Business Analysis: Regulators hover as talk of hedge funds crisis gathers pace

Hedge-fund hysteria has reached a new climax over the past week, as increasing numbers of prominent commentators have begun warning that another Long Term Capital Management (LTCM)-style crisis could be looming.

LTCM, a $4bn (£2bn) hedge fund, threatened to derail global markets seven years ago, after it was wrong-footed by a devaluation in the Russian rouble. Eventually the Federal Reserve had to organise a rescue by a clutch of the world's largest banks for fear that LTCM's collapse would cause multiple bankruptcies through the world's capital markets.

Major financial regulators believe they learned valuable lessons from the LTCM crisis, yet the past few years has seen exponential growth in the hedge-fund market, presenting a new set of challenges. While funds like LTCM - which was believed to be geared as much as 100 times - are a thing of the past, the sheer number of hedge funds today have meant that tens or even hundreds of funds may be exposed to the same positions. Hence, when events do not turn out as expected, large chunks of the hedge -fund community can find themselves caught out simultaneously - sending a tremor across the globe's financial markets.

The first such wobble came at the start of this month, when a large number of hedge funds were caught on the hop by the downgrading of General Motors' debt to junk status. Although the move had been anticipated, it had not - as the hedge funds believed - been priced into the bonds.

As a result, many funds bought the bonds before the downgrade, and hedged their position by short-selling GM shares. In the event, the value of the bonds fell, and the shares were given a boost by Kirk Kerkorian, the veteran corporate raider, who took a 9 per cent stake in the company. Many hedge funds suffered crippling losses.

Coming only days after the industry had turned in its worst four months of performance for many years, this was a heavy blow for many funds, and left a small number in dire straits. Several have admitted to being down more than 20 per cent since January, and may eventually be forced to permanently close their doors.

The GM saga kick-started a wave of negative coverage about the hedge-fund sector. Last week, the Centre for Economic & Business Research (CEBR) warned that some 1,600 funds will go bust over the next two years.

On the same day, Sir Andrew Large, the Deputy Governor of the Bank of England, poured another can of petrol on the bonfire when he warned that hedge funds were posing an increasing risk to financial stability.

And only yesterday, it was revealed that Gerald Corrigan, the former head of the New York Federal Reserve, who conducted the official investigation into the LTCM crisis, is to launch aninvestigation into hedge funds in response to the widespread concern.

But although a flick through the financial pages over the past few weeks may have given the impression that financial meltdown is around the corner, the hedge-fund industry is a different beast today than it was in 1998.

Even Douglas McWilliams, who wrote the CEBR's doom-mongering report last week, admits that the chance of everybody's worst fears being realised, are very slim.

"You could have quite a heavy collapse," he said. "Whether that turns into financial meltdown or not is an interesting question. One of the features of the hedge-fund industry today is that it is syndicated risk - its risk is spread around. Unless you had a really extreme event, then by and large, the financial system can survive."

Seven years ago, things were very different. Not only were hedge funds more highly leveraged, but transparency was almost non-existent. Investors in funds such as LTCM were happy with the excellent returns they received every month, but had no knowledge of how they were being generated, or the true degree of risk they were taking.

Although the hedge-fund industry is still lightly regulated - with the majority of funds based offshore - US, UK and European regulators keep a much closer eye on the situation. Furthermore, a real momentum behind self-regulation, driven by investors, has seen hedge funds begin disclosing their main holdings, and their levels of gearing.

Jacob Schmidt, the director of global hedge-fund research for Allenbridge, believes the industry has not forgotten the lessons it learnt in 1998. "The difference today to LTCM is that there is not really any single multibillion-dollar funds that use leverage," he said. "In the UK, almost all hedge funds' investment advisers are regulated by the Financial Services Authority, and the FSA is a good regulator."

Guy de Blonay, a hedge-fund manager at New Star Asset Management, said that while parts of the hedge fund industry have taken a knock over the past few months, talk of another LTCM crisis is premature. He said: "For a major panic to happen, you need a major hedge fund to collapse. At this stage, we only have some smaller players of specific strategies in trouble."

Mr de Blonay points out that within the hedge fund universe, there are a whole host of investment strategies - most of which were not affected by the GM situation. "These strategies are not more than 10 per cent of the hedge fund industry as a whole," he said.

He admits, however, that the next few months are likely to be tough for hedge funds. Although the GM situation affected only a small proportion of the market, the knock-on effect, as several funds have been forced to sell their holdings to restore liquidity, has brought down the value of other funds' portfolios. But while this vicious circle may help hold markets back for months to come, it is unlikely to create widespread financial stability.

The wobble over the past few weeks has reignited the debate over whether more regulation is needed. As well as Mr Corrigan's report in the US, the FSA is producing two discussion papers, reconsidering whether tighter controls are needed to maintain stability. Opinion on this issue is polarised.

While organisations from the Bank of England down have hinted at the need for a tighter grip on hedge funds, the regulators have so far remained reluctant to interfere with markets any more than they need to.

Although a lot of progress has been made on a voluntary basis over the past few years, the hedge-fund industry is a surprising supporter of increased regulation. David Middleton, the commercial director of global alternative investments for Gartmore, said: "We're all in favour of tighter regulatory control. Within our own business, we've taken a huge number of steps - independent audits, tight compliance schedules ... we've brought the principles from our long-only business into our hedge fund operations."

With a growing fear of the power of hedge funds, it looks likely that regulators will keep an increasingly close eye on the industry. Although the chances of another LTCM are slim, even the industry's staunchest defenders admit there is still a risk of financial meltdown. And this possibility, however slim, will ensure hedge funds remain at the top of the regulators' agenda.