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Thursday, November 30, 2006

The Danger of Hedge Funds 

Editorial
Hedging on Hedge Funds

Published: November 30, 2006
In October, a month after the Amaranth hedge fund lost $6.6 billion — the most ever by a hedge fund — Henry Paulson Jr., the Treasury secretary, spoke with Bloomberg News about the importance of “transparency” at hedge funds and “liquidity” in the system. His remarks were interpreted at the time as a warning, perhaps even a harbinger of more oversight.
What a difference a month makes.
In what was billed as a major economic address last week, Mr. Paulson devoted less than one-tenth of his speech to hedge funds, leaving the impression that he is basically satisfied with the regulatory status quo.
No one wants the Treasury secretary to be an alarmist. But other officials, notably at the Federal Reserve Bank of New York and the Securities and Exchange Commission, have gone further than merely acknowledging “potential risks” and pledging more “deliberations,” as Mr. Paulson did in his speech. Without pushing any panic buttons, they have broached the need for more collateral and better risk controls at banks that deal with hedge funds and greater oversight of hedge funds that solicit investments from pension plans.
Currently, some 9,000 hedge funds manage $1.3 trillion of investors’ money and control trillions of dollars more through their use of loans and derivative financial tools. They invest in all major sectors and operate through banks and securities firms, affecting the economy as a whole. And yet, they remain largely beyond the reach of federal overseers, a holdover from the days when they were much less ubiquitous. In 1990, only a handful of hedge funds existed, and altogether they managed just $39 billion.
Opponents of regulation routinely note that hedge funds are indirectly supervised because the banks they do business with are regulated. According to that logic, banks guard against excesses by their hedge fund clients to protect themselves from losses and regulatory problems. That reasoning also assumes that bankers are free of conflicts that might impair their judgment. But as hedge funds have grown, banks have earned increasingly larger commissions, fees and trading profits from them, a development that could induce some bankers to err on the side of recklessness.
There’s also an issue of practicality. As hedge funds become more numerous and complex, it is simply not feasible for banks to stay on top of their activities. And then there’s the matter of responsibility. It’s not a banker’s job to protect the public interest. It’s the job of regulators.
Mr. Paulson was right when he noted in his speech that the need for regulation must be balanced against the benefits of flexibility. But the challenge of striking a balance is beginning to sound like an excuse for delay. It’s time to move the discussion beyond whether hedge funds require more regulation to how they should be regulated.
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