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Wall Street storm may be brewing
Why regulators are looking at hedge funds and derivatives -- and how they could affect you.
September 29, 2005: 5:30 PM EDT
By Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNN/Money) - In the summer blockbuster "War of the Worlds," ordinary Americans are forced to run for their lives when alien invaders wreak havoc on their planet.

What the victims didn't know was that the seeds for the attack had been germinating beneath their feet for years.

While that was a movie, some financial regulators fear that a less dramatic but similar scenario could be developing in the nation's financial markets.

Their target? Two key segments of the markets -- hedge funds and credit derivatives -- that have been mostly invisible to many ordinary investors but have grown to massive proportions in recent years.

What's making regulators take notice now? Many complex factors, but it boils down to this: those pieces of the capital markets have grown so big so fast, and are so complicated, that any problems could mushroom and spark big losses -- and huge volatility -- for investors around the world.

Hedge funds now manage an estimated $1 trillion in assets worldwide, and in some cases, a single fund can account for a big chunk of the volume on some exchanges. (For more on hedge funds, click here).

The credit derivatives market has swelled to an estimated $8.4 trillion -- that's trillion with a 't' -- and regulators are concerned about trading in these largely unregulated investments. (For more on credit derivatives and how they work, click here.)

"Credit derivatives and hedge funds have grown fairly spectacularly over the last five years," said Andrew Lo, director of the MIT Laboratory for Financial Engineering and a managing member at the hedge fund Alpha Simplex Group.

"There are enormous amounts of capital that have come in and are being deployed in fairly highly leveraged transactions. We don't know the exact amount of leverage being used, and there's even less data about credit derivatives market," he said.

Because of this rapid growth, regulators are concerned that if something happens in the credit derivatives space, such as several companies defaulting on their debt at once, this would affect not just hedge funds but could unnerve financial markets, and affect interest rates and the broader economy.

To be sure, big losses from a series of credit defaults or hedge fund blowups would hurt mostly big investors on Wall Street, but with more and more pension funds putting money into hedge funds, average workers and investors could also suffer.

Concerns about the credit derivatives, which derive their value from underlying corporate bonds, prompted the New York Federal Reserve to meet with several Wall Street firms recently.

The regulators want to make sure that if several companies default on their debt at once or in rapid succession, the financial markets could handle the losses and selling in the derivatives market, without sparking a broader round of panic selling on Wall Street.

Two complex derivatives -- credit default swaps and collateralized debt obligations -- have become especially popular with hedge fund investors in recent years.

People familiar with the matter say regulators want to ensure that the players in the market have enough money to live up to their obligations. And they want to encourage orderly growth in these exotic investments to help curtail the risks of a "systemic" shock to the financial markets.

While regulators are shining their lights on the credit derivatives market, this doesn't mean the regulatory scrutiny for hedge funds will lighten up any time soon.

Christopher Cox, the new chairman of the Securities and Exchange Commission, told the Wall Street Journal recently that he plans to forge ahead with a new rule requiring the funds to register with the SEC as investment advisers.

While some on Wall Street had speculated Cox might reconsider the rule, many others weren't surprised.

The new rule came from ex-SEC chief William Donaldson, who initiated a two-year review of hedge funds and pushed the rule through despite a divided commission, which narrowly passed it by a 3-2 vote.

Cox's decision to go ahead comes as federal and state officials investigate the collapse of Bayou Management, a Stamford, Conn.-based hedge fund.

Federal prosecutors have accused the fund of raising $300 million from investors by lying to investors about returns and their funds' performance. Officials have seized $100 million believed to belong to Bayou investors.


For the latest on hedge funds, click here.

To find out what credit derivatives have to do with you, click here.

For more on the markets, click here.  Top of page

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