Saturday, May 22, 2004

Hedge Fund Watch: FSA (UK) Looks into Systemic Risk

As I've stated before, this hedge fund watch really started out as Brad Delong's thing but there seems to be good stuff out there on it to blog about it so why not?

The FSA in England has according to The Financial Times begun looking into bank exposures to hedge fund risks. This sort of proactive regulatory body behavior is both appropriate and useful. If there are things crawling around in the dark you want to find out now and not after a crisis.

FSA may monitor banks' hedge fund links
By Elizabeth Rigby in London
Published: May 21 2004 22:09 | Last Updated: May 21 2004 22:09

The City of London regulator is considering asking banks for more information on the inner workings of hedge funds, after conducting interviews with firms over the past few months about their relationships with these secretive investment vehicles.

It is understood that the FSA may ask banks to provide them with regular updates on hedge fund leverage levels and more information on credit risk control.

The FSA discussed possible information-sharing at a committee meeting at the London Investment Banking Association on Thursday, as it debriefed prime brokers on the outcome of its fact-finding mission.

The FSA has been looking more closely at prime brokers after highlighting the potential risks hedge funds posed to the financial system in its annual Financial Risk Outlook, published in January.

Since then Stephen Drayson, manager in the wholesale investment bank group at the FSA, has visited at least half a dozen banks, gathering information on their relationships with hedge funds.

Prime brokerage - providing leverage, clearing and other services to hedge funds - is one of the fastest-growing areas in financial services, driven by the rapid proliferation of hedge funds over recent years.

This week, Greenwich Associates, a US-based consultancy, released a survey which found that a quarter of the 36 funds questioned said their banks had extended their credit lines, while a third said they had increased their borrowing over the past year.

"From a regulator's perspective, these results suggest the growing presence of the traditional ingredients of an overheated market," said Peter D'Amario, of Greenwich.

"We are far from the point right now but there is no evidence that things are cooling down of their own accord." [emphasis added]

As a measure of speculation, the activity seems to indicate that we have not bottomed out yet. Typically a true bear market or bull market bottom has to have a crisis sufficient enough to flush out and test the integrity of such financial dealings. That we haven't reached one yet indicates that we haven't reached the bottom of that market yet.

How are UK investors reacting to this short term uncertainty? Quite rationally. The BBC reports that the FSA is criticizing individuals for moving more of their assets from equity investments into savings as of the beginning of 2004.

FSA: Cash may not be king
by Paul Lewis
BBC Radio 4's Money Box

The FSA publishes its Risk Outlook annually
A director of the Financial Services Authority (FSA) has warned savers that putting all their money in cash may be a mistake.
After three years of stock market falls, many investors are still very cautious about risking their money in shares, despite the 14% growth in share prices in 2003.

But Dan Waters, FSA Director of Regulatory Strategy and Risk, told BBC Radio 4's Money Box:

"Consumers seem to be retrenching and moving away from investments into savings.

"We think that over the long term that is likely to be an unsuccessful strategy for many people."

Investor caution

He stressed that cash savings are an important part of a portfolio but should not be the whole thing.

Ideally, he said some of savings should be in cash, some perhaps in property, and some in investments.

Asked if he was concerned by investors' caution leading them to keep a lot of their savings in cash he said: "We do see evidence of retrenchment and that is a worry to us, yes."

Mr Waters was speaking in the week the FSA published its Financial Risk Outlook 2004, in which it warned that consumers had to take more responsibility for understanding their own financial affairs.

The key words here are in the long term. Of course in the long term, equities have traditionally outperformed bank savings accounts or certificates of deposit. However the withdrawal into cash may be a perfectly rational investor strategy that was seeing equity value losses from the currency shift between Europe and America (the pound sterling does trade separately still) and at the same time seeing a falling purchasing power of the US dollar.

In a period of uncertainty with extensive market risk as embodied in Mutual Fund scandals as well as individual corporate bankruptcies that haven't shaken the core of investor trust and confidence such a short term strategy is both beneficial and rational. Anyone who withdrew their money from the markets earlier in the year as the oldman suggested would have been able to comfortably ride out a period of political and economic instability and generally falling markets.

Here is the FSA 2004 Financial Risk Outlook document that both articles quoted above refer to so that you can see it for yourself.

It among other things states that the number of issuers of corporate debt that have been downgraded by credit-rating agencies has continued to "outstrip upgrades, and there have been some further large-scale upgrades" on page 8. It also indicates that household debt continues to grow rapidly in the UK.

It is appropriate for governmental regulatory agencies to state the truth such as that in the long run equities routinely outperform savings accounts. It is also appropriate for reporters to check out stories and provide critical analysis. It is not appropriate for the FSA to be making statements that would encourage people by misunderstanding to re-enter the market in a volatile period if they have already made the (correct) decision to liquidate their positions.

This is something reminiscent of Greenspan earlier this year touting (ARM) Adjustable Rate Mortgages when he knew that he would be leading the Open Market Committee to raise interest rates almost inevitably later in the year. Right now a fixed rate mortgage is the smartest choice a person could make, because the behind-the-curve philosophy the Federal Reserve has adopted will lead to an increased risk of systemic inflation which will require truly draconian monetary policy tightening later in order to accomplish. The Federal Reserve may have a significant concern about the exposure in bad loans that Freddie Mac and Fannie Mae have outstanding but the way to preventing insolvency is not to beggar Mom and Pop in the heartland!

Greenspan has his legacy to look after I'm sure, but I would feel a lot better if him and UK regulatory agencies such as the FSA tried to look out after the little guy at least once in a while instead of blatantly protecting with moral hazard and favortism big investors that get bailed out on more favorable terms than their market calls would deserve on the public dime. How is the Free Market supposed to work and punish people who make mistakes when regulatory bodies openly shield them from the consequences of their mistakes?

Snow's statement while foolhardy about Fannie Mae not being too large to fail and not to anticipate a public bailout was correct policy. The problem is that it was foolhardy because no one believed him because of past government actions in similar bailout situations. To credit the Bush Administration, under Paul Oneill, they resisted an appeal to bail out Enron. While I feel for the Enron employees who took a bath on bad company boosting to its own employees, the correct step was not to bail out Enron but to make liable corporate insiders who made fraudulent statements.


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