Government Considers Regulating Hedge Funds to Protect Markets

Federal financial regulators may order banks and brokerages to limit their lending to hedge funds in the wake of the near-collapse of Long-Term Capital Management, key officials told Congress on Wednesday.

“Weaknesses in risk management practices clearly need to be addressed,” Patrick M. Parkinson, the Federal Reserve’s associate director for research and statistics, told the Senate Agriculture Committee. “Private market discipline seems to have largely broken down.”

The officials’ comments, the first from a Clinton administration task force reviewing the September bailout of Long-Term Capital, suggest that direct government oversight may be proposed for hedge funds, which are fast-moving, normally secretive investment funds used by wealthy individuals and large institutional investors.

That would be a big change from previous assertions by Fed Chairman Alan Greenspan and Treasury Secretary Robert Rubin that investors in hedge funds are sophisticated enough to fend for themselves.

On Monday, New York Fed President William McDonough said that hedge funds that become large enough to disrupt the financial system “have to be subject to control in the public interest.”

Goldman, Sachs & Co., J.P. Morgan & Co. and 12 other banks and brokerages bought Connecticut-based Long-Term Capital for $3.6 billion in late September--in a deal overseen by the Fed--amid fears that the fund’s collapse could cause a crash in world markets.

The hedge fund lost more than $4 billion from wrong-way bond bets made with more than $100 billion of borrowed money from a long list of major lending institutions.

While regulators are considering direct regulation of hedge funds, they may prefer an indirect solution such as urging banks and brokerages to tighten standards for doing business with hedge funds, a change that some industry participants say is already taking place.

Given the rapid pace of market movements, Senate Agriculture Committee Chairman Richard G. Lugar also questioned whether regulators could receive and evaluate reports from hedge funds quickly enough to identify a looming crisis before it erupted. “This may be in the realm of the unknowable,” said Lugar, an Indiana Republican.

Among steps already being taken by the Fed is development of new banking guidelines that might limit the credit exposure among participants in so-called derivative securities trades, increased scrutiny of the credit-approval process, requirements for banks to estimate worst-case loss scenarios for hedge-fund loans, and new policies about minimum collateral needed for such loans, Parkinson said.

Separately, the task force is considering requiring hedge funds to notify regulators of any “ominous” changes in their financial situation, said CFTC Chairman Brooksley Born.

The task force also may call for more public disclosure about the activities of hedge funds, their risk to lenders and the creditworthiness of the banks and brokerages they do business with, said Parkinson and Roger L. Anderson, the deputy assistant secretary of Treasury for federal finance, and Richard Lindsey, director of market regulation at the Securities and Exchange Commission.

Direct regulation of hedge funds won’t be an easy task, said Hunt Taylor, executive director of Tass Management Inc., a hedge fund consultant based in New York. Regulators “completely understand that the people they most want to monitor are the large funds, and they are the ones that can most easily move” to other countries if U.S. regulations are too stiff.

The federal task force’s examination of hedge funds comes as the same group already was looking at broader questions about possible regulation of the huge market for over-the-counter derivatives--synthetic securities tied to assets such as stocks, bonds, currencies and commodities, and used by Wall Street and many companies to bet on, or hedge against, market moves.

Regulation of derivatives has been a source of controversy since last spring, when the CFTC’s Born started a study of whether new regulations were needed. That sparked opposition in the derivatives industry and among rival regulators even before Long-Term Capital’s near collapse. The question gained more urgency because of Long-Term Capital’s derivatives investments.