As the fifth installment in an ongoing series of hearings regarding the current financial crisis, the House Oversight and Government Reform Committee recently held a hearing regarding “Hedge Funds and the Financial Market.” The purpose of this hearing was to formulate a better understanding of the following three issues: (1) the role played by hedge funds in the current financial crisis; (2) whether hedge funds pose a systemic risk to the U.S. financial system; and (3) what level of government oversight and regulation should be required for these private investment vehicles in the future.
To answer these questions, the committee assembled two panels comprised of independent experts and hedge fund managers. The first panel was comprised of independent experts, including scholars and professors of both business and law. The second panel was comprised of five of the most preeminent hedge fund managers in the industry.
The Role Played by Hedge Funds in the Current Financial Crisis in the U.S.
Overwhelmingly, both panels agreed that hedge funds did not cause, or significantly contribute to, the current financial crisis. James Simons, president of Renaissance Technologies, LLC, noted that hedge funds were not a major contributor to the recent crisis and that, in fact, the converse was actually true, with hedge funds generally increasing liquidity and reducing volatility in the markets during this turbulent time. Without notable deviation, each of the panelists stated that the current financial crisis was a direct result of weak credit underwriting standards, excessive leverage amongst financial institutions and a fundamental mispricing of credit risk.
While both panels agreed that the hedge fund industry did not cause or significantly contribute to the current crisis, several panelists alluded to the fact that the industry may have exacerbated some of the negative effects of the crisis. Rep. Carolyn Maloney (D-NY) highlighted that hedge funds purchased over 70 percent of the riskiest tranches of collateralized debt obligations. Although the panelists recognized that hedge funds facilitated the growth of the market for these informally named “toxic waste tranches,” many were quick to point out that free markets require that participants must exist that wish to assume such risk, and that, if hedge funds did not buy these assets, it is likely that they would have been held by banks, further exacerbating the current crisis
Some panelists and committee members also recognized that, as a result of the crisis, hedge funds are increasingly being forced to sell off significant portions of their holdings to satisfy a sudden influx of investor redemption requests. Rep. Maloney cited market analyst Jeff Bagley’s estimation that hedge funds might be forced to sell half a trillion dollars worth of assets as a result of this financial crisis. Professor Andrew Lo, director of the MIT Laboratory for Financial Engineering in the Sloan School of Management at MIT, noted that “those effects are the unavoidable aspects of a free capital market and something that, while we need to be aware of, and we need to prepare for, it may not require any direct oversight.”
Whether Hedge Funds Pose a Systemic Risk to the U.S. Financial System
Many of the investment banks that participated in the bailout of the hedge fund Long Term Capital Management (LTCM) are no longer in existence, or are too severely weakened to provide assistance. Therefore, the discussion as to whether hedge funds pose a systemic risk to the U.S. financial system centered largely upon the ramifications of a hedge fund failure of the magnitude of LTCM.
Professor Lo noted that “hedge funds are now involved in virtually every aspect of economic activity, investing in every kind of market and asset, making loans for all purposes, including mortgages, engaging in market-making activity, financing bridges, highways, tunnels, and other infrastructure in many countries, and even providing insurance” and that it is the industry’s “ubiquity, size, leverage, illiquidity and lack of transparency that creates systemic risk for the financial system.” As such, he stated that “too large to fail” hedge funds could pose significant market dislocation, providing further support for his proposal that, going forward, regulators track the risk taken on by all hedge funds much more closely.
The view that the hedge fund industry contributed to systemic risk in the U.S. economy was not shared by all of the panelists. Houman Shadab, the senior research fellow of the Mercatus Center at George Mason University, disagreed with the notion that hedge funds pose a systemic risk to the economy, and noted that, while investment banks may not be available to bail out failed hedge funds, other hedge funds do exist that could acquire the assets of those hedge funds that ultimately are unable to continue to operate. Similarly, Philip Falcone, senior managing partner at Harbinger Capital Partners, noted that “if we look at where the failure and stress points have been in the system, they have been in the regulated institutions, whether it’s AIG, an insurance company, Fannie or Freddie, the banking system . . . we have not seen hedge funds as a focal point of carnage in this recent financial tsunami.” Mr. Simons furthered these sentiments by highlighting the fact that over the last 10 years, hedge funds have had an annual volatility of only seven percent, as compared to 15 percent volatility for the S&P 500 stock index.
The Level of Government Oversight and Regulation Appropriate for These Private Investment Vehicles
Virtually all of the panelists, both the independent experts and current hedge fund managers, agreed that increased oversight and regulation of the hedge fund industry was appropriate. The crux of the reform suggested by the panelists or put forth by the committee members addressed the following five issues:
- a need for greater transparency regarding the risk undertaken by hedge funds;
- the reformation of the tax code’s current treatment of the carried interest received by hedge fund managers;
- the regulation of derivative transactions;
- the imposition of increased limits on the amount of leverage used by financial institutions; and
- whether revisiting the federal investment adviser registration requirements was necessary.
While the panelists pointed to increased regulation of the hedge fund industry as being necessary, each also warned of the ill effects that could result from heavy-handed over-regulation. George Soros, chairman of Soros Fund Management, LLC, noted that the current crisis was exacerbated by excessive deregulation, but adamantly stated that “there’s a real danger that the pendulum will swing too far the other way. That would be unfortunate because regulations are liable to be even more deficient than the market mechanism itself. That’s because regulators are not only human but also bureaucratic and susceptible to political influences.”
Increased Risk Transparency
The vast majority of the panelists concurred that the most important issue regarding the hedge fund industry and requiring governmental attention was a general lack of understanding of the risk undertaken by these market participants. Due to the private nature of these investment vehicles and the highly complex transactions in which they engage, very little is known as to the extent of risk they undertake as part of their daily operations. Without this knowledge, it was recognized that the true impact that hedge funds could have on the markets is undeterminable, and that prevention against possible failures would be impossible. To this end, the suggestion was made by Professor Lo to require all hedge funds, or their prime brokers, to periodically provide certain risk measures to regulators. It was generally agreed that the Federal Reserve would be the most appropriate government body to analyze such information. This suggestion was viewed as a practical solution by most of the participants; however, the hedge fund managers eagerly reminded the committee members that such information would have to be on a confidential basis, on account of the proprietary trading systems used by the hedge fund managers. The suggestion was also made that such information should also only be transmitted to regulators on an aggregate basis, to ensure that data could be easily interpreted.
As each of the panelists agreed that greater risk transparency was required of the hedge fund industry, Rep. Christopher Van Hollen (D-MD) questioned whether the conveyance of such additional information should also confer upon the regulators increased regulatory powers over hedge funds. Specifically, he asked whether regulators should be permitted to intervene or impose additional requirements upon those vehicles they determine to be causing systemic risk. The panelists overwhelmingly agreed that the regulators, whether it be the Federal Reserve or the SEC, should be placed in a position to act upon the risk data they receive from hedge funds.
Amendment of the Tax Code
The topic that received a substantial amount of attention from the committee members was the taxation of the carried interest portion of the compensation received by hedge fund managers. In accordance with current partnership tax law, the carried interest portion of a hedge fund’s income merely passes through the nature of the underlying investment generating such income to the general partner. Thus, for example, to the extent that a partnership owns a security for more than one year, the income it receives from the sale of such an asset would be taxed as long-term capital gain, at a tax rate of 15 percent, in the same manner as if it were held directly by an individual investor. Several committee members questioned whether affording hedge fund managers the ability to potentially pay a lower tax rate (long-term capital gain) than school teachers and firefighters making less than $45,000 a year was equitable. Professor Joseph Bankman of Stanford University Law School also noted that the benefits of this treatment to hedge fund managers have been estimated at more than $30 billion over the next ten years.
While Chairperson Henry Waxman (D-CA) stated in his opening remarks that each of the hedge fund managers serving on the panel “receive special tax breaks” and “treat the vast majority of their earnings as capital gains,” each of the panelists noted that the vast majority, if not all, of their income was actually taxed as ordinary income. Accordingly, none of the panelists conveyed significant concern over amending the tax code but noted, to ensure equity in the code, such changes should apply across the board to all partnerships, including those involving private equity, venture capital, oil and gas, and real estate, as each operates under the same taxation principles.
Last June, the House passed legislation (H.R. 6725) that would tax carried interest at the normal income tax rate. The Senate has been less forward-leaning on the issue and, to date, no legislation has been considered by the Finance Committee, which has jurisdiction over tax matters. Next year, as the fiscal outlook continues to worsen, it is likely that this provision will once again come under increased scrutiny by Congress.
Given the nature of the questions posed by the committee members, it appears that reform in this area will likely occur in the very near future.
Regulation of Derivative Transactions
John Paulson, president of Paulson & Co., Inc., suggested that the concept of “too big to fail” has been replaced, largely in part due to the rapid growth of the use of derivatives, with the idea that institutions may be “too interconnected to fail.” He states that the use of derivatives has “created an opaque market whose outstanding notional value is measured in the hundreds of trillions of dollars.” He further illustrates this point by noting that, in the area of credit default swaps alone, “there is an estimated $55 trillion of outstanding notional contracts between market participants . . . [which is] almost four times the GDP of our nation.”
The common consensus with regard to the regulation of derivatives was the need for central clearinghouses to act as intermediaries and guarantors of financial derivatives. The panelists noted, however, that such institutions should be created not to limit the use of such instruments, but rather to simply minimize systemic losses and to ensure that the government maintains an accurate picture of the risk involved in such transactions.
Limiting the Use of Leverage
A recurring theme throughout the hearing was the panelists’ belief that the root of the current financial crisis was largely the ineffective limits placed upon the use of leverage. Mr. Paulson noted that “one of the primary reasons why financial firms have run into trouble, whether it’s Lehman Brothers, Bear Stearns, or AIG, is they have way too much leverage. Lehman Brothers, as an example, had over 40 times the assets compared to their tangible common equity. They just did not have enough equity.” As such, he held that more stringent leverage requirements on banks and financial institutions was required and, where necessary, limits on the use of leverage by hedge funds. Kenneth Griffin, CEO and president of Citadel Investment Group, LLC, however, disagreed with the latter aspect of this proposal, stating that “hedge funds are already regulated indirectly by the fact that the banking system is regulated and the banking system is the primary extender of credit to hedge funds.” Virtually all panelists agreed that far more restrictive constraints should be imposed upon the use of leverage by financial institutions. Mr. Soros agreed with Rep. Darrell Issa’s (R-CA) suggestion that disclosure requirements concerning the use of leverage by financial institutions should be included in President-elect Obama’s short list of items to be targeted during his first 100 days in office. He noted, however, that regulators must first understand the leverage involved in many of the derivative transactions currently utilized by the market before they can effectively regulate such instruments.
Investment Adviser Registration
As most of the hedge fund managers on the panel were already registered with the SEC as investment advisers, they were fairly ambivalent as to whether a hedge fund adviser registration rule, similar to that initially approved by the SEC in 20041 and later overturned by the Goldstein case,2 should be implemented by Congress. The independent experts, however, were more outspoken on this issue. Specifically, Professor David Ruder of Northwestern University School of Law stated that he believed that the SEC should be provided the power to require all hedge fund advisers to (i) register with the SEC; (ii) disclose the size and nature of hedge fund risk positions; and (iii) disclose the identities of their counterparties, and monitor and assess the effectiveness of hedge fund risk management systems implemented by such advisers. In concert with Professor Lo’s suggestion regarding the increase of risk transparency, Professor Ruder noted that it should be the responsibility of the SEC to collect risk data from the hedge funds that would later be analyzed by the Federal Reserve.
It appears that Congress has an appetite for increased regulation of the hedge fund industry, and that proposals to make these changes will receive priority consideration during the next Congress. The odds of passage for such legislation are too early to tell without additional details, but there is a momentum towards congressional action.