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Analysis: As stability czar, Fed could pry into hedge funds

If the Federal Reserve gets a sweeping new role as the czar of market stability under a US Treasury plan, hedge funds could come under increased scrutiny, driving some to change their practices or move offshore.

The massive investment funds, which have thrived on secrecy to pursue alternative investment strategies, may have to open their books to the Fed under the plan, chilling the appetite for riskier strategies, experts say. “There’s a new sheriff in town. Time to close up the bars and the girlie houses,” said Roger Robson, who advises hedge fund investors at CapTrust Advisors in Tampa, Florida.

Hedge funds have been described as the next layer of risk in the unfolding credit crisis due to their heavy investments in complex, illiquid securities backed by mortgages. A failure of a major leveraged fund, like the 1998 collapse of Long Term Capital Management, could set off a chain reaction of investor withdrawals and threaten a market meltdown just as a collapse of Bear Stearns could have. More transparency could reduce systemic risks, but also might reduce returns. Under the Fed’s possible future role as “market stability regulator,” it would likely try to police excessive use of leverage by hedge funds that could destabilize the financial system, Robson said.

Hedge funds are already having a hard time borrowing as banks pull back credit lines. But having the Fed peering into their inner workings could further reduce their appetite for credit-intensive investment strategies, he said. Treasury Secretary Henry Paulson’s long-term vision for the ideal financial regulatory structure, announced on Monday, did not spell out specific new regulation for hedge funds. But in designating the Fed as the future “market stability regulator,” it would allow the US central bank to seek information from hedge funds and other private investment players on capital, liquidity and margin practices if it determined there was a risk to market stability. “To do this effectively, the Fed will collect information from commercial banks, investment banks, insurance companies, hedge funds, commodity pool operators. But rather than focus on the health of a particular organization, it will focus on whether a firm’s or industry’s practices threaten overall financial stability,” Paulson said. “It will have broad powers and the necessary corrective authorities to deal with deficiencies that pose threats to our financial stability.”

 
LIFTING LID OF SECRECY

The $2.5 trillion hedge fund industry has thrived in recent years amid light regulation and the ability to keep investment strategies secret. Some could choose to move overseas in search of a more freewheeling environment if the new regime proved restrictive. “A lot of hedge funds hold their secrecy close to their heart. Depending on what happens with this proposal, it could be something that hedge funds would find problematic,” said Daniel Farkas, hedge funds analyst at Morningstar Investment Services in Chicago. To be sure, the long-term portions of the Treasury plan to morph the current patchwork of regulatory agencies into three super-regulators, one for market stability, one for insured financial services and one for business conduct, will face years of debate. Indeed, they could be quashed by the next president.

Numerous trade groups, lawmakers and regulatory agencies voiced criticism of the plan as soon as it was announced. Some experts believe the Treasury will ultimately maintain its traditionally light regulatory touch on hedge funds. Last year, the Treasury-led President’s Working Group on Financial Markets came out with best practices guidance for hedge funds and other private investment pools that prescribed no new rules. Instead, it urged more disclosure and transparency on the part of funds and more due diligence by investors and counterparties. “Paulson and (Treasury Undersecretary) Bob Steel are no fools. I’m quite sure they are trying to do something judiciously balanced in this area,” said Michael Hennessey, who selects hedge funds at Morgan Creek Capital in Chapel Hill, North Carolina. Most well-established funds are likely to participate in the process and welcome streamlined regulation “with open arms,” he said.

Paulson likely had little choice but to at least address hedge fund risks in the regulatory blueprint because of heightened investor concerns over potential losses from mortgage-backed securities, added Morningstar’s Farkas. There is much uncertainty about what may be lurking on their balance sheets. “With hedge funds, there are a lot of black boxes out there, so there’s a lot of speculation about leverage and liquidity and risk than there are actual hard facts.” The industry’s main trade group, the Managed Funds Association, sounded a conciliatory note in its reaction. Its president, former Republican Congressman Richard Baker – no stranger to long, drawn out debates over regulatory change -- said the MFA was “in full support” of the Treasury’s goals. “We share Secretary Paulson’s view that a principles-based approach is prudent, and we believe this blueprint provides a solid foundation for providing regulatory clarity, reducing duplicative oversight, monitoring and mitigating systemic risks and promoting the highest levels of excellence in sound business practices and commercial honor,” Baker said. (Reuters)