"Hedge funds know how to trade toxic assets, and that expertise is helpful right now."

TO BE NOTED: From Business Week:

"Hedge funds stand to gain, but also face oversight

By STEVENSON JACOBS

Hedge funds are being offered a sweet deal to help the Obama administration rescue the U.S. banking system: A low-risk opportunity to scoop up soured bank assets that could one day make them a killing.

But the deal could make for an uneasy partnership.

The government also wants to closely police hedge funds, some of which have been accused of placing irresponsible bets that helped trigger the financial crisis. Such regulatory overhaul could reshape an industry known for secrecy and little oversight.

"It's certainly problematic because we don't know where the current political fervor is going to end up," said Kjerstin Hatch, portfolio manager for Madison Capital Management, a $550 million hedge fund specializing in distressed assets.

Several big investors have already voiced interest in joining the administration's effort to buy up banks' bad assets. That task is considered crucial to propping up teetering banks, restarting lending and ending the recession.

But with anti-Wall Street critics seething in Washington and elsewhere, Hatch and other hedge fund managers say they want assurances that they won't be hit with heavy-handed restrictions if they were to take part in the bank-rescue plan.

"You don't want to paint a bulls-eye on your back," said Steven Persky, managing partner of Dalton Investments, a Los Angeles hedge fund that's already invested $400 million in toxic mortgage-backed assets. He wants more details on the government's plan.

"The potential returns are attractive, but you have to be aware, more than ever, about the regulatory risks," he added.

Hedge fund insiders expect the reforms to be the most sweeping since the high-flying and thinly regulated industry's birth two decades ago.

"The era of lack of regulation for hedge funds is over," said Sol Waksman, founder and president of Barclay Hedge Ltd., a firm based in Fairfield, Iowa, that tracks and invests in hedge funds. "The question is how intrusive will the new rules be."

Strict rules would be a new experience for hedge funds, which are large investment pools that cater mainly to the rich. They've long toiled in Wall Street's Wild West.

With high-tech trading models and a gambler's instinct, hedge funds have generated outsized paydays that dwarf those of other investment funds. They've also swelled the ranks of the world's billionaires, making stars out of top fund managers including John Paulson and George Soros.

Unlike mutual and money market funds, hedge funds don't have to register with the Securities and Exchange Commission. That means they don't have to disclose such details as who runs the fund, how much money they manage and what securities they buy.

Hedge funds have fended off past attempts to regulate them. They sued, for example, to overturn an SEC push to register them in 2005. Today, hedge funds are barred only from advertising or courting investors worth less than $1 million or a yearly income of $300,000.

"Basically, nobody regulates hedge funds today," said Nadia Papagiannis, a hedge fund analyst at research firm Morningstar.

That seems sure to change.

The Obama administration is pushing the idea of a regulator-in-chief. That role might be given to the Federal Reserve -- to oversee and, if necessary, take over nonbank financial entities like hedge funds and private equity groups whose failure could upend the U.S. banking system.

Treasury Secretary Timothy Geithner, who is expected to detail the overhaul plan soon, last week urged Congress to enact legislation that would give the government sweeping oversight power.

"One of the key lessons of the current crisis is that destabilizing dangers can come from financial institutions beyond banks, but our current regulatory system provides few ways to deal with these risks," Geithner said during a speech in New York.

The push for reforms coincides with the administration's revamped financial rescue plan. It seeks to entice hedge funds and other investors to buy banks' toxic assets so they'll start lending again.

The plan uses cheap government financing to offer would-be buyers of toxic assets the potential for juicy double-digit returns. Taxpayers are left to shoulder most of the risk.

Hedge funds could sure use the business. A record 1,471 hedge funds -- or nearly 15 percent of the industry -- closed in 2008, with half of them vanishing in the fourth quarter alone, according to Hedge Fund Research. The average hedge fund lost 18 percent last year.

But not all hedge funds fared poorly.

The top 25 highest-earning hedge fund managers got paychecks totaling $11.6 billion last year, industry magazine Alpha announced last Wednesday. The top spot went to James Simon, who took home a cool $2.5 billion.

Some worry that onerous government regulation could bring an end to the good times.

Critics of hedge funds have called for tighter rules on everything from how much the funds should be allowed to borrow, to what kind of securities they can trade and what information they must disclose publicly.

Such reforms are designed to tame what some see as hedge funds' gorilla-sized influence on financial markets. Last year, hedge funds were blamed for causing huge gyrations in the stock market and oil's record run above $140 a barrel.

The hedge fund industry says there's no evidence to support such claims.

"We want to dispel, once and for all, this misconception that the hedge fund industry is opaque and uncooperative," Andrew Baker, chief executive of Alternative Investment Management Association, a hedge fund lobby group, said in a statement.

His group pledged to support calls for more hedge fund transparency. But it hasn't endorsed more stringent reforms sought by some investors.

Many argue that fees charged by hedge funds are out of whack and should be changed. Hedge funds typically charge investors a management fee equal to 2 percent of their assets and a performance fee equal to 20 percent of profits. That's several times the fees charged by mutual funds and most other investment firms.

That fee structure, critics say, disproportionately rewards hedge fund managers in good times while disproportionately hurting their investors in bad times, such as last year's market crash.

"The incentives are completely misaligned," Morningstar's Papagiannis said.

Others caution against over-regulating the industry, saying it could backfire and undercut the government's financial rescue plan.

"You don't want irrational regulation," said Thomas Donaldson, professor of legal studies and business ethics at the Wharton School of the University of Pennsylvania. "Hedge funds know how to trade toxic assets, and that expertise is helpful right now."

"Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out.

TO BE NOTED: From Real Clear Markets:

"Uncle Sam's Massive Hedge Fund By Robert Samuelson

Call it Uncle Sam's hedge fund. The rescue of the American financial system proposed by Treasury Secretary Timothy Geithner is, in all but name, a gigantic hedge fund. The government would lend vast sums to private investors to enable them to buy loss-ridden assets at discounts from banks with the prospect of making sizable profits. If that's not a hedge fund, what would be? The hope is that the $14 trillion U.S. banking system would expand lending if it could get rid of many of the lousy securities and loans already on its books.

Almost everyone thinks that a healthier banking system is necessary for a sustained economic recovery. Can the Geithner plan work? Maybe, though obstacles abound. One is political. Private investors may balk at participating because they fear populist wrath. If the plan succeeds, many wealthy people will become even wealthier. Congress could subject them (or their firms) to humiliating hearings or punitive taxes. Why bother? Another problem: Investors and banks may be unable to agree on prices at which assets would be bought.

But succeed or fail, Geithner's plan illuminates a fascinating irony. "Leverage" -- borrowing -- helped create this mess. Now it's expected to get us out. How can this be? It's not as crazy as it sounds. Start with the basics on how leverage affects investment returns.

Suppose you bought a stock or bond for $100 in cash. If the price rises to $110, you make 10 percent. Not bad. Now, assume that you borrowed $90 of the purchase price at a 5 percent interest rate. Over a year, the stock or bond still increases to $110, but now you've made more than 50 percent. You pay $4.50 in interest and pocket a $5.50 gain on your $10 investment. Note, however, that if the price fell to $95, you'd be virtually wiped out ($4.50 in interest paid plus $5 lost on the security).

Economist John Geanakoplos of Yale University argues that the economy regularly experiences "leverage cycles." When credit is easy, down payment terms are loose. Investors or homeowners can borrow much of the purchase price of houses and securities. Prices of assets (stocks, bonds, real estate) rise, often to artificial levels because investment returns are so attractive. But when credit tightens -- government policy shifts or lenders get nervous -- the process reverses. Prices crash. Leveraged investors sell to repay loans. New borrowers face stiff down payment terms.

To Geanakoplos, we're suffering the harshest leverage cycle since World War II. Three years ago, he says, homebuyers could put down 5 percent or less. Now they've got to advance 20 percent or more. Hedge funds, private equity funds and investment banks could often borrow 90 percent of security purchases; now borrowing can be 10 percent or less. "Deleveraging" has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject more leverage into the economy -- not to previous giddy levels but enough to reverse the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1 leverage ratios in some cases. Here's an example. Private investors put up $5; the Treasury matches that with another $5. This equity investment could then be expanded by $60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.

Sounds simple. In practice, it won't be. Given all the deleveraging -- a record 15 percent of hedge funds closed last year -- the market prices of many securities have been driven well below prices that seem justified by long-term cash flows. Geanakoplos mentions one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.

If banks sold this and similar credits at today's market prices, they would have to record huge losses. ("Banks Face Big Writedowns in Toxic Asset Plan," headlined the Financial Times.) Their capital would be depleted, and they'd have to raise more or request more from the government. Presumably, the government-supplied leverage would enable investors to pay higher prices. After all, that's the purpose. Still, whether sellers and buyers ultimately agree on prices is unclear.

If they can't, Geithner's hedge fund will remain puny. Cautious banks will continue to constrict credit. But success also poses problems. Money managers talk about making huge annual returns of 20 percent or more from a scheme in which government puts up most of the funds and takes most of the risk. A political backlash might squash the project before it starts. Geithner treads a narrow line between financial paralysis and populist resentment.

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