The Charmed Life of Hedge Funds

There's one corner of Wall Street that is happily backing Congress's regulatory overhaul of the U.S. financial system: the $1.7 trillion hedge fund industry.

The private investment pools have been largely silent during this year's legislative imbroglio, confident that the regulatory proposal that directly affects them—a requirement to register with the Securities & Exchange Commission—won't crimp their business. Backed by well-connected lobbyists, including Richard Baker, a former senior Republican on the House Financial Services Committee, hedge funds have thus far dodged the Washington reform bullet.

Their pitch to lawmakers goes like this: Not a single hedge fund took government aid during the financial industry bailout. Nor were any funds implicated in the various scandals that made this credit crisis so unnerving. "Unlike almost all the other actors on the stage of financial regulation in Washington, we were the pure capitalists," says James Chanos, president of Kynikos Associates, a short-selling hedge fund in New York. "If we made bad decisions, we lost money and suffered the consequences."

Chanos supports hedge fund registration, which would give the SEC the ability to inspect the firms' books and require them to disclose more information. More regulation than that isn't needed, he argues, because hedge funds don't receive the taxpayer support that banks do.

Still, there is a growing concern that by ignoring hedge funds, and to a lesser degree private equity and venture capital firms, which are also largely unregulated, Congress may be setting a path for the next economic disaster.

"You're talking about an industry that manages trillions of dollars of wealth, and to leave them in the dark while we create a 21st century regulatory framework for the banks would be a huge mistake," says Dan Pedrotty, director of the AFL-CIO's investment office that advises union pension funds with more than $500 billion in assets. "There needs to be a level playing field here so money doesn't flow to the unregulated parts of Wall Street."

House Minority Leader John Boehner (R-Ohio) has highlighted the loophole to show how loosely regulated hedge funds would be compared with what he calls the "massive new regulatory structure being imposed on other financial firms."

The tightening of regulations on banks could usher in a new era of profitability for hedge funds, pushing money and trading talent their way. One example that is gaining attention: Senators are about to give final consideration to the so-called Volcker Rule, named after its proponent, former Federal Reserve Chairman Paul Volcker, that would bar commercial banks from so-called proprietary trading—that is, solely for their own accounts. If it passes—and a similar version is adopted by the House, which approved its financial overhaul legislation in December—star traders in search of better bonuses may flock to hedge funds. The Volcker Rule would also prohibit banks from owning hedge funds.

The tougher leverage limits and capital requirements now envisioned for banks could make it harder for them to compete against hedge funds' higher returns. A third proposal, to separate derivatives trading from commercial banking, is opposed by the Treasury Dept. because it worries that more trading in the complex securities would gravitate to—you guessed it—hedge funds.

Big banks are fighting the derivatives rule and Volcker plans and could yet defeat them on the Senate floor. So far, though, few lawmakers are offering to help. As public outrage against Wall Street runs high, no politician in an election year wants to be seen as soft on banks.

The Obama Administration is comfortable with the current proposals for hedge funds. Requiring funds to register with the SEC will give regulators a window onto the funds' opaque operations, a big improvement over the status quo, the White House reasons. If a hedge fund grows too large, it would also face stepped-up oversight by the Federal Reserve under the proposed reform legislation.

One issue that may be debated on the Senate floor in coming days is whether private equity and venture capital firms should get the same treatment as hedge funds. Senator Jack Reed (D-R.I.) intends to try to end that disparity. Not everything is going the industry's way. Hedge fund and private-equity managers remain in the cross hairs as Congress gets ready to again take up the issue of raising taxes on their personal income.

The bottom line: If hedge funds get light regulatory treatment from Congress they will end up with a huge competitive advantage over commercial banks

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