Barney Frank of Massachusetts have already begun hearings to do that.

At least three actions are crucial. First, where hedge funds compete with regulated funds, a more level playing regarding transparency and regulation seems appropriate. This can be done informally through self-regulation or through a body such as the Federal Reserve or Securities and Exchange Commission.

Second, the funds themselves must permit greater disclosure to investors, particularly regarding risk. Because these funds (along with private equity funds) are private, assuring privacy is crucial. However knowledgeable investors are perhaps the best way to ensure that risk and reward are kept in balance.

Finally, allowing hedge-fund managers with little or no money invested in their portfolios to be taxed at the capital-gains rate of 15 percent is simply wrong and unfair to other managers who are taxed at the higher earned interest rate.

As history repeatedly shows, financial markets rise and fall. When leverage becomes excessive and appropriate regulation is absent, the ingredients for an explosion are present. Defusing these explosive forces now can prevent future financial disaster.

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