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May 22, 2006 at 08:00 PM
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.
