SEC Takes Notice of Risky Hedge Fund Leverage

The Securities and Exchange Commission is hip to the need for vigilance over the amount of leverage hedge funds use to boost returns, although it has no desire to regulate it, a senior SEC official said.

The warning comes at a time when numerous reports are predicting a bursting of the hedge fund bubble (see MME, July 11 edition: "Last Call for Hedge Fund Party?"). In fact, this morning's edition of The Wall Street Journal has a headline story on steep losses and huge redemptions at Madrid-based Vega Asset Management, which, with $11 billion of assets under management, is still one of the world's largest hedge fund managers.

Leverage, or the practice of borrowing money to wage bigger bets on the market, is a key hedge fund technique but carries significant risk. An example of leverage gone horribly awry can be found in the storied collapse of Long Term Capital Management in 1998 following Russia's debt default, which sent tremors through the financial markets.

"We have potential huge bets being made, and if they are wrong and we have a serious domino effect...we can realize that student loans could be affected by something happening in Russia," Roel Campos, SEC commissioner, told a Managed Funds Association symposium, according to Reuters.

Still, Campos said he is not suggesting that leverage should be regulated. "I do not advocate our agency establishing some regulation over leverage," Campos told Reuters.

Last October, the SEC ruled that any fund manager with 15 or more U.S. investors and more than $30 million in assets must register with the agency beginning Feb. 1, 2006, as a means of more closely monitoring the loosely regulated investment vehicles.

The rules are designed to protect shareholders at a time when the hedge fund industry is becoming more mainstream and attracting more pension fund clients. More stringent regulation for hedge funds has prompted concerns that some firms may try to skirt the rules.

Campos said the SEC is open to discussing the details of the rules but reminded attendees that regulation is needed to help the industry grow and thrive.