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Don’t blame hedge funds for ringing the alarm bell

After a dinner in April with US treasury secretary Henry Paulson, Lehman Brothers Holdings Inc. CEO Richard Fuld emailed the good news of what he learnt to his general counsel. Fuld reported that Paulson wanted to “kill the bad” hedge funds and “heavily regulate the rest”.
Fuld was delighted to hear that the treasury sided with Lehman against hedge funds that were short-selling its shares, along with those of several other investment banks. Instead of blaming hedge funds for their prediction that Lehman’s share price would fall, Fuld should have acted on the short-sellers’ clear warning, months ago, that he was atop a powder keg of mortgage-related securities that would soon explode. Instead, Lehman is bankrupt and Fuld is a former CEO.

Lightly regulated institutions were the ones to identify problems in the most regulated parts of the industry
 

For their part, regulators spooked markets by trying to make short-sellers the scapegoats for problems they didn’t cause. The biggest impact of the temporary ban on short-selling, which expired earlier this month, was its role in undermining the trust on which markets rely. Why would regulators ban short-selling in nearly 1,000 companies, effectively banning accurate information from the markets?
By targeting short-sellers as a way to prop up share prices, regulators clearly panicked. This, in turn, panicked finance professionals and individual investors who saw regulators losing faith in the system they oversee. A UBS research note spoke of the widespread disbelief that modern regulators could ban short-selling, even temporarily, even as a circuit breaker. “This can be characterized as a populist reaction of no positive value,” the report said. “Anyone who seriously thinks that the cause of this crisis arises from the actions of evil and manipulative speculators, lacks the insight and knowledge to be allowed anywhere near the regulation of financial markets.”
Academic studies found that the three-week ban on short-selling did not stop banking shares from falling. But the ban had several unintended consequences. It undermined risk-lowering hedging strategies. It raised the costs of trading by widening the bid-ask spread, added to volatility, and made prices less accurate. Meanwhile, we haven’t heard much about the Securities and Exchange Commission investigation launched in the summer into whether short-sellers violated the law by spreading false rumours about financial firms. The truth, it seems, was bearish enough.
Admittedly, short-sellers are not especially sympathetic characters. After all, they benefit from the decline in value of other people’s investments. But, in complex markets, short-sellers are akin to investigative journalists, looking for the scoop of finding an overvalued company or industry. Also, like journalists, short-sellers aren’t always popular with corporate managements or regulators. Forensic accounting experts at hedge funds have performed the hat-trick of being the first to signal, through short-selling, troubles at Tyco, Enron and now Fannie Mae, Freddie Mac and banks.
Adding insult to hedge fund injury, several funds are in danger of being driven out of business as collateral damage from the Lehman bankruptcy. Lehman acted as a prime brokerage to some 3,500 clients, including many hedge funds which used Lehman for stock and derivatives transactions. Lehman’s London affiliate has some $65 billion (Rs3.17 trillion) client assets, with $45 billion in long positions and $20 billion in short positions. The company’s administrators in bankruptcy say they may demand margin calls on shares that were sold short.
These accounts have been frozen at Lehman for weeks. The hedge funds find that they might have been turned into unsecured creditors, with their assets wiped out. One Hong Kong hedge fund manager complained, “We’re looking at many hedge funds that will have to shut down, but they can’t even shut down because they don’t know what they have left.” Many hedge funds are suing Lehman for their assets — including allegations of fraudulent conveyance for transferring funds to the London affiliate — and meanwhile, billions of investment dollars are out of the system when they’re needed most.
Hedge funds would be forgiven for asking, “Where’s our government bailout?” There are estimates that half of the 8,000 hedge funds in the US, with a total of $400 billion in investments, could go out of business as returns falter. This is bad news for their investors, who, besides wealthy individuals, include public sector, union and company pension funds as well as universities and charitable foundations.
Hedge funds managed to operate profitably outside the morass of mortgage-based securities. They are lightly regulated, in contrast to traditional investment and retail banks. This means the least regulated financial institutions were the ones that identified problems in the most regulated parts of the industry. Hedge funds and their short-sellers deserve thanks for delivering information to markets. But alas, it’s human nature to blame the bearers of bad news, especially when the news turns out to be true.
Source: Livemint

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