Hedge funds still pose significant risks to the financial system

Despite closer monitoring by regulators, hedge funds still pose significant risks to the financial system, a government report said Monday.
The report by the Government Accountability Office, the investigative arm of Congress, found that hedge funds’ inclination to take substantial risks with increasingly large sums of money - and to leverage those bets - means losses can spread and be magnified throughout the financial system.
The report said banks eager to do business with hedge funds often are not critical enough when assessing the risks of their complex investment strategies.
The head of the Managed Funds association, a trade group for hedge funds, said there are ways to fix the problems and said a committee appointed by President Bush will soon offer specifics. “Remedies may be found,” said Richard Baker, a former House Republican from Louisiana.
Hedge funds are vast pools of capital that operate with little government supervision. Investors use them in hopes of obtaining healthy returns, even when the stock market declines, through sophisticated and often-complicated investment strategies.
Traditionally catering to institutional investors and wealthy individuals, they have grown explosively in recent years, luring an increasing number of pension funds and university endowments.
Hedge funds are also big players in the market for derivative investments such as credit default swaps, essentially insurance contracts that protect investors against default of certain securities.
Some have suffered due to the credit crisis that has ravaged Wall Street over the past year. For example, New York-based Bear Stearns Cos. (nyse: BSCPRE - news - people ) managed two hedge funds that filed for bankruptcy last year after making losing bets on mortgage investments.
The GAO noted that those problems recall concerns about risks associated with hedge funds that have been present since 1998, when hedge fund Long-Term Capital Management came close to collapsing.
Still, the report noted that regulators including the Securities and Exchange Commission and the Federal Reserve have stepped up scrutiny of the parts of hedge fund activity that are able to oversee.
The SEC oversees nearly 2,000 hedge fund advisers, accounting for about one-third of total hedge fund assets under management in the U.S., the report noted.
The report also said that hedge fund advisers “have increased their level of disclosure” in response to demands from big investors like pension funds.
Since 1998, hedge funds have grown from more than 3,000 funds with $200 billion in assets to more than 9,000 funds with more than $2 trillion in assets last year, the report said. The majority of those assets - an estimated $1.5 trillion - is managed by U.S.-based hedge fund advisers.
The report “illustrates that even with the combined expertise of all the relevant regulators, we still lack the data necessary to judge the full risks associated with hedge funds,” Rep. Michael Capuano, D-Mass., one of the lawmakers who requested the report, said in a statement.
While Congressional Democrats have expressed concerns about the industry’s growth, business groups and a White House policy group have urged increased vigilance, not new government rules, as the best way to handle risks.
Pensions plans’ investments in hedge funds have grown from $3.2 billion in 2001 to $50.5 billion in 2006, the report found.