May 22, 2006

Dealers Must Tighten Terms to Hedge Funds

NEW YORK (HedgeWorld.com)--Major dealers should take a cold, hard look at financing conditions and margin practices for hedge funds, the president of the Federal Reserve Bank of New York warned at a conference Tuesday.

Timothy Geithner said most of the growth in credit derivatives has come in auspicious economic conditions such as decreasing volatility and a falling number of bank failures. The risk of default by a major financial institution is now very low, he said.

As he sees it, these conditions have resulted in a growing number of transactions, a reduction in covenants to protect lenders, and very favorable finance terms for hedge funds. This increases the odds of a negative surprise under adverse market conditions, when there's a reduction in liquidity, he told attendees at the conference, which was organized by Moody's Investors Service and New York University.

While such concerns are not new, Mr. Geithner stressed that financial institutions need to take action and that the system will be more resilient if margin requirements are set to be sustainable in less benign conditions.

Another speaker at the conference, Myron Scholes, chairman of Oak Hill Platinum Partners and the winner of the 1997 Nobel Prize in economics, highlighted the evolving role of intermediaries, with an emphasis on the positive effects. Broker-dealers have moved from being agents to being principals that produce what clients want, Mr. Scholes said.

He described the new role broker-dealers play in packaging bonds as collateralized debt obligations and creating bespoke bond portfolios for clients like insurance companies and pensions, using derivatives to hedge the risk. He said he regards hedge funds as companion actors in these transactions, helping bring balance to markets.

Edward Altman, professor at New York University's Stern School of Business, pointed out similarities between today and 1998 with respect to the credit market--including low default rates, high recovery rates, changes in the regulatory environment and strong profits for banks and other financial businesses.

Then, as now, there was a lot of research into credit risk, although risk was not seen as a problem, he pointed out. Mr. Altman did not touch on events that took place in late 1998, when Long-Term Capital Management, the giant hedge fund in which Mr. Scholes was a principal, started to collapse after Russia defaulted on its bonds and the shock caused investors to forsake risky assets.

Concerned that the highly leveraged LTCM might drag down its counterparties, the New York Fed encouraged the formation of a consortium of banks to liquidate the fund in an orderly way.

Apropos of counterparty risk, Mr. Geithner said major institutions need to continue to improve their ability to measure risk in less benign environments. They should measure not just their direct exposure to hedge funds but also the indirect effect of an economic shock, which is harder, he said.

The need for improved risk management aside, Mr. Geithner's view of changes in credit markets in recent years is similar to that of Mr. Scholes; both see the overall impact of developments like the growth of credit derivatives as beneficial in spreading risk more broadly to those willing to take it.

CKurdas@HedgeWorld.com

Contact Bob Keane with questions or comments at bkeane@investmentadvisor.com.

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