In 2014, under the Obama administration, the Financial Stability Oversight Council kick-started an initiative aimed at better understanding the risks posed by the asset management sector. The willingness of the Trump administration to continue that work — particularly as it pertains to hedge funds — has been a looming question. The early signs, unfortunately, are not encouraging.
Before the Dodd-Frank Act created the FSOC, regulators only focused on their specific slice of the financial sector, with no systemic risk mandate. The lack of a systemic risk regulatory body to foster sustained communication and collaboration among disparate regulators was a key flaw in the financial regulatory structure prior to the financial crisis. Bringing together the different financial regulators around one table, the council gives them the authority to investigate risks to financial stability and the tools necessary to mitigate those financial stability threats across the financial system.
The FSOC under former Treasury Secretary Jack Lew initiated the work stream on asset managers with a public conference. As this work stream progressed, the FSOC identified the $3 trillion hedge fund industry as a subsector worthy of enhanced scrutiny, and formed a working group to investigate the issue further. In November 2016, the hedge fund working group provided a public update on the progress of this inquiry and outlined a compelling framework for how hedge funds could pose a systemic risk to the financial sector.
But there is growing concern that the council led by current Treasury Secretary Steven Mnuchin will drop the inquiry.
On Friday, Mnuchin was scheduled to preside over his fourth meeting of the FSOC since he assumed the chairmanship of the panel in February. Once again, an update on the council’s work investigating potential financial stability risks posed by the hedge fund industry was missing from the agenda. The lack of progress by the Trump administration to date in following up on the hedge fund inquiry is particularly troubling in light of the ties of Mnuchin and other key Trump backers to the hedge fund industry.
The FSOC’s framework discussed under the Obama administration revolves around the potential risk posed by highly leveraged hedge funds. When a hedge fund employs leverage — through repurchase agreements, loans or derivatives contracts — it increases its risk of failure because it diminishes its capacity to absorb losses in the face of a financial shock. While the hedge fund industry is not highly levered in the aggregate, there are several highly leveraged funds, and the strategies that use the most leverage are growing as a percentage of the industry’s assets.
According to the Office of Financial Research, the top 10% of macro and relative-value hedge funds, which control over $800 billion in gross assets, are leveraged at roughly 15-to-1. Higher leverage certainly increases the chance a hedge fund will be wiped out in times of severe stress, but the key question for financial stability purposes is whether hedge funds then transmit that stress throughout the financial system.
The FSOC pointed to two likely transmission channels: counterparty exposure and asset fire sales. If a large and highly leveraged hedge fund were to fail, it would not be able to pay off its loans or meet its derivatives obligations, which would transmit stress to its counterparties — many of which are systemically important banks. Moreover, after a financial shock, a large leveraged hedge fund may scramble to unwind its positions to meet its obligations by selling off assets at fire-sale prices. The sell-off may push down prices across an asset class, potentially causing margin calls from concerned creditors at other financial institutions, propagating further fire sales.
Both of these scenarios are plausible ways that hedge funds could disrupt financial stability. The FSOC’s hedge fund working group had also outlined a series of data limitations that must be addressed to give policymakers a better understanding of potential hedge fund financial stability risks.
This framework is not only theoretical. In September 1998, the Federal Reserve Bank of New York facilitated a private bailout of Long Term Capital Management, a highly leveraged hedge fund. LTCM was leveraged at 30-to-1, with $4 billion in net assets, but $125 billion in gross assets. The leverage figure was even more staggering when factoring in synthetic leverage from derivatives. Major Wall Street banks were highly exposed to LTCM and if it had failed, the ensuing stress at these major banks could have sparked a financial crisis. Moreover, research from the Federal Reserve Bank of San Francisco found that during the 2007-2008 financial crisis, hedge funds were a key vehicle through which stress was transmitted throughout the financial sector and concluded that further research into hedge fund risks was warranted.
Not only is the hedge working group’s conspicuous absence from the FSOC’s agenda over the past eight months troubling, but the Trump administration also endorsed the House-passed Financial Choice Act. The Choice Act slashes the FSOC’s budget in half and eliminates its authority to subject systemically important nonbank firms, including hedge funds, to enhanced regulation and oversight by the Federal Reserve Board.
At the next FSOC meeting, Secretary Mnuchin should affirm the necessity of the hedge fund working group and provide an update on its findings, including the actions the FSOC has taken to rectify the data limitations outlined in its previous public update. This inquiry is too important to be shut off or hidden from public view.