Hedge Funds Mystify Markets, Regulators
Deeply Powerful, Largely Unchecked

By David Cho
Washington Post Staff Writer
Wednesday, July 4, 2007

Wall Street chroniclers one day could look back at the early 21st century and easily dub it the Era of the Hedge Fund. The question is whether it will be remembered as an age of reason or irrational exuberance.

Hedge funds hold unparalleled sway over the financial markets, as confirmed by the recent unraveling of $20 billion in Bear Stearns funds. Portrayed as the new masters of the universe by author Tom Wolfe, hedge-fund managers are responsible for more than a third of stock trades and control more than $2 trillion worth of assets, according to industry researchers. Each of the top hedge-fund managers earned more than $1 billion in 2006 alone.

But like the Wizard of Oz, these funds hide behind a cloak of mystery as they pull the levers that make Wall Street go. "To a great degree they're unregulated and hardly understood or not understood at all," said James Grant, publisher of Grant's Interest Rate Observer.

Understanding the impact of this secretive world gained urgency in Washington after the crisis at the two Bear Stearns hedge funds sent the Dow Jones industrial average down 279 points and prompted the Securities and Exchange Commission to begin an informal investigation last week.

The Bear Stearns funds were on the cutting edge of the hedge-fund world that reaps billions of dollars from slicing up corporate loans, mortgages and other kinds of debt into pieces that can be traded like shares on the stock market. This process is considered by many bankers and regulators to be one of the great advances in finance over the past five years. With hedge funds acting like shock absorbers, investment banks and lenders have been able to make massive loans to freewheeling borrowers and feel less impact from the risk.

Money became easy to get and was easily lent. Banks offered huge mortgages to people with questionable credit. The business of borrowing billions of dollars to buy troubled companies boomed. Backed by hedge funds, insurance companies could offer coverage to homeowners in New Orleans after Hurricane Katrina.

Some analysts say hedge funds have become more important financiers than the long-established investment firms of Wall Street. Greenwich, Conn., where more than half of the biggest hedge funds are based, has earned nicknames such as "The New Wall Street" and "Hedgistan." It also has become one of the most important stops along the presidential campaign fundraising trail.

Yet the trouble at Bear Stearns is revealing that the system may not be as crash-proof as once thought. And it has left Washington regulators and Wall Street analysts with questions: How dependent has the new financial system become on hedge funds? Are their trades getting more risky? If one of them unravels, who absorbs those losses?

The answers are unclear, even to top economists. Part of the problem is that most hedge funds do not reveal much about their trading activities. Many operate offshore. Even for the ones that are based in the United States, no federal agency is empowered to regulate or watch their activities.

The SEC in 2004 passed a rule requiring hedge-fund managers to register with the agency and submit to some oversight. But a U.S. Court of Appeals struck down that rule in June 2006. Later that summer, SEC Chairman Christopher Cox testified to the Senate Banking Committee that hedge funds were operating in a "gap" in the SEC's authority, but he fell short of asking Congress to address the issue through legislation.

The President's Working Group on Financial Markets, which was founded after the collapse of hedge fund Long Term Capital Management in 1998, said in February that hedge funds needed no regulation.

Yet many market watchers worry that, shielded from regulators and operating in the dark, the biggest and most influential hedge funds might be making bets that put the entire financial system at risk. As the two Bear Stearns funds demonstrated, some hedge funds are investing large amounts of money in complex securities that are difficult to value accurately. And much of it is being done with borrowed money -- or "leverage" -- which can magnify returns but also exacerbate losses.

"There's been a fundamental change in the debt markets that I don't think people appreciate yet," said Richard Bookstaber, who has managed hedge funds and recently wrote a book on the topic, "A Demon of Our Own Design."

"I don't think anybody knows how much leverage a particular [group] of hedge funds is using or how much leverage has grown. . . . We are running the risk of making the markets more levered and more complex so that something can go wrong all of a sudden," Bookstaber said.

So what is a hedge fund?

For starters, hedge funds take money only from those with deep pockets. They pool huge amounts of money mainly from super-wealthy investors, Wall Street banks and other hedge funds. About 25 percent of their money comes from pension funds and endowments, according to data from Greenwich Associates.

In the late 1940s, managers of the first hedge funds invented ways to make money no matter which way the stock market was moving. They used terms like "short the market" -- a technique for profiting when stocks go down -- and "going long" -- which means selling stocks after their prices have gone up. The trick was figuring out how many "short" and "long" positions a manager should have in a portfolio.

But to understand what hedge funds do today, it could take "two PhDs and an MBA," as Greenwich Associates hedge-fund analyst Karan Sampson put it.

Some funds bet on how stocks, gold prices and interest rates will move. Others turn almost any kind of cash flow -- including credit card payments, home mortgages, corporate loans, plane leases, and even movie theater revenue -- into bonds and trade them.

One of the most successful fund managers, Edward S. Lampert of ESL Investments, runs an $18 billion fund that makes money in part from what are called "total return swaps." These provide insurance for traders holding risky investments. If the investment goes down, Lampert absorbs the loss, but if it goes up, he enjoys the gain. In exchange for agreeing to the swap, the trader gets regular cash payments from Lampert.

Lampert's fund reportedly has earned returns of 30 percent every year by trading in swaps and other obscure financial tools. He personally made more than $1 billion last year. Most fund managers get their pay by taking a 20 percent cut of the profits from their trades and collecting from investors a 2 percent annual fee based on the total value of a portfolio.

Former Federal Reserve Chairman Alan Greenspan was an advocate for how hedge funds help spread investment risk across many partners. The concept of "risk dispersion" has been described by Federal Reserve Governor Donald L. Kohn as a pillar of the "Greenspan doctrine." Over the past five years, advocates say, it has created a more stable financial system.

In 1998, just when hedge funds were starting to become big, Long Term Capital Management collapsed, nearly paralyzing the U.S. bond market. The disruption was so severe that the Fed had to organize a temporary rescue. The fund lost about $3.6 billion before closing in 2000.

But when the Amaranth hedge fund imploded in September 2006, losing about $6.4 billion on bad bets in natural-gas commodities, federal regulators stayed on the sidelines. Returns plummeted for a few hedge-fund managers and a pension fund in San Diego, but the markets generally shrugged off the news.

The new financial system seemed to be working.

Still, a growing number of market watchers wonder whether the system is encouraging hedge funds to take on too much risk.

"It's a weird dynamic that the market has now," said Dan Freed, a senior writer at Investment Dealer's Digest. "You used to have a small number of institutions taking a lot of risk. Now you take something that's toxic and you divide it into a thousand pieces and you say, okay, well, it's not toxic anymore. . . . But if it's toxic, isn't it [still] toxic?"

The Bear Stearns hedge-fund managers not only made risky bets but also did so with massive loans. They raised hundreds of millions of dollars from wealthy investors and other hedge funds, and borrowed many times that amount from Wall Street banks. With $20 billion at their disposal, they traded obscure securities backed by mortgage loans made to homeowners with shoddy credit histories.

The securities were so exotic that few knew whether the managers were getting good prices as they traded them.

The problem is similar to what happens in the housing market. Because houses are "traded" infrequently, homeowners often struggle to figure out the right price to attract interest. An appraisal can help, but a house's actual value is established only when a buyer and seller agree on a price.

Stocks, on the other hand, are exchanged every day, so their prices generally are considered accurate.

In the case of the Bear Stearns funds, the managers appeared to struggle to value their assets accurately or find buyers for them. In May, they said the funds had lost 6.75 percent of their value in April. In June, they revised that loss to 18 percent. The revision spooked traders, and ultimately some of their assets had to be dumped in a fire sale. Bear Stearns also lent $3.2 billion to bail out one of the funds after Wall Street banks demanded their money back.

Analysts worried about the ripple effects. Other hedge funds holding similar securities had to mark down the value of their assets. Banks suddenly got skittish about making big loans.

Some analysts wondered whether the era of easy money was ending. Daniel A. Strachman, author of "The Fundamentals of Hedge Fund Management," noted that the markets had put a lot of confidence in the new hedge-fund-dominated financial system even though it had not been tested seriously during the economic expansion of the past five years.

"I think there are a significant amount of people who call themselves hedge-fund managers who have been very lucky because they were able to ride the market wave," he said.

But as the Bear Stearns case showed, it may be impossible to know from where the next crisis will emerge and whether there are other troubled hedge funds.

"Wall Street creates all these increasingly sophisticated financial products, and no one really seems to understand them but the people involved in creating them," Freed said. "They assure everybody that everything's going to be okay, and we are forced to believe them."

View all comments that have been posted about this article.

© 2007 The Washington Post Company