Hedge Funds in U.S. May Face Unprecedented Demands for Information on Risk

Hedge funds, broker-dealers and mortgage companies may face unprecedented demands for data on everything from risk exposure to trading partners as U.S. regulators seek to identify firms that pose a potential threat to the financial system, a confidential government report says.

The staff of the Financial Stability Oversight Council identified dozens of “potential metrics” to decide which non- bank financial firms should be designated “systemically important” and subject to Federal Reserve supervision, according to an 80-page study obtained by Bloomberg News.

For example, insurance companies might be asked to divulge their derivatives exposure and the names of principal creditors, according to the study. Asset managers might have to submit a new form, dubbed PF for private funds, with details of their gross exposure, ties to other firms and portfolio risk as measured in stress tests.

“The FSOC will be after a lot of information,” Amy Friend, managing director of Promontory Financial Group in Washington, said at a Feb. 25 seminar at the U.S. Chamber of Commerce. “The Fed may come knocking on some doors, and people need to know how to talk to the Fed.” Friend is former chief counsel of the Senate Banking Committee, where she worked on the Dodd-Frank bill that created the council.

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U.S. banks with more than $50 billion in assets, including JPMorgan Chase & Co., are automatically subject to heightened Fed scrutiny. Close

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Photographer: Chris Hondros/Getty Images

U.S. banks with more than $50 billion in assets, including JPMorgan Chase & Co., are automatically subject to heightened Fed scrutiny.

The council, charged with averting another financial crisis, will collect data that can be used to force firms to raise capital, increase liquidity and sell assets deemed too concentrated in any segment of the economy. Industry groups for hedge funds, mutual funds and insurance companies are lobbying to avoid being designated systemically important.

Draft Report

The study is “a draft report and should be treated as a draft report,” Treasury spokesman Steve Adamske said yesterday. He said the Treasury would have no further comment until draft rules are released.

The council, whose members include Fed Chairman Ben S. Bernanke and Treasury Secretary Timothy F. Geithner, may begin making its designations of non-bank financial companies by midyear.

The Feb. 3 report offers a glimpse of issues the council will consider without making recommendations. Some its contents were first reported by Bloomberg on Feb. 17.

A list of metrics dated Jan. 26 and marked “draft/sensitive/confidential” covers eight categories of non- bank firms. Some, such as community development financial institutions, are considered unlikely to pose a broad threat. Others, like insurance companies and asset managers, are flagged for further study.

Private Equity

The report describes a $40 trillion investment-management industry that includes retirement programs, private equity firms and $2.4 trillion in specialty funds that banks use to manage their assets. It warns that futures dealers who handle swaps, commodities and foreign-exchange agreements could have a systemic impact if a “large default” set off a chain reaction within the industry.

Regulators may want to collect data from broker-dealers on their market share, concentration and counterparty exposures, along with any hedging and off-balance-sheet activity, the study said.

“Firms that are concentrated in particular assets or sources of funding and revenues are susceptible to shocks from those assets or sources,” the study said in its list of possible data requests. “Large exposure to particular counterparties increases the likelihood that shocks to those counterparties will affect a firm.”

Derivatives Exposure

Mortgage companies might be asked in a survey for their potential, current and future exposure on derivatives. Likewise, real estate investment trusts, or REITS, could be asked about their derivatives exposure and the identity and exposure of their counterparties, the study said.

Financial companies don’t have any incentive to disclose more information than they do now, said Thomas Cooley, an economics professor at New York University’s Stern School of Business.

“Opacity has been the friend of Wall Street firms,” said Cooley, who studies issues related to financial stability. “At least they see it that way. They probably make more money when people don’t know exactly what they are doing.”

Data can be used as a “starting point” that can be supplemented by a more detailed analysis of each financial firm, he said.

The data collection and analysis may be more important than the designations, said John Douglas, a partner in the financial institutions group of Davis Polk & Wardwell LLP in Washington.

‘Gentle’ Process

“A gentle information-gathering process from large, interconnected institutions is more useful and valuable than trying to make some artificial determination at this point as to which ones are systemically important,” Douglas said. “Knowledge and information will be extremely valuable, not some list.”

Geithner, the council’s chairman, suggested in September that such a list could encompass New York-based American International Group Inc., the bailed-out insurer, and GE Capital, a unit of Fairfield, Connecticut-based General Electric Co. that benefited from a government backstop for financial- company debt. The Treasury chief has indicated he’d like regulators to have some discretion in assessing risk.

“There’s no objective standard for what’s systemic,” Geithner told the Financial Crisis Inquiry Commission in 2009 testimony released in February. “It’s only a judgment you can make at the time.”

Asset Managers

The study said asset-management firms could be required to fill out a new form on so-called gross notional exposure “to give an indication of whether the firm takes large derivatives positions.” Notional refers to the face value of a contract rather than a firm’s cost of purchasing an agreement.

Specialty lenders that, for example, offer financing for education needs or big-ticket purchases could be subject to a new industry survey. Data such as a firm’s market share of assets can capture “how difficult it would be for other firms to step in and provide the same or similar financial services,” the report said.

Insurance companies could be asked for data on their off- balance-sheet positions, which could help the council gauge the true size of the firm. Insurers may also be required to give information on how many shares of other companies and municipal bonds they own -- data that could allow regulators to judge how tied the insurer is to other firms.

Regulators also could assess how hard it would be to dismantle an insurance firm by studying the number of regulators involved and the complexity of the company. Geithner said in 2009 that he changed his mind on whether to rescue AIG after recognizing how much chaos a failure could cause.

Hedge Funds

The list suggests new document requirements so the council could see how much capital asset managers have to support their investment positions, the complexity of hedge funds’ portfolios, and the amount of leverage private-equity funds use. Another proposed form would include stress tests of asset managers.

Agencies, including the Securities and Exchange Commission, are also proposing to step up demands for information from firms such as hedge funds, which SEC Chairman Mary Schapiro in November said have been “out of sight and were unknown to financial regulators and the public.”

The FSOC staff report’s considerations “are meant to provide context and an initial filter” for regulators as they consider individual firms, the document said.

In addition to Geithner and Bernanke, the council’s 10 voting members include the chairmen of the Federal Deposit Insurance Corp., the SEC and the Commodity Futures Trading Commission.

‘Aggregate Picture’

Data is “so critical to regulators to get an aggregate picture,” the CFTC’s chairman, Gary Gensler, said in a Feb. 17 banking committee hearing.

In some cases, such as assets-to-equity for a publicly traded company, data would come from SEC filings. In other cases, regulators might tap into sources such as money-market mutual fund data gathered by iMoneyNet and Crane Data LLC.

“If size is one of the most important factors, then the odds are a money fund may fall under that category,” said Pete Crane, president of the Westborough, Massachusetts-based money- fund research firm. “But mutual funds overall have a good chance of not being systemically important.”

U.S. bank holding companies with more than $50 billion in assets -- including JPMorgan Chase & Co., Bank of America Corp., Citigroup Inc. and Goldman Sachs Group Inc. -- are automatically eligible to be designated systemically important.

Regulators have had little public discussion of how they might collect new categories of data. At the Feb. 17 hearing, Bernanke indicated that an annual industry-wide assessment would fit with the council’s mandate.

“It makes sense that there be an annual review of all the major financial sectors to try to identify any emerging problems or developments in those sectors,” Bernanke said.

To contact the reporters on this story: Rebecca Christie in Washington at rchristie4@bloomberg.net; Ian Katz in Washington at ikatz2@bloomberg.net

To contact the editors responsible for this story: Christopher Wellisz at cwellisz@bloomberg.net

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