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Credit crunch for hedgers?
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January 5, 1999: 6:17 p.m. ET
Regulators seek approach that would work, as one lender heads for the door
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NEW YORK (CNNfn) - The dust is still settling over Greenwich, Conn., where Long-Term Capital Management was rescued four months ago in a dramatic $3.6 billion bailout by a group of banks and brokerages.
The collapse of the one-time high growth hedge fund sent shock waves through the financial community and served as a wake-up call for securities regulators, who until then had little oversight or knowledge of how the complex investment pools worked.
They do now.
The Treasury Department, Federal Reserve, Securities and Exchange Commission and Commodity Futures Trading Commission are due this spring to release a comprehensive and collective report on hedge funds and derivatives, complete with recommendations on how best to prevent an LTCM-like disaster from happening again.
Some say the report will have little to no impact on U.S. hedge funds.
Others believe it will lead to new regulations that could force the funds to become more transparent and require creditors to limit their lending practices.
At least one lending institution, however, won't be around to find out.
Comerica Inc., a Detroit-based bank holding company, told CNNfn Tuesday that lending to hedge funds is no longer consistent with its long-term strategy.
"We are reducing our exposure to hedge funds," said company spokesman Bob Doetsch, confirming Comerica's ultimate goal is to cut out hedge fund lending altogether.
Doetsch said lending to hedge funds represents less than 1 percent of the bank's $28 billion in total loans outstanding. He said the company lends less than $250 million to hedge funds each year.
Comerica, however, may be just the tip of the iceberg. Industry insiders, speaking on conditions of anonymity, said they have spoken to a handful of other banks that are considering similar policy changes.
"Among the large banks, we are seeing some shrinking in the amount of money they will lend hedge funds and in some cases, they are just getting out of the business," one source said.
Regulating the unknown
Hedge funds are private investment partnerships that invest in a variety of securities.
The funds, usually reserved for the very rich, are designed to maintain consistent, if not aggressive growth, in both bear and bull markets, by betting on stocks and currencies the investment manager believes are heading down.
At the same time, the fund buys into securities believed to be moving up -- thereby mitigating their risks in all types of market conditions.
Shortly after LTCM hit the headlines, high-ranking regulators, including Federal Reserve Chairman Alan Greenspan, said they did not believe regulating such a diverse industry would be feasible, saying the creditors themselves (banks and primary brokerage firms) are best equipped to control leverage levels in the market.
Moreover, they expressed concern that new regulations deemed too onerous would merely penalize the economy by driving U.S. hedge funds offshore.
But comments underscoring the need for stricter oversight of the industry are once again swirling on Capitol Hill.
Patrick Parkinson, associate director of research at the Federal Reserve, told the Senate Committee on Agriculture, Nutrition and Forestry earlier this month that "private market discipline seemed to have largely broken down" in the case of LTCM.
"These weaknesses in risk management practices clearly need to be addressed," he said. "The (banks and securities firms) themselves should bear primary responsibility for designing and implementing the necessary improvements."
Even so, he said, "prudential overseers can and should promote the adoption of sound practices throughout the financial sector through issuance of supervisory guidance."
In the case of U.S. banks, the Federal Reserve and the other banking regulators, he said, already have made "considerable progress in identifying sound practices for dealing with highly leveraged firms" and for incorporating the lessons learned into "supervisory standards and procedures."
Disclosure and leverage
Three weeks ago, Deputy Assistant Secretary of the Treasury Roger L. Anderson told the same Senate committee that the Treasury Department is looking closely at the issues of hedge fund disclosure and leverage.
"There is a question whether LTCM's creditors made some decisions based upon insufficient information or inadequate analysis of information, and there is a broad consensus that creditors need to reexamine how they make such decisions," he said.
Anderson added, "More disclosure of information by entities such as hedge funds, particularly to their counterparties and creditors, would be useful and appropriate."
The inside scoop
Some say tighter controls over the hedge fund industry are not necessarily a bad idea.
"Regulation of hedge funds, even at the bank or brokerage house level, is not necessarily all bad as long as it's reasonable," said George P. Van, chairman of Van Hedge Fund Advisors International. "But it would be very hard to implement since every hedge fund has a different risk profile."
Van said it wouldn't surprise him if the government at some point requires the nation's largest hedge funds to confidentially report their ratio of leverage against assets, setting up an oversight committee to monitor those levels.
"That is something that could be done that would make some sense," he said, adding even that would be expensive to taxpayers since each hedge fund would have to be studied on a case by case basis.
For reasons cited by regulators themselves, however, David Friedland, president of Magnum U.S. Investments Inc., a Miami-based fund of funds, said he doesn't believe that will happen.
"We don't believe there is going to be regulation of hedge funds per se," he said. "It's just not practical. All that's going to do is drive the funds in the U.S. offshore and I don't think (regulators) are going to do that."
He said the industry doesn't need to be more tightly regulated, just more closely monitored.
Most involved in the industry agree that commercial banks already operate under a strict set of lending restrictions and won't likely be targeted for tighter controls. It's the prime brokers, they say -- the deep pocket lenders like Morgan Stanley and Goldman Sachs -- that could come under closer review.
For the most part, hedge fund executives believe those firms will remain steadfast in their lending practices.
They'd better hope so. If commercial banks continue cutting back on hedge fund lending, prime brokers and private investors may become their sole sources of credit.
--by staff writer Shelly K. Schwartz
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