Hedge Funds and the Credit Crisis

The RAND Group published a paper examining the role of hedge funds during the credit crisis of 2008.  The question was whether or not funds create or contribute to the systemic risk that caused it.  This was triggered when Lehman Brothers declared bankruptcy and caused the financial markets to melt down globally.  The researchers reviewed that crisis and the 1998 private bailout of Long Term Capital Management orchestrated by the Federal Reserve.  They found six areas of concern:

• Lack of information on hedge funds
• Lack of appropriate margin in derivative trades
• Runs of prime brokers
• Short selling
• Compromised risk management incentives
• Lack of portfolio liquidity and excessive leverage

Dodd-Frank legislation was passed to handle these issues to avoid new crises in the future.  To create more transparency on hedge funds, the reform was to require funds with $150 million in assets under management to register with the SEC.  However, there is a loophole as non-US hedge funds with no offices in the US and less than $25 million invested from US investors were exempt from the reporting requirement.  There is pending legislation from Europe that would affect those hedge funds but no reform in Asia is anticipated.  Funds are to submit the following data points:  assets under management, total leverage, counterparty credit risk exposure, trading and investment positions, asset valuation processes, asset types, side arrangements or letters with investors and trading practices.  Additionally, the SEC would have periodic inspections of the fund.  Since derivative trades were at the center of the crisis, swap trades need to be registered in a central repository. 

The CFTC and SEC would impose minimum capital restrictions on these trades and the funds must trade them on an exchange if possible.  To prevent funds from closing their prime brokerage accounts, their accounts would be segregated from the prime broker’s funds and rehypothecation of assets would not be allowed.  Rehypothecation is when the prime broker uses the hedge fund’s assets for its own business such as securities lending or as collateral. 

Short selling rules will be enforced to prevent bear raids on a stock.  When a stock falls 10% or more in price from the prior day’s close, then the uptick rule will be triggered.  This rule restricts short sales to when the stock price is above the last sale or the best bid price.   In a short sale, the stock must be borrowed first.  These shares must be delivered by the settlement date (within three days) of the trade.  There must be monthly disclosure of short positions aggregated by stock. 

Dodd-Frank also limits bank investment in hedge funds to three percent of the fund’s assets and three percent of the fund’s tier 1 capital.  Hopefully, this will prevent banks from bailing out their funds.  This is true from a financial perspective but banks may be motivated to bail them out to mitigate reputational risk.  These restrictions are only applicable to US entities.

To address the liquidity and leverage concerns, large hedge funds with $50 billion or more of assets under management are candidates to be regulated by the Federal Reserve Bank.  These funds are determined by the Financial Stability Oversight Council who assesses them based on a wide range of factors; quantitative and qualitative, industry and firm-based and the Department of the Treasury.  If two thirds of the council plus Treasury agree, then the fund will be regulated.  There will be position limits on futures and options for physical commodities and annual stress tests for funds with $10 billion in assets under three scenarios – baseline, adverse and severely adverse.  Regulating the prime brokers of hedge funds indirectly addresses leverage.  They will have higher capital requirements and have less credit to extend to funds, limiting their available leverage.

The reforms are changing the way hedge funds operate.  This is ironic as they did not cause the credit crisis.  The gap is in the potential lack of portfolio liquidity and excessive leverage.   There is too long a time delay before reporting positions.  The number of funds covered are few.  Prime brokers and regulators will have incomplete data as funds use multiple brokers and home countries.   Of the other points, lack of information, lack of margin on derivative trades and runs on prime brokers are strongly addressed and short selling and risk management incentives are moderately addressed.  Regulators should continue analyzing the hedge fund universe to better understand and monitor their risk.

The source for this article can be accessed here.