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THE LONG-TERM CONSEQUENCES
OF THE LONG-TERM BAILOUT
by Brady Willett
and Todd Alway
FallStreet.com
August 16, 2006
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.
© 2006 Brady Willett
Editorial Archive
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FallStreet.com
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