Avoiding Financial Armageddon

05/25/2011 11:55 am ET
  • Ann Lee Author, What the U.S. Can Learn from China; Senior fellow, Demos

With the U.S. Senate's recent hearings on hedge funds, it's time for greater media scrutiny of these lightly regulated financial vehicles. Accounting for over a trillion dollars of invested capital, the public at large should be made aware of the risks hedge funds pose to the global financial system.

Similar to mutual funds, hedge funds are professionally managed pooled investments. To invest, a participant must have a minimum net worth of $1M, and individual funds are limited to a maximum of 99 investors. However, everyday citizens have indirect exposure to hedge funds through their pension plans, insurance policies, and checking accounts at major banks. Hedge funds primarily differ from mutual funds in that they can employ trading techniques not available to most mutual funds such as shorting or can adopt multiple strategies in a single fund as opposed to sticking to one strategy.

Despite recent concerns regarding corporate governance, hedge funds remain surprisingly unregulated, allowing fund managers tremendous flexibility regarding investment decisions. Since hedge fund managers are compensated for absolute performance, including an emphasis on short-term returns, they have enormous incentives to adopt high-risk strategies including holding highly concentrated positions and exercising leverage.

Managers have many financial vehicles available to mask the true financial health of a hedge fund. For example, a manager can simply buy private equity investments, a strategy with little transparency and minimal reporting requirements. Worse still, with an open checkbook available to trade illiquid investments such as junk bonds and emerging market debt, pricing manipulation can easily occur. Because these instruments may not trade for days, a hedge fund manager can price illiquid instruments at his discretion, resulting in an easily inflated portfolio that can go undetected for a long time.

Hedge fund managers get paid enormous sums on their performance, generally collecting a 1%-2% fee on assets under management and anywhere from 20%-60% of the profits. As a result, the temptation for fraud and abuse is extremely high. Moreover, hedge fund managers have every incentive to take huge risks. If a speculative trade pays off, the manager receives a windfall. And if poor investment decisions result in the hedge fund manager's termination, he can simply get employed at another fund where he is paid to play again.

Recently, hedge funds have flourished as a result of loose regulations and a low interest rate environment offering easy access to capital. Investment and commercial banks are now competing fiercely for a share of the hedge fund business. Many of these institutions have lowered their credit standards to lure hedge fund clients, as banks are also under competitive pressure to meet short-term profit targets. With little incentive to inspect hedge funds for potential red flags, the growing inclusion of these investments has become a higher percentage of bank revenues.

Among the highest risk investments embraced by the hedge fund community are credit derivatives. These financial instruments, initially developed and standardized during the 1980s, are insurance contracts on credit instruments like bonds or bank debt. In the first decade of their introduction, credit derivatives accounted for approximately $800 million in value. Today, valuation estimates of this market are in the $12-13 trillion range, primarily due to the huge appetite for these contracts from hedge funds. Put into perspective, the credit derivatives market is now equivalent to our gross national product. Individual transactions between broker and hedge fund often exceed $100 million notional value, and this marketplace may see hundreds of these transactions happen in a single day. Yet, despite these astounding numbers, many of the individual credit derivative transactions that occur are settled by hand, not electronically, potentially masking settlement problems for weeks or months. Combining the size and quantity of these transactions with inefficient processing, loose credit terms, and a lack of transparency creates a situation ripe for disaster. Even the slightest hiccup in this complex and amorphous marketplace could have massive repercussions on financial markets worldwide. Although a massive failure has not occurred with credit derivatives, examples in the past such as the failure of the hedge fund Long Term Capital, whose leveraged bets on derivative instruments, nearly bankrupted multiple large investment banks.

Markets benefit when we can stimulate innovation with flexible financial vehicles such as hedge funds while simultaneously maintaining regulations that reign in abuse. Many people tout the benefits of hedge funds, most often citing their liquidity, efficiency, and the ability of banks to offload credit risks to unregulated parties. However, it is also irresponsible to assume that the financial industry can self-regulate given the enormous financial incentives for abuse and the speculative, high-risk nature of hedge fund investments. Governmental oversight and increased media scrutiny are long overdue as referees of this ever more precarious marketplace.