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Volume 21, Number 6

Harassing Hedge Funds

James M. Sheehan

Not content with extracting $1.4 billion in fines from Wall Street securities firms, New York Attorney General Eliot Spitzer has set his sights on hedge funds. The state prosecutor has begun a formal investigation to determine whether certain hedge funds misled investors and manipulated the stock market. Federal regulators are piling on, collecting internal documents from hedge funds in order to construct new regulatory requirements. The scrutiny of hedge funds is part of a broader government attack on financial privacy and freedom.

Hedge funds are similar to mutual funds, except they are able to sell shares short in a variety of ways. They often employ sophisticated trading strategies involving futures, options, and other derivatives. Nearly every news story written on hedge funds disparages them as risky, unregulated investment vehicles for the "super rich." The conclusion one is meant to draw is that all responsible people favor stricter government control of hedge funds. Opponents of more regulation are de facto in favor of unbridled market manipulation, sudden sharp losses at the expense of unwary investors, and financial mega-calamities akin to Long Term Capital Management in 1998.

The knee-jerk suspicion that anything too loosely regulated must be wrong forms the basis of Spitzer's hedge fund inquiry. Naturally, Spitzer was put on the case by a handful of bitter companies whose shares fell in value because of hedge fund short-selling. MBIA Inc., the Federal Agricultural Mortgage Corporation (a state-run company better known as "Farmer Mac"), and Allied Capital each complained to Spitzer that their shares plummeted in a conspiracy orchestrated by New York hedge fund Gotham Partners.

 

Spitzer leapt at the opportunity to expand his regulatory portfolio. His investigation will determine whether Gotham Partners, now defunct, misled investors with inaccurate stock research. Apparently he regards as criminal their spreading of bearish views about stocks. Gotham Partners not only published negative reports, but distributed them to the public via the internet. Before it went out of business, the hedge fund shared these wicked, bearish sentiments with other hedge fund managers, who in turn sold the stocks short. Several hedge fund managers asked "hostile" questions of Farmer Mac's executives on a conference call. Adding to the air of conspiracy, some of the hedge fund managers even went to business school together.

The implications for hedge funds are obvious. If you want to avoid harassment by regulators and prosecutors, you should: (1) keep bearish views to yourself; (2) ask only positive, obsequious questions of management; (3) publish bullish research reports. Yet by doing exactly these three things, Wall Street research analysts were fined more than a billion dollars by Spitzer. He said they had misled investors by being overly optimistic about stocks.

Spitzer's harassment of hedge funds is misguided and potentially detrimental to the proper functioning of markets. Short sellers are unpopular with many publicly traded companies, but they are essential players in the stock market. It was contrarian hedge fund manager James Chanos, we should recall gratefully, who first discovered the fraud at Enron. He alerted investors and saved them millions.

Bears not only provide additional liquidity for buyers, they establish price support levels at the point where they buy the stock back, or "short cover." These support levels are often more rational price levels than those prevailing in frothy bull markets and bubbles. Optimists and pessimists must be allowed to compete freely against one another. Government policies that favor bulls over bears only short-circuit information flows and the market process, giving rise to asset mispricing.

We should not expect new hedge fund regulation to correct the flaws of existing regulation. To legally invest in a hedge fund, an investor must own $1.5 million in assets or have a personal income in excess of $200,000. This standard wrongly assumes that risky investments are suitable only for wealthy investors. However, the degree of risk is entirely a function of what percentage of your net worth is exposed, not the aggregate size of your portfolio.

In addition, market knowledge and investment expertise—not net worth—should determine how much risk-taking is appropriate. A professor of finance at a small college earning less than $200,000 per year is forbidden from investing in most kinds of hedge funds. Meanwhile an internet millionaire who may know zilch about investments is deemed by federal bureaucrats to be fit to make large leveraged bets on derivatives. Individuals are best positioned to determine how much risk they take on, not some arbitrary standard set by political processes.

We do not yet know what the new regulatory framework will look like. A recent Wall Street Journal report revealed that federal authorities wish to confine derivatives trading to a "select club" of financial institutions. Regulators "appear to have sanctioned the idea of banks with highly sophisticated risk-management systems taking risks, while keeping potential losses confined within that arena, insulating the general economy" (Michael Mackenzie, "Cost-Cutting Wall Street Bets On Fixed-Income, Derivatives," Dow Jones Newswires, January 16, 2003).

If the feds get their way, we might wind up with a kind of derivatives cartel. Hedge funds and their clients may face additional restrictions, justified as measures to prevent market manipulation. The coming rules should be seen for what they really are: government supports for the share prices of shaky companies. .FM

James M. Sheehan works in the financial services industry in New York (Jsheehan2000@yahoo.com).

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