The introduction to a series of presentations on "Hegding the Global Market: Avoiding Excessive Hedge Fund Regulation in a Post-Recession Era". Additional presentations to follow. By Jon Terracciano, 2008

1. Hedging the Global
Market
Avoiding Excessive Hedge Fund Regulation in a
Post-Recession Era
Series by Jon Terracciano

2. Introduction
In the wake of numerous financial institution collapses, there has been an
intense public and political uproar over who is to blame, how these events
occurred, and how to prevent these problems in the future. By 2008, the U.S.
financial market witnessed extreme turmoil in the financial system. The crisis
was marred by the collapse of over two hundred banks and financial
institutions, notably Bear Stearns and Lehman Brothers. It was also
exemplified by a consolidation of several large national banks. The Federal
Reserve’s bailout of Bear Stearns in the form of a heavily facilitated sale to JP
Morgan, along with the virtually forced sale of Merrill Lynch to Bank of
America were major efforts taken by the U.S. officials in trying to restore
financial order. Moreover, the government takeovers of the two mortgage
giants, Fannie Mae and Freddie Mac and insurance giant American
International Group (AIG), and the TARP (“Troubled Asset Relief Program)
bailout of the seventy largest national banks, were other ominous signs of the
U.S. economy’s fragile state.
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1 http://www.fdic.gov/bank/individual/failed/banklist.html; Anne Stjern, The Failure of Bear Stearns, Lehman
Brothers and AIG: Is Another Great Depression in our Future? Associated Content. Sept. 17, 2008.
http://www.associatedcontent.com/article/1043016/the_failure_of_bear_stearns_lehman.html
2 Id.

3. These events did not resonate well with the public, sparking sharp condemnation
amongst many politicians, investors, and everyday citizens. News headlines such as
“U.S. Recession Worst Since Great Depression” and “World’s Wealthy Lose Faith in
Fund Managers,” aptly classified the fallout from the market’s turbulence. The crisis
was not downplayed by even the highest ranking politicians, leading President
Obama to characterize the economic chaos at the end of 2008 as a “continuing
disaster” for the United States. Despite the stock market’s rebound and relative
stabilization of major indices such as the Dow Jones, nearly all believe that the
“Great Recession” rolls on.
The recent failure of several major investment banks and private funds has been
both a cause and consequence of the deep economic recession that has spread
across the world. In the United States, the financial sector has been especially
ravaged by a series of successive private fund meltdowns, totaling 1,471 hedge
fund failures in 2008, in addition to the bank failures previously discussed. The
recent instability of U.S. and international financial markets stemmed from a
combination of factors that has shaken investor confidence in these systems.
3 http://www.bloomberg.com/apps/news?pid=20601087&sid=aNivTjr852TI
4http://business.timesonline.co.uk/tol/business/industry_sectors/banking_and_finance/article6571355.ece
5 BBC News. “Obama Calls Recession a Disaster.” Jan. 30, 2009. http://news.bbc.co.uk/2/hi/business/7860892.stm
6 http://online.wsj.com/article/SB10001424052748703837004575013592466508822.html
7 Volume 56, Number 8 · May 14, 2009 How to Understand the Disaster By Robert M. Solow.
http://www.nybooks.com/articles/22655
8 New Record For Hedge Fund Failures. Anita Raghavan , 03.18.09, 09:30 AM EDT 1,471 hedge funds went out of
business in 2008. http://www.forbes.com/2009/03/18/hedge-fund-failures-business-wall-street-funds.html.
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4. The breakdown in market stability and investor confidence can be largely
attributed to loose lending practices and erroneous subprime mortgage
valuation in the United States. Consequently, many financial institutions were
excessively leveraged with debt and held major positions on overvalued
mortgage-backed securities. When the subprime mortgage market began
rapidly crashing, institutions holding large amounts of mortgage-backed
securities incurred severe losses, mainly through writedowns. Moreover,
financial institutions exercised mark-to-market writedowns in valuing assets
even though they were no actual, tangible asset losses. This especially proved
troublesome to the financial institutions that held massive amounts of assets
in the form of collateralized debt obligations (CDOs) and mortgage-backed
securities. In a frozen market where firms were reluctant to lend and buy
assets, the mark-to-market accounting method “require[d] that lenders assign
a value to an asset based on its current market value, as opposed to a more
traditional hold-to-maturity model that uses historical income and other
criteria for valuing assets.” Thus, huge amounts of level three assets, which
include CDOs and subprime mortgage-backed securities, had to be written
down to a fraction of their original book values as the market for these
securities became increasingly illiquid and began to vanish.
9 5 B.Y.U. Int'l L. & Mgmt. Rev. 99; Jenny Anderson & Heather Timmons, Why a U.S. Subprime Mortgage Crisis
is Felt Around the World, N.Y. TIMES, Aug. 31, 2007, at C1.
10 Id.
11 Id.
12 Id.
13 Id.
14 Id..
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5. The “maturity mismatch” of long-term, illiquid assets funding short-term debt
put firms, such as Bear Stearns, in grave danger when a liquidity shock
occurred, causing investors to cease lending. Hence, several firms that were
relatively solvent, meaning it had enough assets (though somewhat illiquid) to
pay off debts, were damaged because their short-term liquidity was virtually
tapped out. “Liquidity” is characterized as “capital resources necessary to
conduct normal business without disruption.” Illiquidity was a huge problem
for firms like Bear Stearns, especially in its finals days before merging with JP
Morgan. But the fact that banks had so many assets tied up in toxic mortgage-
backed securities drove fears that many were insolvent as well. No one knew
how much these level three assets were worth and many feared they could be
worth only a fraction of what they were valued at. Thus, bank insolvency
concerns spread throughout the market from mounting liquidity problems
because of these toxic security assets.
15 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana
University] 2 October 2008. <http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>.
16 Drum, Kevin. “The Next Step on the Bailout.” Mother Jones 30 September 2008.
<http://www.motherjones.com/kevin-drum/2008/09/solvency-vs-liquidity>.
17 Id.
18 Id.
19 Id.
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6. With the exorbitant level of debt raised to finance these now quasi-worthless
(or at best questionably-valued) securities, the inability to cover losses and
debt led to the swift downfall of many financial institutions and the overall
U.S. financial market. Ultimately, the collapse of the U.S. market rippled
throughout the world because many international investment funds and banks
held substantial positions in these level three securities from frequent trading
with U.S. counterparties.
In the aftermath of this financial calamity, much of the public and political
criticism has been directed at hedge funds, based on their huge investments
and trading in subprime mortgagebacked securities. Hedge funds, a specific
type of quasi-regulated, private investment vehicle (discussed in depth later),
were an obvious scapegoat target due to their high debt leverage ratios and
limited financial transparency to individual investors and institutional
counterparties.
20 http://therealdeal.com/newyork/articles/mark-to-market-makes-a-mess
21 Id. For example, Germany's Deutsche Bank AG announced $3.11 billon in write-downs, with much of the losses stemming from mortgage loans. David Reilly & Edward
Taylor, Banks' Candor Makes Street Suspicious, WALL ST. J., Oct. 4, 2007, at C1. Switzerland's Credit Suisse Group also earlier announced $1.1 billion in similar losses, id.,
while another Swiss bank, UBS, announced $3.41 billion in write-downs, much of which stemmed from losses in securities tied to U.S. subprime mortgages. Jason Singer et
al., UBS to Report Big Loss Tied to Credit Woes, WALL ST. J., Oct. 1, 2007, at A1; Boyd, Roddy. “The Last Days of Bear Stearns.” Fortune Magazine 31 March 2008.
<http://money.cnn.com/2008/03/28/magazines/fortune/boyd_bear.fortune/index.htm>; Schmerken, Ivy.
“Counterparty Risk Is a Top Concern in the Wake of the Credit Crisis.” Advanced Trading 15 September 2008.
<http://www.advancedtrading.com/derivatives/showArticle.jhtml?articleID=210601645>.
22 Id. Germany's finance minister, Peer Steinbrueck, charged that “[t]here is a sizable, remarkable number of hedge funds which are not behaving properly on the market.”
Somerville, supra note 1. Further elaborating on the risks associated with hedge funds, he asserted that “[n]o expert that I have met up to now could exclude a potential
financial crisis caused by all these leveraged impacts of hedge funds.”
23 Leverage is defined as the “use of debt capital in an enterprise or particular financing to increase the effectiveness (and risk) of the equity capital invested therein.”
“Leverage also increases the magnitude of failure in addition to making the equity capital invested more effective, and such large failures may cause harm to overall
market confidence. Counterparties that trade with hedge funds and parties that provide services to hedge funds may also be harmed. In particular, it is feared that the
collapse of a large hedge fund would cause the fund's creditors to become insolvent, creating a cascading effect throughout the market.” Michael Downey Rice, Prentice-
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7. The high degree of leverage and inability of regulators and counterparties to
assess the true, intrinsic value of various assets under management make
hedge funds a source of concern regarding systemic risk. Also referred to as
“contagion,” “systemic risk” is defined as “the danger of widespread disruption
of financial markets and institutions that, in turn, affects the macroeconomy.”
It is the “potential that a single event, such as a financial institution's loss or
failure, may trigger broad dislocation or a series of defaults that affect the
financial system so significantly that the real economy is adversely affected.”
Regulators are also concerned with the recent rise in fraud among private
funds that has hit investors during this period of extreme market vulnerability.
Most notably, Bernard L. Madoff Investment Securities (BLMIS), a New York-
based hedge fund defrauded investors over $50 billion through a “Ponzi
scheme,” “an investment fraud that involves the payment of purported returns
to existing investors from funds contributed by new investors.
24 See, e.g., Paul Davies et al., Prosecutors Begin a Probe of Bear Funds, WALL ST. J., Oct. 5, 2007, at C1 (describing the July 2007 collapse of two
mortgage-related hedge funds at Bear Stearns after large losses on U.S. subprime mortgages, costing investors $1.6 billion). More recently, Bear
Stearns required a bailout after massive losses on subprime mortgage related securities. Robin Sidel et al., The Week That Shook Wall Street: Inside
the Demise of Bear Stearns, WALL ST. J., Mar. 18, 2008, at A1. Unlike other bailouts of financial institutions, the Bear Stearns bailout required the
Federal Reserve Bank to actually take responsibility for $30 billion in securities on Bear's books. Id.
25 Bullard, James. “Systemic Risk and the Macroeconomy: An Attempt at Perspective.” [Speech at Indiana University] 2 October 2008.
<http://www.stlouisfed.org/news/speeches/2008/10_02_08.html#_ftn3>.
26 Hedge Funds and Systemic Risk: Perspectives of the President's Working Group on Financial Markets: Hearing Before the H. Comm. on Financial
Servs., 110th Cong. 63 (2007) [hereinafter Testimony of Steel] (testimony of Robert K. Steel, Under Secretary for Domestic Finance, United States
Department of the Treasury), available at http://www.treasury.gov/press/releases/hp486.htm.
27 http://www.france24.com/en/20081215-hsbc-faces-1-billion-risk-madoff-scandal-fraud; http://www.sec.gov/answers/ponzi.htm
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8. More recently, the Antiguan-based Stanford International Bank (SIB), and its
Chairman Sir Allen Stanford, have been indicted for engaging in a scheme to
defraud investors of over $7 billion. From SIB’s practices, and the fact that
they shielded themselves from SEC oversight, SEC officials state that SIB
operated like a typical hedge fund opposed to a bank. From these two
instances of fraud and hundreds more like it, fraud detection and prevention is
a second key goal of regulators. The failure to detect scandals like these have
devastated investor confidence in U.S. regulatory agencies, such as the
Securities and Exchange Commission (SEC) and the Commodities Futures
Trading Commission (CFTC).
Congress has responded to the crisis with several proposals to overhaul the
current regulatory system governing hedge funds. Most notably are the
“Hedge Fund Transparency Act of 2009” (HFTA), “Hedge Fund Adviser
Registration Act of 2009” (HFRA), “Private Fund Transparency Act of 2009”
(PFTA), “Hedge Fund Study Act” (HFSA), and “Stop Tax Haven Abuse Act.” In
conjunction with these proposed bills that would directly regulate the hedge
fund industry, there are bills on the table that would raise corporate tax rates
on U.S. investment firms that operate domestically, as well as those that
operate internationally but have close ties to the U.S. market.
28 http://www.justice.gov/criminal/vns/caseup/stanfordr.html; Securities and Exchange Commission v. Stanford International Bank, et al., Case No. 3-
09CV0298-L (N.D.TX.)
29 Id.
30 http://www.bloomberg.com/apps/news?pid=20601109&sid=afUo_v5lEmwc
31 Hedge Fund Transparency Act of 2009, S. 344, 111th Cong. (2009).
32 Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009).
33 Private Fund Transparency Act of 2009, S. 1276, 111th Cong. (2009).
34 Hedge Fund Study Act, H.R. 713, 111th Cong. (2009).
35 Stop Tax Haven Abuse Act, 111th Cong. (2009).
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9. Proposed legislation aimed at minimizing systemic risk and fraud could
unintentionally bring about a wide departure of U.S. hedge funds into international
tax havens, where lax regulation and oversight allows and could exacerbate these
existing threats. Moreover, a mass exodus of hedge funds would also mean the
disappearance of many beneficial impacts on the U.S. financial market. Legislators
and regulators must develop a system that balances efficient hedge fund regulation
that is no more restrictive than needed to minimize systemic risk and fraud, while
permitting the benefits of hedge funds to permeate the market, in order to avoid a
mass exodus of U.S. hedge funds into international tax havens, which have become
a growing concern in regards to investor fraud, corruption, and systemic risk.
This paper will examine the current regulatory environment in which hedge funds
operate, and will argue that although the regulatory system is in need of reform,
proposed legislation is unnecessarily restrictive and could actually harm U.S. and
international markets. Part I of this paper will provide information on the
background and structure of hedge funds and discuss the current bodies of
legislation governing the hedge fund industry. Part II will examine possible risks and
threats hedge funds pose in the financial market, as well as the benefits they
provide. Part III will address several proposed laws aimed at regulating hedge funds
in the aftermath of the recent global recession. Part IV will recommend only limited
additional regulation through a domestically and globally coordinated effort, that
will allow the U.S. hedge fund industry, and overall financial market, to remain
competitive in the global arena. The main goals of this new regulatory structure will
be better mitigating market risk, improving market integrity, and allowing the
benefits of hedge funds to operate and grow in the market.

10. Upcoming from Jon Terracciano
Stay Tuned for Part I:
CURRENT OPERATIONAL AND REGULATORY ENVIRONMENT OF
HEDGE FUNDS