Monday, April 30, 2007

ECON310: Potential Impact of Additional Hedge Fund Regulation

Our last assignment for Money and Banking was to apply all the wunderbar tools that we'd learned throughout the semester and write a paper. This is not a traditional research paper as much as an opportunity to prove that we didn't occasionally: (A) sleep through class, (B) come to class drunk, (C) leave early to meet Andrew for a nosh at Metro 29 Diner, or (D) all of the above [guilty].

I really liked my professor, and I learned a lot on this class, but I have no plans to change my major. Economics is a still a social science, which is why this paper reads like "My friend Billy's arbitrage scheme wasn't hugged enough as a child, and studies show that insufficient hugs cause boo-boo-sadness in one-half of one-quarter of all forward contracts".

I am so glad this semester is almost over.

Hedge funds are private investments that seek to profit in all kinds of markets. The term hedge fund is used to differentiate from retail funds; typically they are limited to a certain number of investors and have restrictions on the divestiture of their shares. Despite $2 trillion invested among some 6000-7000 funds, the Securities and Exchange Commission is nearly powerless under the current regulatory structure.

A trend that concerns the SEC is the increase in hedge fund investments along with a lack of sophistication in hedge fund investors. For example, investment by pensions in hedge funds is expected to rise from $5 billion in 1995 to $300 billion in 2008, but most pension fund participants -- and even some pension executives -- do not realize they have investments in derivatives.

The SEC has sought further regulation of hedge funds to prevent another failure like that of Long Term Capital Management. Among the board of directors at LTCM were two Nobel Prize winning economists who helped to develop their fixed-income arbitrage model. Though they did very well in their first four years of operation, LTCM had a $4.6 billion loss in 1998 and eventually shut down in 2000. This illustrates the kind of risk the SEC feels the average, unsophisticated investor should have more protection from. Though many different regulations have been proposed, we will review two and see their affect on a real hedge fund like Eddie Lampert's ESL Investments.

Re-defining accredited investor

Currently the SEC only requires that hedge fund clients be accredited investors: they must have a net worth of at least $2 million or have made at least $200,000 per year ($300,000 if married) for the last two years. At an open meeting December 13, 2006, they proposed adding a new category, accredited natural person, to differentiate between pension funds and individuals. Either group would be required to own no less than $2.5 million in investments, which would be adjusted periodically for inflation. The SEC says that 8.47% of US households are eligible under current rules, and the new rules would reduce that number to 1.3%.

By limiting the number of households who could invest, this regulation may reduce the working capital available to hedge funds. Data has not been collected to show what percentage of current hedge fund investors would be disqualified by this change, but it is likely that this would cause only a small reduction in working capital to a fund like ESL Investments. This small reduction in working capital would slightly reduce the amount of leverage ESL has to make investments, and may then slightly reduce their profitability, but in all likelihood that reduction would again be very small.

Likewise, there is no data to show how this would protect investors from a hedge fund failure, but would only keep people will fewer financial mean from investing in such funds. In short, this won't stop hedge funds from failing, but should one fail the direct investors who had invested should hopefully be rich enough to better absorb the loss.


Unlike publicly traded companies, hedge funds are not required to file financial reports with the SEC. Proponents of further regulation would like hedge funds to disclose what investments it makes, what risk they carry, and file un-audited quarterly and audited annual financial statements with the SEC in the hopes that additional scrutiny will keep fund managers honest.

The Securities Act of 1933 recognizes that registration of a security is a long and expensive process, and the cost of compliance with registration greatly exceeded any public benefit. We can infer this by looking at Section 3 of the Act, which provides exemptions for securities issued by the Federal Government, national banks, non-profit organizations, and farmers' cooperatives. With the passage of the Sarbanes-Oxley Act of 2002, several public companies chose to buy-back their stock rather than incur the added expenses of auditor independence, corporate governance, and financial disclosure. While most bank covenants require private companies to share their audited financials, it may not be to the extent and expense that the SEC requires of public companies.

For a fund like ESL, this would slightly increase their overhead costs to add additional staff to oversee and prepare financial statements. This would slightly reduce their profitability, however it may also give their competition insight into the secret of their success. Likewise, the SEC would need to add additional staff to review the additional financial statements from hedge funds for compliance. Individual and institutional investors would receive the largest benefit from a reduction in information costs: they would have a more clear understand how the particular fund sought its profits, and have a better understanding of the risks they were taking before they chose to invest.


There is little question that the SEC's chief concern with respect to hedge fund regulation is maintaining the public trust: preventing mom and pop investors from losing their life savings, preventing unsuspecting pension fund investors and the PBGC from substantial loss, and, increasing visibility into hedge funds to deter fraud. Both of the regulations examined directly affect the profitability of hedge funds, but do little to protect investors from catastrophic loss.

A secondary concern of the SEC in this is the potential impact of a hedge fund failure as it ripples through the economy. Whether a fund fails through honest miscalculation or fraud, there is the potential to upset either a pension fund or a bank. If a pension has over-levered itself into a fund that fails, the Pension Benefit Guarantee Corporation (PBGC) will need to step in and bail the pension fund out. If a bank has over-lent to the fund on margin, it too could fail and require the FDIC to step in. Re-defining accredited investor will not prevent either of these from happening, but additional transparency into funds may deter fraud. One could argue that public companies like Enron and WorldCom, managed to defraud their investors while following SEC guidelines, but we may never know how many corporate failures transparency prevented. If the risk of conscious fraud can be reduced through transparency, it would be of considerable benefit to investors. Ultimately, the decision to create additional hedge fund regulation should be a positive one and not a normative one.

From this day forward, I promise to never compare and contrast things as being positive or normative.

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