Hedge Funds, Private Equity Under Congressional Microscope

U.S. regulators said Wednesday that Bear Stearns should be able to unwind the positions of its two troubled hedge funds without causing wider financial market distress.

However, in testimony to Congress the regulators renewed a call for big global banks to improve their hedge fund risk management practices.

Favorable market conditions have helped the Bear Stearns-managed hedge funds to close out positions with a "limited impact on the broader markets," Erik Sirri, the Securities and Exchange Commission's market regulation director, told U.S. lawmakers.

"But there is no guarantee that such favorable conditions will persist, and we must be prepared to assume that they will not," Sirri told a hearing of the House Financial Services Committee.

"Thus, the regulatory community must continue to engage with the systemically important banks and securities firms encouraging additional efforts to improve and expand risk management capabilities," Sirri added.

The two Bear Stearns hedge funds suffered big losses by making bad bets tied to subprime mortgage loans to people with weak credit histories. The subprime market has been hit hard by the decline of the U.S. housing sector this year.

Bear Stearns has said it would bail out only one of the two struggling hedge funds, providing $1.6 billion of financing to save its High-Grade Structured Credit Strategies Fund. The other fund, which carried more leverage, has about $1.2 billion in debt that is being worked out.

The SEC has made informal inquiries about the meltdown in the Bear Stearns funds, according to people familiar with the matter.

The hearing before the influential House panel comes as Congress focuses on an industry that has amassed vast wealth in recent years and that some lawmakers think should pay higher taxes. They have also voiced concerns about whether they should be regulated more tightly to protect investors.

Hedge funds have grown rapidly in recent years, with more than 9,000 funds managing more than $1.5 trillion in assets by the end of 2006.

Fed: Better Risk Management Needed

Federal Reserve Governor Kevin Warsh also told the committee that hedge funds growth could pose risks to financial stability if big commercial and investment banks that deal with hedge funds fail to improve their management practices.

Warsh said the Fed fully supports new hedge funds principles recently released by the President's Working Group on Financial Markets, which places the onus for maintaining market discipline on hedge fund creditors and counterparties and their supervisors, on investors, and on hedge fund managers.

"The Board believes that even those banks with the most sophisticated risk management practices must further strengthen their enterprise-wide systems to put the ... principles fully in place," he added.

Nonetheless, Warsh said the Fed believes the increased scale and scope of hedge funds has brought benefits to financial markets, including the ability to disperse risks more broadly and serve as a large pool of opportunistic capital that can stabilize markets in the event of disturbances, such as big U.S. corporate bond defaults in 2001 and 2002.

Robert Steel, the U.S. Treasury's undersecretary for domestic finance, said the department and other regulators are reviewing hedge funds and private equity firms, but current rules are sufficient to protect investors.

"The existing regulatory framework provides broad authority, which should be used to address these issues."

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