Murky world of hedge funds in need of more transparency |
Date: Tuesday, July 3, 2007
Author: Barrie McKenna, Globe and Mail
WASHINGTON -- High-Grade Structured Credit Fund.
The name alone evokes quality, strength and liquidity.
As it turns out, the troubled Bear Stearns Cos. Inc.'s hedge fund has none of those attributes. Quite the opposite.
Last week, Bear Stearns reluctantly acknowledged it would have to pump in $1.6-billion (U.S.) to prevent the fund from total collapse. The root of the problem is that no one - including the fund's lenders - can figure out what its exotic portfolio of risky mortgage derivatives is really worth as the subprime market spirals downward.
The episode has exposed a practice that has become all too common in the murky world of hedge funds and private equity. In their quest for big returns, these highly leveraged funds have sought out increasingly exotic, but not very marketable investments.
"Armed with borrowed money, these magical venues for investor avarice have been buying up all kinds of illiquid, hard-to-value assets, ranging from toll roads to timber," explained economist Peter Morici, a business professor at the University of Maryland.
The Bear Stearns fund, for example, is heavily invested in mortgaged-backed bonds and other derivatives known as collateralized debt obligations. They are essentially pools of assets - in this case, high-risk home mortgages - that are sliced into tranches.
But what are these assets really worth at a fixed point in time? A CDO issue may be owned entirely by a single hedge fund.
Likening the process to financial alchemy, Prof. Morici worried that hedge fund managers are coming up with dubious valuations, using financial models that aren't necessarily based on what the assets would fetch in the open market.
In that environment, there is too much incentive for greedy fund managers to tweak the models to spit out whatever values boost their own compensation, he said.
"As most economists not on the take will tell you, the answers financial models give you depend on what assumptions and data you put into them," he explained.
Prof. Morici isn't alone in worrying about the valuation problem.
U.S. Securities and Exchange Commission chairman Christopher Cox said last week that the regulator is probing a dozen cases involving complex bundled financial instruments, including the Bear Stearns fund.
Mr. Cox told a congressional hearing that the SEC is concerned about how these assets are created, sold and priced.
In the Bear Stearns case, the crisis was triggered when several creditor banks moved to auction off some of the mortgage derivatives included in the fund, injecting a scary dose of valuation reality.
The U.S. Federal Reserve Board and the U.S. Financial Accounting Standards Board are also grappling with the issue of putting a fair value on hard-to-price assets. A new FASB rule, set to take effect for all fiscal years after Nov. 15, requires companies to use market data wherever possible, instead of internal assumptions.
"The problem is fraud," Mark Carey, finance project manager at the Fed, told a recent conference at the University of Pennsylvania's Wharton School of Business. "We are worried about the state of a world in which a firm wants to conceal its insolvency. That's fairly easy to do in a fair-value system."
And yet he acknowledged that regulators have already "lost the battle" to get rid of fair-market accounting. The key for regulators - in the United States and elsewhere - will be to push for standard valuation models, because right now many hedge funds are making their own rules, according to Mr. Carey.
The problem isn't the hedge funds themselves. But the hedge fund industry's relentless drive for high returns has exposed a troubling vulnerability in the financial system. And it cries out for better oversight and more transparency.
The big returns from hedge funds have been one of the main drivers of the private equity takeover binge. If it turns out that at least part of the boom was built on an artifice of inflated asset values, Bear Stearns' pain could become everyone's problem.
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