Saturday, November 15, 2008

Hedge Funds and the Financial Marketplace (E.M. Chang)

The Oversight and Government Reform Committee of the US House of Representatives held a hearing titled, “Hedge Funds and the Financial Market” on Thursday, November 13, 2008. The hearing examined systemic risks to financial markets posed by hedge funds and considered regulatory and tax reform proposals. Among the topics, the panels discussed three major issues:
1. What role have hedge funds played in our current financial crisis?
2. Do hedge funds pose a systemic risk to the financial system?
3. What level of government oversight and regulation is appropriate?

Over the last decade, hedge fund holdings reportedly increased five-fold, to more than $2 trillion. The role of the hedge fund industry in the current financial system is becoming more important given this dramatic growth trend. However, hedge funds are virtually unregulated, and not required to report any information on their holdings, their leverage, or their strategies to any government agency. The opacity and non-transparency characteristics of the hedge funds industry hides uncertainty and potential risk to the financial market.

Panel members agreed that hedge fund activities do make positive contributions to capital formation, market liquidity, price discovery, and market efficiency. However, negative impacts might occur when losses cause them to liquidate market positions, resulting in downward pressures on the asset classes they are selling. Given the huge positions that hedge funds hold, the failure of this industry will lead to systemic risk.

The Federal government and SEC can regulate hedge fund relationships with their investors, but these is no explicit rule giving the SEC or the government the power to monitor and assess the effectiveness of hedging activities, especially those that might create systemic risk. During the hearing, Professor Ruder argued that “through legislation or (via) the use of available power, efforts should be made to determine the risk positions being taken by various participants in hedging and derivative trading activities.” However, most panel members also mentioned that “government regulation of financial market systemic risk is a necessity, but government control over market activity should be avoided.” We still need to encourage financial innovation and encourage creative thinking.

Furthermore, the complexity of financial markets is straining the capacity of regulations to keep up with innovations. Professor Lo, director of MIT Laboratory for Financial Engineering, pointed out that “the committee and other parts of government should refrain from reacting too hastily to market events, but deliberate thoughtfully and broadly to craft new regulations for the financial system of the 21st century. However, the financial crisis may be an unavoidable aspect of human behavior, and the best we can do is to acknowledge this tendency and be properly prepared.”

The other important issue the Committee addressed during the hearing concerned tax rules. Currently, most hedge fund managers are compensated in two ways. First, they receive a management fee, typically 2% of the fund’s assets. Second, they receive a profit percentage; typically set equal to 20% of the fund’s profits. The profit is sometimes referred to as "carried interest" and is taxed as capital gain (15% tax rate.) Compared to the tax rate on ordinary income, 25% for most hard-working people, hedge fund managers seem to benefit from an unfair and inefficient tax code. One member argued that “the fund managers do not perform the same functions or face the same risks as entrepreneurs.” Therefore, hedge fund managers should be subject to higher tax rate for capital gains. Some senators and panel members agreed and suggested that we need a new, more fair and efficient tax code to eliminate this unfair tax treatment. However, and not surprisingly, the participating hedge fund managers did not agree with this point of view. They asserted that most of their compensation is taxed as ordinary income. They don’t think there is anything wrong with paying a lower tax rate on capital gains, since all who receive capital gains will subject to the same tax rate.

Furthermore, most hedge fund managers participating in this hearing did support regulations to increase transparency and decrease systemic risk. However, they don’t think hedge funds added to or directly caused the current financial crisis. In fact, they believe there is not enough information to draw conclusive inferences about the systemic risks posed by hedge funds. Mr. Soros, Chairman of Soros Fund Management, argued that the housing bubble and lax credit policy were the main causes of the current financial turmoil. However, for most hedge funds, equity is too small to support the assets of the funds. Congress and most scholars participating in the hearing proposed regulation to control leverage and monitoring to control systemic risk.

In sum, most panel members agreed with new regulation and new organization to increase transparency and help build required risk monitoring systems for the hedge fund industry. However, these regulations should not stifle the market innovation and most wanted to keep their trading strategies confidential. In addition, we still need to examine current tax rules to increase fairness and efficiency of our tax system. There is no reason to penalize wealthy people with a higher tax rate just because they earn much more than others. But it is also unreasonable to grant hedge fund managers favorable tax rates. We expect the government to revise the tax code to eliminate unfairness and restore accountability.

Panel 1 Profile:
Professor David Ruder, Northwestern University School of Law
Professor Andrew Lo, Director, MIT Laboratory for Financial Engineering, MIT
Professor Joseph Bankman, Stanford University Law School
Houman Shadab, Senior Research Fellow, George Mason University

Panel 2 Profile:
John Alfred Paulson, President, Paulson & Co., Inc.
George Soros, Chairman, Soros Fund Management, LLC
James Simons, President, Renaissance Technologies, LLC
Philip A. Falcone, Senior Managing Partner, Harbinger Capital Partners
Kenneth C. Griffin, CEO and President, Citadel Investment Group, LLC