Are Hedge Funds Too ‘Safe to Fail’?

A global hedge fund association, seeking to deflect efforts to increase regulation of the investment vehicles, said today hedge funds aren’t “systemically important financial institutions” that would require special government oversight.
While more than 1,400 hedge funds closed during the recent financial crisis, the Alternative Investment Management Association said, they did so in “an orderly manner.”
“The 2008 experience shows that hedge funds are ‘safe to fail,’ even if they are not fail-safe,” said Todd Groome, chairman of the association, said in a statement. “This difficult period provided a very up-to-date and significant stress test concerning hedge fund risk to markets.”
AIMA’s argument comes as regulators continue to mull which organizations should be deemed systemically important, in a bid to better devise rules to rein in financial companies that are “too big to fail.”
The Dodd-Frank financial-overhaul law automatically designates banks with $50 billion or more in assets as systemically important, but gives regulators authority to decide which nonbank financial firms pose systemic risks.
Some regulators have told Congress they want a larger number of non-bank firms, such as hedge funds, to provide data to regulators even if they escape the systemic designation.
AIMA, a London-based lobbying organization with over 1,250 corporate members worldwide, is arguing that registration alone already allows for improved monitoring of hedge funds in the $2 trillion industry.
A registration-and-reporting regime for hedge fund advisers was put in place last month in which funds with $150 million or more in assets will have to report to the Securities and Exchange Commission.
One often-cited example in the argument to boost regulation of hedge funds is the 1998 rescue of Long-Term Capital Management L.P. organized by the Federal Reserve, which had feared its failure might cause a chain reaction in markets and among counterparties on Wall Street.
Roger Lowenstein’s book, “When Genius Failed: The Rise and Fall of Long-Term Capital Management,” said leverage at the fund manager reached 250-to-one after worried investors began withdrawing funds.
Industry participants argue hedge funds have been far more tame in their use of leverage since then. Hedge Fund Research Inc. said in May that funds on average employed leverage that is 1.1 times investment capital, while large funds’ leverage utilization stood at two to five times.
AIMA, in its statement Thursday, also contended that “hedge funds collectively represent a relatively small group of extremely heterogeneous and often very small businesses, and even their collective positions and exposures are not such that individual failures pose a risk to financial stability.”
It added that hedge fund firms have much smaller balance sheets than some individual financial institutions and employ significantly lower levels of leverage than banks and some other financial institutions.
According to the National Information Center, which holds data collected by the Federal Reserve System, the country’s two largest banks–Bank of America and J.P. Morgan Chase –each had more than $2 trillion in assets as of March 31. The hedge fund industry’s total assets in April, the latest data available, were $2.02 trillion, according to HFR.