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Hedge Funds Begin to Show Up on Regulators' Radar

By Carrie Johnson and Jeffrey H. Birnbaum
Washington Post Staff Writers
Friday, February 9, 2007

For years, hedge funds barely registered on the Washington agenda, and that was just the way they liked it.

These investment pools designed for wealthy individuals flourished in the shadows: They collected more than $1 trillion; seized control of underperforming companies; and increasingly drew money from gigantic pension funds, including those of government employees.

But now they are so large and numerous -- there could be as many as 9,000 hedge funds -- that federal regulators, state authorities and lawmakers are clamoring to learn more about them, including whether fraud and risky trading flourish in their secretive operations.

This week, the Securities and Exchange Commission staff confirmed that it was conducting a sweeping inquiry into whether hedge funds are misusing information they receive from investment banks to get a jump on trades and sweeten their profits. Last week, federal prosecutors in New York charged a fund manager with criminal securities fraud, saying it cost investors $88 million. And today, German officials are putting hedge fund risks at the top of the agenda of the Group of Eight meeting in Essen, Germany.

"All over the place, there are signals of rising regulatory concern," said Damon A. Silvers, who tracks the issue as an associate general counsel at the AFL-CIO. "It's certainly not an issue that's going away. If anything, it's escalating."

The last time a major coalition of federal agencies said anything on the subject was in 1999, after a star-studded hedge fund named Long-Term Capital Management nearly collapsed and shook the financial markets. Back then, the agencies rejected direct regulation of the funds, a position the U.S. government continues to hold.

Federal scrutiny, if not action, has increased significantly, however. High-ranking Treasury Department officials held 15 meetings over three days last year with representatives from prominent hedge funds, investors, lawyers and others to gather information about hedge funds' operations. Next week, the President's Working Group on Financial Markets -- comprising leaders from the Treasury, the Federal Reserve Board, the SEC and the Commodity Futures Trading Commission -- will meet and consider issuing a statement that highlights the importance of the funds to the market and the risks, insiders say. For now, federal officials say the best way to police hedge funds is to ensure that banks, which handle billions of dollars of the funds' business in loans and trades, are aware of the risks they face. Market analysts add that it is unlikely that the collapse of one large hedge fund would topple the market. But under certain scenarios, an over-leveraged fund could set off a string of events that could bring a large investment bank to its knees, touching off a dangerous chain reaction.

"Treasury believes systemic risk and investor protection are important concerns," said Jennifer Zuccarelli, a Treasury spokeswoman. "We continue to believe that market discipline and working through counterparties are the best way to address hedge funds."

Key lawmakers, including Sens. Charles E. Grassley (R-Iowa) and Arlen Specter (R-Pa.) and House Financial Services Committee Chairman Barney Frank (D-Mass.), have expressed interest in learning more about how the industry operates, including holding hearings. But lawmakers have mostly stopped short of calling for stiff oversight of the funds, in part out of fear that it might do more harm than good. In addition, many lawmakers have said that if rich people want to put their money at risk, there is no public policy reason to get in their way.

Another obstacle to more regulation: No single federal agency has the resources to oversee the esoteric hedge fund sector. After SEC officials tried in 2005 to impose a new rule requiring fund managers to register, two SEC commissioners wondered aloud whether the information the funds provided would ever be as up to date as the managers' rapid-fire trades and whether overworked agency staff would have the time to fully inspect the funds.

Federal Reserve Board Chairman Ben S. Bernanke said in a speech last May that he was "skeptical" about creating a hedge fund database. And Republican SEC Commissioner Paul S. Atkins has said registration could backfire by giving investors a false sense of security that the funds were being scrutinized when in fact the reviews would be cursory.

The SEC has the authority to bring civil fraud cases against funds and their managers. Since June 1999, the agency has filed more than 100 such cases, according to a review of public records. In recent months, SEC officials have been meeting with the largest banks that handle trades for hedge funds to review risks, agency chairman Christopher Cox said. Connecticut Attorney General Richard Blumenthal, whose state is home to hundreds of hedge funds, last year set up a special unit to probe their misconduct.

Even though the government has been reluctant to take on hedge funds, the collapse last year of Amaranth, resulting in a loss of $6 billion, and the renewed interest of multiple government outlets is prompting some of the largest funds to abandon their private, go-it-alone approach. Hedge funds are stepping up their lobbying, hiring new staff members for their main Washington trade group, the Managed Funds Association, and creating a second organization to educate lawmakers and regulators about the industry. Previously, hedge funds had not been heavily involved in the lobbying game.

The Managed Funds Association aims to more than double the size of its political action committee, to $400,000, in the current election cycle and has been widening its lobbying efforts. "We want to be part of identifying the problem and part of designing the solution," said Lisa S. McGreevy, the group's new vice president and a veteran of more than two decades as a financial services industry advocate.

Also last year, a group of a dozen hedge funds formed the Coalition of Private Investment Companies, which will lobby and take a more active stance with regulators and legislators. Job one, said lobbyist Andrew Lowenthal, is explaining what hedge funds do to an audience that may all too easily fit them into a stereotype.

"Hedge funds right now are a proxy for much of the complexity in the financial services world," he said.

The funds do not appear to be fighting hard against the single pending regulatory proposal that would affect them. Last December, the SEC proposed raising the minimum amount of assets investors would need to be eligible to pour money into hedge funds from $1 million to $2.5 million. If it wins approval, the change would make fund investing more exclusive and protect average investors from the risks inherent in frequent trading.

Still, the growing appeal of hedge funds to less-wealthy people and to pension funds bothers some current and former market watchdog groups.

"The fact that this industry remains for the most part unregulated is worrisome for investors and the markets in general," said Joseph P. Borg, president of the North American Securities Administrators Association, a trade group for investor protection officials.

Columbia University law professor Harvey J. Goldschmid, a former SEC commissioner, warned that the industry is only "two serious scandals away" from vigorous legislation that goes far beyond the registration drive that the agency attempted two years ago.

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