Hedge Funds Are a Holdout in Fed’s Plan to Prevent the Next Lehman

Regulators need help from hedge funds to make sure a bank failure in the future doesn’t roil markets the way Lehman Brothers Holdings Inc. did. The problem is hedge funds don’t see what’s in it for them.

The Federal Reserve, Federal Deposit Insurance Corp. and Bank of England have met with representatives for firms such as Citadel LLC, D.E. Shaw & Co., BlackRock Inc. and Pacific Investment Management Co., to try to persuade them to wait before canceling contracts with a collapsing lender, said three people with knowledge of the matter.

The purpose is to give regulators more time to resurrect a failed bank so derivative trades and lending arrangements that underpin the global financial system don’t have to be terminated.

Money managers who account for trillions of dollars of swaps trades are resisting, because they’re concerned that giving up their right to quickly kill contracts with a bankrupt firm could stick them with losses and violate a requirement that they act in their investors’ best interests.

“What you’re giving up is, in many cases, not your own money; it’s your client’s money,” said Darrell Duffie, a finance professor at Stanford University who has studied derivatives markets.

‘Serious Concerns’

Spokesmen for the Fed, FDIC and Bank of England declined to comment.

“We continue to have serious concerns about efforts to suspend rights that protect customers during U.S. bankruptcy proceedings,” said Nick Simpson, a spokesman for the Managed Funds Association. The Washington-based trade group represents hedge funds.

Late last year, regulators resolved the issue for an estimated 90 percent of the swaps market when they persuaded the International Swaps and Derivatives Association to change its legal documents for transactions directly between banks.

Under that agreement with the industry’s main standard-setter for derivatives, lenders will wait as long as 48 hours before pulling collateral from failed lenders and canceling transactions. The delay, if all goes well, would negate the need to terminate contracts, because the failed firm would return to health.

In private discussions, including one last month in New York, regulators have urged big money managers to adopt similar policies, said the people who asked not to be named because they weren’t authorized to speak publicly.

Coming Rules

While the Fed and FDIC lack direct authority to write rules for hedge funds, the agencies plan to use their power over banks to try to get what they want.

The regulators can insist that any contract with a bank be allowed to stand for some period of time during a failure, and they’ve said they’ll propose a rule in the coming months that affects the entire financial industry.

The Fed and FDIC’s efforts are clashing with current bankruptcy law that allows traders to end deals immediately. Regulators argue that changing contracts for derivatives trades and short-term funding transactions -- including repurchase agreements and securities lending -- is crucial to resolving insolvent banks.

The goal is preventing a recurrence of what happened after Lehman’s 2008 bankruptcy. The bank’s clients either rushed to terminate swaps trades or haggled over the value of deals, exacerbating the broader market panic.

“What people talk about with Lehman is how much value Lehman lost because of the absence of a stay,” said David Skeel, a University of Pennsylvania law professor who studies bankruptcy law. A wave of terminations caused a “significant loss of liquidity,” coupled with a spike in collateral demands that helped cripple the firm, he said.

Irked Funds

At the New York gathering, regulators made their case again to several dozen lawyers and executives, including representatives for Citadel, D.E. Shaw, Pimco, BlackRock and other trade groups for banks and funds.

The June 25 meeting irked some money managers, who felt there wasn’t enough discussion about whether it made sense for funds to change their policies, two of the people said. Instead, regulators focused on technical issues for revising financial contracts, the people said.

Spokesmen for Citadel, D.E. Shaw, Pimco and BlackRock declined to comment on the meeting.

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