Hedge Hogs - Part I

As conservatives busily rewrite the history of our current financial crisis, and insist that they never intended deregulation to prevent the Securities and Exchange Commission (SEC) from doing it's job, I hope they don't forget to include role of hedge funds.

Traditionally the province of wealthy clients and institutional investors, hedge funds use a variety of derivatives and investment strategies (including short selling). On any given day, hedge funds account for about a third of transactions, so their impact on the markets is huge. Their investors are often willing to accept returns on a "no questions asked" basis, and since they are not regulated, they make great Ponzi schemes (just ask Bernie Madoff).

A few years ago, in a fit of regulatory zeal, then SEC Chairman William Donaldson decided to attempt to regulate hedge funds, saying they had been central figures in a variety of market trading abuses and that registration was at least a way for regulators to begin to understand them. He wanted to shine a light in what he described as a "dark corner" of the market. So the SEC issued a ruling in December 2004 requiring that hedge funds register by February 1, 2006 (this even caused Bernie Madoff to register).

So much for William Donaldson. He resigned "following repeated criticism from the two other Republican members of the agency and from some business groups and administration officials that his enforcement and policy decisions had been too aggressive," according to a New York Times report at the time.

The U.S. Court of Appeals for the District of Columbia overturned the regulation in June, 2006 and sent it back to the SEC to be reviewed. For technical reasons, Congress would need to pass a law to give the SEC oversight of hedge funds. But by then, President Bush had finally found what he had been looking for; an SEC Chairman, Christopher Cox, who understood the meaning of "deregulation." So the SEC regulation was dropped.

In February, 2007, the New York Times reported that the Bush administration said that there was "no need for greater government oversight of the rapidly growing hedge fund industry and other private investment groups to protect the nation’s financial system. Instead, the administration, in an agreement it reached with the independent regulatory agencies, announced that investors, hedge fund companies and their lenders could adequately take care of themselves by adhering to a set of nonbinding principles."

Within six months (July, 2007), two Bear Stearns hedge funds had collapsed. In announcing SEC plans to prosecute fraud in the case of these funds almost a year later, SEC Chairman Cox stated "hedge funds are by no means unregulated when it comes to fraud. Those who commit fraud at the expense of investors will always be the target of a relentless SEC."

It may be that Cox was beginning to understand that the point wasn't to protect hedge fund companies themselves, but to protect their clients (and financial markets) from the hedge funds. He may have even realized the absurdity of the idea that "nonbinding principles" would be adequate. But his reference to a "relentless SEC" makes me believe he was overmedicated.

The collapse of the Bear Stearns hedge funds was followed by the Bear Stearns bailout...and eventually Fannie and Freddie. The rest, as they say, is history.