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The last week has been a nail-biter in the financial markets. Early last week a story came out that a Bear Stearns Hedge Funds was in trouble. The rest of the week had stories of how the hedge fund was trying to deal with their problems. The week ended with what appeared to be a solution -- albeit a probably temporary one. The end result of this is simple: Congress needs to find a way to deal with hedge funds.
First, a bit of history. Hedge funds have been around for a long time -- almost as long as mutual funds. The easiest way to think of hedge funds is a mutual fund that isn't subject to securities regulation. Rather than selling shares to the general public, hedge funds get funds from private individuals without using a sales force. It's more a word of mouth type of situation. Because there is no public solicitation, federal securities rules do not apply.
There are several often overlooked benefits of the securities laws. The first is verification of information. Despite the problems of Enron and Worldcom, most companies take their responsibility of providing accurate information seriously. However, the SEC does perform a necessary oversight function by verifying company's financial reports to insure the information is accurate.
The second is confidence. If investors think they are regularly provided with good and reliable information, they will be more prone to take risks. This increases liquidity and the number of people who participate in the financial markets. This in turn helps the markets grow and thrive. It diversifies risks and offers more opportunity to more people.
The Bear Stearns funds' situation highlighted two problems within the fund. The Bear Stearns funds used a high degree of leverage and made investments in an illiquid area of the market. "High degree of leverage" simply means the funds borrowed a lot of money. In this case, the fund borrowed about 9 dollars for every dollar invested. That's a ton of risk.
Leverage works both ways. In a rising market it amplifies gains. And in a falling market if amplifies losses. With these funds, the manager finally came out and said the losses were far larger than originally reported. Lenders started to panic, threatening to withdraw collateral. Merrill Lynch threatened to auction its collateral, which totaled $800 million. An auction that large would have set-off a possible selling panic on the street which would have rippled through the markets in a variety of unpleasant ways. Merrill withdrew its threat towards the end of last week.
The second problem is the fund -- at least from what I understand from news reports -- invested primarily in the illiquid portions of collateralized debt obligations. This amplified the losses the fund experienced. CDOs are risk management tools that have been around for about 15-20 years. They are designed to spread out the risk of a variety of underlying assets. Here's a link to the Wikipedia page on CDOs. The problem with CDOs is they have never been tested so we don't know how they will perform. My guess is they will work pretty much as advertised with a few kinks along the way. However, that does not alleviate the fear of not knowing if they will perform as advertised. And that fear played out in the markets last week as traders wondered whether or not these assets would do what they were supposed to do.
The main problem highlighted by last week's events is simple: lack of transparency. We have no idea if there are other funds out there with a similar make-up to Bear's funds or whether Bear's situation is unique onto itself. If the situation is the former, then the market's reaction of heightened concern was warranted. If the Bear situation was unique, then the reaction may have been extreme.
And there lies the problem. We have no idea what is out there in the hedge fund universe. And we need to know. If there are more funds like Bear's, then some quiet back-door action would be warranted. This would mean someone from the SEC could talk to the fund manager and say, "you've got a ton of illiquid investments plus a ton of leverage. Is that really a good idea? Maybe you should unwind some of those positions."
At minimum, we need to know who owns what security and how much leverage they have on their books. This would alleviate a lot of tension in the markets and provide investors with answers to a burning question: "Is this the only problem out there, or is this a systematic problem?" Because right now we don't know and we need to know.
So to any Congress people reading this, please put through a bill that requires hedge funds to report their holdings on a quarterly basis.