Please Note: You are viewing the unstyled version of Subprimelosses. Either your browser does not support CSS (Cascading Style Sheets) or it is disabled. As a result, much of this website will not look the way it was intended, although all of its contents will be accessible to you. For more information, visit our Browser Support page.

Skip to Primary Site Navigation, Secondary Site Navigation, Content

Home > Cases > Hedge Fund Problems Overview

Hedge Fund Problems

GAO Report: Hedge Funds Improve Disclosure, But Concerns Remain

Despite industry efforts to improve accountability and transparency, hedge funds continue to pose a “systemic” risk to the nation's economy, according to a newly released report by the United States Government Accountability Office (GAO).

The GAO report examines the roles of federal financial regulators and market participants in overseeing and imposing discipline on hedge funds, as well as the potential risks posed by the $1.8 trillion hedge fund industry.

The report comes in the midst of ongoing troubles for hedge funds, including two major funds sponsored by Bear Stearns. The Securities and Exchange Commission (SEC) also is involved in several investigations concerning potential insider trading by hedge fund managers.

Hedge Funds Background

Hedge funds serve as privately managed, lightly regulated investment vehicles. The funds are typically leveraged and mostly open to only a limited number of investors, such as institutional investors and wealthy individuals. In recent years, however, hedge funds have become attractive to pension funds and university endowments.

In 1998, hedge fund activities gained national attention, following the near collapse of Long-Term Capital Management (LTCM), a large, highly leveraged hedge fund. Despite those early warning signs, hedge funds continued to experience rapid growth. From 1998 to 2007, the number of hedge funds rose from 3,000 to more than 9,000. The assets managed by hedge funds ballooned, as well, from approximately $200 billion to more than $2 trillion today.

The importance of hedge funds in the marketplace is significant. They account for more than 40 percent of the trading volume in the leveraged loan market, more than 85 percent of the distressed debt market, and more than 80 percent of certain credit derivatives markets.

Oversight of Hedge Funds

Unlike other investment pools — such as mutual funds — hedge funds typically are structured and operated in a way that allows them and their advisers to qualify for exemptions from certain federal securities laws and regulations, including mandatory registration and disclosure requirements.

Under the existing regulatory structure, the Securities and Exchange Commission and the Commodity Futures Trading Commission can provide direct oversight of registered hedge fund advisers and, along with federal bank regulators, monitor hedge fund-related activities conducted at their regulated entities.

Currently the SEC oversees an estimated 1,991 hedge fund advisers. This includes 49 of the largest U.S. hedge fund advisers, which account for approximately one-third of hedge fund assets under management.

As part of routine inspections, the SEC conducted approximately 321 examinations of registered advisers it believed to be involved with hedge funds. Deficiencies among those groups included: information disclosures, reporting, and filing — i.e. private placement memorandum was outdated; personal trading — i.e. quarterly reports were not filed or filed late for personal trading accounts; and compliance rules — i.e. policies and procedures were inadequate to address compliance risks.

Another important SEC activity is its supervision of regulated securities firms that conduct transaction with hedge funds.

Bank regulators, including the Federal Reserve and the FDIC, monitor hedge fund activities. Their role centers on the management practices of their regulated institutions' interactions with hedge funds as creditors and counterparties. Bank regulators examine the extent to which banks follow sound risk management practices.

Market participants also play an important role in keeping hedge funds in check. Investors, creditors, and counterparties impose market discipline on hedge funds by providing additional funding or better terms to hedge funds that are willing to disclose credible information about the fund's risks and prospective returns. In recent years, hedge fund advisers have taken steps to improve their disclosure practices in hopes of attracting institutional investors with fiduciary responsibilities like pension plans.

Existing Oversight Challenges

Even though hedge funds have improved their disclosure practices, many prospective investors do not have the capacity or expertise to analyze the information they receive from hedge funds. Some investors may invest in a hedge fund based purely on prior returns without fully evaluating the risks.

Financial regulators and industry observers alike share concerns regarding credit risk management at major financial institutions because it is a key factor to controlling the potential of this risk for hedge funds. These institutions, which act as the principal creditors and counterparties to hedge funds, are the most important providers of market discipline. But with the recent explosion in hedge funds, there are questions on how well they can measure and manage their credit risk exposure to the funds.

In addition to counterparty credit risk, there is unease in the industry over market liquidity. If numerous market participants are all on the same side of a trade, this concentration and interconnectedness could strain liquidity if market conditions compel traders to simultaneously unwind their positions. In turn, losses by hedge funds could cause significant losses at intermediaries and in financial markets. For example, the Bear Stearns funds that failed, while not triggering a large-scale sale of assets, contributed significantly to the subprime mortgage debacle.

Looking Ahead

Whether or not increased oversight on the part of government regulators and market participants will have an effect on hedge funds remains to be seen. In the meantime, the continued vigilance certainly can't hurt.

Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage related investment losses.

In the summer of 2007, our group, who individually and collectively have extensive experience in representing investors against Wall Street, formed an affiliation. Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage related investment losses. Contact us.


Return to Cases >


Top