Federal regulators told Congress Wednesday that new rules curbing hedge fund financing are unnecessary because lenders are limiting themselves.
"We have seen some tightening of market discipline since last fall," said Lee Sachs, deputy assistant secretary for government financial policy at the Treasury Department. "Suppliers of credit to highly leveraged financial institutions are demanding more collateral or requiring more margin on their repurchase and derivative transactions."
At the same time, prospects for another government-orchestrated bailout of a large hedge fund have receded, Federal Reserve Bank of New York President William J. McDonough Jr. told House Banking's capital markets subcommittee.
The hearing was the first of two this month on Long-Term Capital, a high-flying hedge fund that crashed in September. The fund was so large and so leveraged that regulators feared a default could cause a financial panic. The New York Fed organized a controversial rescue by 12 commercial and investment banks.
Since then, the capital markets have recovered sufficiently that the New York Fed no longer is worried that a hedge fund's collapse would trigger a market panic, Mr. McDonough said.
"I would have a very different view than the one I had last fall," he said.
Banks also are requesting and receiving detailed information on the investment strategies used by hedge funds, Mr. Sachs said.
The President's Working Group on Financial Markets is expected to issue a report on Long-Term Capital soon. Mr. Sachs, who worked on the report, said it will focus on how excessive leverage can cause systemic crises. It also will address risk management, transparency, and disclosure of financial data, he said.
The working group also may recommend imposing some regulations on hedge funds or their lenders, according to Mr. Sachs.
"As enhanced market discipline may not be adequate to address these issues, we must carefully weigh the costs and benefits of adopting some additional regulatory constraints in an effort to further mitigate systemic risks," Mr. Sachs said.
New restrictions on loans to hedge funds rests squarely with the banking industry, which must prudently manage lending to highly leveraged firms, Mr. McDonough said.
"The best way to achieve this is through the adoption of sound practices by the industry," he said. "If banks themselves do not follow sound practices, then supervisors must step in and take the necessary actions."
One regulatory response could be requiring higher capital reserves on loans to hedge funds, said Mr. McDonough, who also chairs the Basel Committee for Banking Supervision, which currently is rewriting the international risk-based capital accord.
Mr. McDonough identified failings by lenders to Long-Term Capital, including poor analyses of credit risk, inadequate measuring of the bank's exposure to losses, and insufficient stress testing of how loans would perform during serious market disruptions.
"If each counterparty manages its risks appropriately, the chances of contagion to other institutions and the financial markets more broadly would be reduced substantially," he said.
Lawmakers, however, were skeptical that better risk management by banks or disclosure of data by hedge funds to regulators would have prevented the Long-Term Capital debacle. Portfolios change so quickly that it would be impossible for a lender or regulator to know of trouble early enough to prevent a massive financial loss, said Rep. Richard H. Baker, chairman of the capital markets subcommittee.
"The only thing we could know is how big is the train wreck," Rep. Baker said. "But we couldn't have avoided the wreck."
The Louisiana Republican also questioned whether Long-Term Capital was truly too leveraged. During a private briefing, officials from the hedge fund said they had borrowed between $20 and $30 for every $1 in capital, which is not uncommon, Rep. Baker said. Its leverage ratio only soared to 50 to 1 during the days preceding its collapse when investors were pulling out equity, Rep. Baker said.
Also, Rep. Baker said he failed to understand how lenders could comprehend the hedge fund's complex investment strategies without setting up shop at the firm, which would be impractical.
"We cannot guarantee that this will not happen again," he said. "In fact, it is likely to happen again."