Hedging on Hedge Funds

The esoteric world of hedge funds was thrown open to public view last year, when one of the most prominent of the funds nearly failed. The Federal Reserve rallied Wall Street investment firms to rescue Long Term Capital Management (LTCM), since its collapse could have further riled shaky world financial markets.

These funds, after all, are not small players. Some 6,000 hedge funds worldwide wield $355 billion. That nearly matches India's annual output of goods and services, or Australia's gross domestic product.

Most of the money comes from wealthy individuals seeking high returns, even if at great risk, through lightly regulated, often secretive, limited investment partnerships. Fund managers often borrow extensively as well, to gain investment leverage. Investment styles are varied. Some "hedge" by investing both in stocks expected to go up and stocks they expect to fall. Some use derivatives or other exotic investments. Others are as conservative as most mutual funds.

Though hedge fund assets are impressive, LTCM's disaster last year prompted calls in Washington for investigation and tighter regulation. Last month, Rep. Richard Baker (R) of Louisiana introduced legislation requiring large hedge funds to make themselves and their financial dealings transparent to the public and to securities and banking regulators.

The bill is aimed at preventing another LTCM-type affair. After nearly tripling its investors' money in 3-1/2 years, LTCM ran into deep trouble in the summer of 1998. Russia devalued the ruble and imposed a moratorium on some debt repayments. This, naturally, upset world financial markets.

As a result, bond interest rates shifted in the wrong direction for LTCM's investment bets. The fund had leveraged $4.8 billion in investor capital by 25 times to some $123 billion of assets. When the value of those assets fell, the investors' original investment shrunk even more rapidly.

The Federal Reserve's rescue left LTCM investors with seven cents on each dollar invested.

Baker's bill, based on a presidential task force recommendation, is designed to make such extreme leverage and risky investments more visible to investors and to the banks making loans to hedge funds. Forewarned, those putting up money might be more cautious. The bill would apply to only the biggest hedge funds with $3 billion or more in capital. They're only about 3 percent of total hedge funds, but they're presumably the ones that could damage world financial markets.

The problem is that hedge funds can shift operations easily to other locales. If they find American regulations too onerous, they could set up, say, in the Cayman Islands, where regulation and disclosure are minimal.

A better approach than the Baker bill would be the indirect one of insisting that banks that lend to hedge funds know enough to gauge the riskiness of their loans. There should be no more blind lending.

Further, Washington should seek the imposition of such an approach in other key nations, as urged by the Basle Committee on Bank Supervision - an international effort to keep banks financially sound.

That approach might tame, a little, these financial playthings of the rich, reducing the risk of disturbing shocks in world financial markets.

(c) Copyright 1999. The Christian Science Publishing Society

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