Regulating Big Asset Managers Part 2
In my previous post, I suggested that the size of an asset management firm was not an appropriate marker for determining systematic risk, defined as risk to our overall financial system. Rather, it’s leverage that can turn asset managers into problems for our financial system. By and large, it’s hedge funds and other lightly regulated investment vehicles that pose the biggest threat. Sometimes the leverage comes in obvious form: borrowing huge amounts of capital to invest alongside client capital. Other times, the leverage is more difficult to ferret out because it is imbedded in derivative contracts. Fortunately, statutes and government regulations prevent mutual funds from being a major culprit in the game of leverage.
When you think of risk to the financial system, you need to think about Long-Term Capital Management (LTCM) or perhaps Amaranth Capital. The former borrowed heavily to build long and short positions in a huge portfolio of fixed income trades. The managers were betting that small price differences would converge giving them consistent profits. Massive amounts of leverage were used because the long and short positions appeared to offset one another in normal markets, and the leverage turned small gains into big profits. In 1998, the Russian debt crisis led bond prices to move in the direction opposite to LTCM’s strategy. The firm incurred massive losses, which were magnified by the leverage.
A quick aside. The 1997 Nobel Prize winners, Myron Scholes and Robert Merton, were on the LTCM board. Mssrs. Scholes and Merton, along with Fischer Black, are the co-developers of the Black-Scholes-Merton model for pricing options among other market insights. You might have expected these financial experts to raise great concerns about LTCM’s strategies. It didn’t happen. Tomorrow I’ll look at the contributions to investments of the three most recent recipients of the Noble Prize in economics: Robert Shiller, Eugene Fama, and Lars Peter Hansen.
Amaranth’s investment strategy involved making massive bets in the energy derivatives markets. These bests went badly awry. What had been a well diversified multi-strategy hedge fund turned into a massive and leveraged bet on natural gas prices. When gas prices moved in the wrong direction, Amaranth’s hedge fund collapsed.
Even if strict regulations had been applied to the top 100 money managers, neither LTCM nor Amaranth would have been subject to heightened regulatory scrutiny as described in the recent report by the Office of Financial Research (OFR). The firms were not nearly large enough to wind up on the OFR’s radar screen. Nonetheless, LTCM caused major havoc in the financial markets and had to be rescued by a consortium of big Wall Street banks. Amaranth caused turmoil and huge distortions in the natural gas markets.
You might expect that the banks and brokerage firms that extended credit to LTCM and Amaranth would have reined them in before the funds toppled. In both situations no one bank had a complete picture of just how leveraged either fund had become. By the time the distress became apparent, it was too late. It’s fairly clear from these anecdotes and a host of other hedge fund failures that the private sector alone can’t properly control or govern leverage levels.
I believe regulators should be monitoring leverage among hedge funds. Unquestionably, it would take a degree of knowledge and nuance, because all leveraged isn’t created equally. Some strategies can comfortably support more leverage than others, much as some bank loans require more capital than others.
Here’s the part that the SEC isn’t going to like (not that my opinion matters to them). The Federal Reserve should provide oversight for this function. First, the SEC doesn’t have experience monitoring leverage levels or providing substantive oversight of asset managers. Rather, the SEC’s regulatory scheme involves required disclosures, public filings, and periodic audits. The SEC is more process oriented. The Fed, on the other hand, is experienced in overseeing the assets and liabilities of nation’s major banks. While some of its regulatory oversight was wanting in the build up to the financial crisis, Dodd-Frank reinforces their role as a substantive regulator.
I think the Fed should be aggregating leverage levels among hedge funds in order to determine if certain strategies or certain banks (counter-parties) are taking on too much risk. They also should be looking for particular hedge funds that are putting on unusual amounts of leverage. I’m not suggesting that the Fed should be telling specific hedge funds about how to construct their portfolios. Rather, I think the Fed should be alerting banks when leverage becomes excessive, and in extreme cases the Fed should require banks to pare lending to over leveraged hedge funds. This role is exactly the Fed’s role as described by former Chairman William McChesney Martin. He said the Fed’s job was "to take away the punch bowl just as the party gets going.”