Hedge Funds Still Pose Systemic Risk, Says GAO

by Leroy Baker, Tax-News.com, New York

27 February 2008

Hedge funds have improved their risk-management and disclosure practices in recent years, but they remain a potential source of systemic risk and require continued monitoring by regulators and counterparties, according to an initial Government Accountability Office (GAO) report.

The report was released earlier in the week by House Capital Markets Subcommittee Chairman Paul E. Kanjorski (D-PA), Congressman Michael Capuano (D-MA), and House Financial Services Chairman Barney Frank (D-MA). After reviewing the findings, the three senior Democrats on the Financial Services Committee are asking for a follow-up GAO study.

Commenting on the GAO's initial report, Kanjorski stated that: “Hedge funds have expanded greatly in the last decade and produced considerable financial gains for many. We need to ensure that we have adequate knowledge of this sector of our capital markets and effective market discipline, especially as the pension assets of more and more Americans are invested in hedge funds."

"The GAO report details the risk-management improvements and transparency advances made by hedge funds, financial institutions, and regulators, but concludes that there is still the potential for systemic risk. We must therefore remain very watchful in this field.”

Capuano added that: “This GAO report illustrates that even with the combined expertise of all the relevant regulators, we still lack the data necessary to judge the full risks associated with hedge funds. Congress should follow the recommendations outlined by the GAO to continue to vigilantly monitor hedge funds."

Frank observed that: “This report is a useful update on an increasingly significant part of the global financial system. But the dynamic nature of the financial markets requires that we continue to examine evolving practices in this area."

Hedge funds are privately managed, lightly regulated investment vehicles that are often leveraged and typically open to only a limited number of investors.

The GAO report examined the roles played by federal financial regulators and market participants in overseeing and imposing discipline on hedge funds as well as investigated potential systemic risks posed by hedge funds.

Although registered hedge funds have improved disclosure and transparency, the GAO concluded that some investors lack the expertise and capacity to accurately assess risks, given the increasingly complex strategies of hedge funds.

Additionally, the report noted that because most large hedge funds use more than one prime broker, no individual broker can have the necessary information to comprehensively asses a hedge fund’s overall risk profile.

Since the near collapse in 1998 of Long-Term Capital Management, at the time a major hedge fund, the number of hedge funds has grown considerably, as has investment in the vehicles by pension funds and other institutional investors. According to the study, from 1998 to 2007, the number of hedge funds grew from 3,000 to more than 9,000, and assets under their management increased globally from USD200 billion to more than USD2 trillion.

In 2007, the President’s Working Group on Financial Markets (PWG) issued guidelines calling for increased market discipline to address concerns of systemic risks associated with hedge funds.

Because the GAO notes that it is too soon to evaluate the effectiveness of the PWG guidelines, Congressmen Frank, Kanjorski, and Capuano will ask the GAO to conduct a subsequent review.

In addition, the GAO is expected to release a more extensive report examining the scope of public and private pension funds’ exposure to hedge funds in the coming months. The GAO report released Monday noted that these investments are considerable. Defined benefit pension plans’ investments in hedge funds have grown from USD3.2 billion in 2001 to USD50.5 billion in 2006.

These additional GAO reports and their findings will help lawmakers to determine whether further legislative and regulatory reforms, if any, should be pursued.

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