Risk Watchers,
Part 2: Peering
Over the Hedge
By HENNY SENDER
Staff Reporter of THE WALL STREET JOURNAL
February 25, 2005; Page C1
The watchmen are back. And they're watching the hedge funds again, among other points of concern.
The group, which wields the weighty title Counterparty Risk Management Policy Group II, was established to monitor risks to the world-wide financial system in the wake of the 1998 implosion of hedge fund Long-Term Capital Management.
E. Gerald Corrigan, past president of the Federal Reserve Bank of New York and now a managing director at Goldman Sachs Group Inc., is serving as chairman of the revived 15-member group, which includes representatives from major brokerage firms, banks and one insurer as well as the hedge funds with which they often trade. It will hold its first formal meeting next month.
The group's revival comes with the quiet backing of the New York Fed, which appears to have grown more concerned about potential market disruptions. For example, in a speech in November, New York Fed President Timothy Geithner noted "hedge funds -- and financial leverage more generally -- still present a source of potential risk to the financial system" and went on to cite a relaxation in credit terms and other risks.
The risk watchers are also back at a time when interest rates remain low and the global financial system is flooded with cash. "We agreed that it was a good time to take soundings and try to shape events given the relatively benign financial environment," Mr. Corrigan says.
Yet some of the issues likely to dominate the group's agenda arise precisely out of today's seemingly quiescent mood in the financial markets: Corporate-bond spreads -- the yield difference on corporate debt against safer Treasury debt -- are historically thin. The spreads narrow as perceived risk diminishes. "At some point credit spreads will widen," Mr. Corrigan says. "And we need to think about the consequences."
Today, Mr. Corrigan says he is especially concerned about credit-risk management among securities firms, hedge funds and other financial players, a concern shared by regulators and some market participants.
"The biggest shock [to markets] would be around credit and a turn in the credit cycle," says Ethan Berman, founder and head of RiskMetrics Group, a service that analyzes investment portfolios and then provides information on exposures to hedge funds, their counterparties, and their investors. Mr. Berman is especially worried about sharp moves in corporate-bond spreads.
Today's easy credit also has led hedge funds to embrace many new products that essentially can hide their use of borrowed money. Such borrowing amplifies gains from successful strategies but also can amplify losses when strategies go awry.
The reconstituted risk-study group also will look at relations between banks and brokers and the hedge funds to which they provide funds. By controlling the extent of financing made available to the hedge funds, the brokers essentially control the capital base of hedge funds and how leveraged their positions are.
Many regulators also are keeping vigil over the credit-default swap market for any signs of trouble. This oddly named market, where participants buy and sell protection against credit defaults by companies or countries, has weathered previous troubles, such as the Enron Corp. collapse. But the market is young and opaque. And some risk scenarios suggest that disputes or defaults in this market easily and quickly could ricochet into other financial markets with unwelcome consequences, creating the kind of "systemic risk" that was posed by Long-Term Capital Management.
The original risk group's report in June 1999 noted that excessive borrowing could create problems for the financial system and called on banks to provide greater disclosure of material exposure to institutions such as hedge funds that are significantly leveraged. Since that time, bankers and brokers say they have improved their risk models and are careful to learn about a hedge fund's overall borrowings.
Despite those efforts, heavy use of derivatives products has made it harder to measure hedge-fund borrowing. At the same time, new entrants into prime brokerage -- the banking and securities units that cater to hedge funds -- are offering attractive deals to hedge funds to get their business, such as the promise to guarantee credit lines for as long as two years.
Still, many of the issues on the agenda of the new committee are similar to those that preoccupied financial markets in 1998 when LTCM was forced to sell billions of dollars of positions established with borrowed money in everything from Japanese government bonds to Danish mortgage-backed securities at huge losses. That forced liquidation was enough to put pressure on world-wide markets and left the banks and brokerage firms on the opposite side of the fund's trades with inadequate collateral.
Since that time, there hasn't been one gargantuan hedge fund that created such risk. But some central bankers worry that because numerous hedge funds use basically the same risk models and assumptions to put on identical trades, if one stumbles, there still could be an LTCM-like contagion effect.
Mr. Corrigan stresses that the revival of the group "is not driven by hedge funds per se." Still, the concern about leverage in the system is clearly focused on hedge funds, given the combination of light regulation and the ability to use a lot of leverage, whether direct or disguised.
Write to Henny Sender at henny.sender@wsj.com1
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