November 13, 2008
Statement of Rep. Tom Davis
Ranking Republican Member
Committee On Oversight and Government Reform
"Hedge Funds and the Financial Market"
Hedge fund losses, and in some cases complete liquidations, are an effect of the current financial crisis. It's unlikely they are the cause. The real origin of this market contraction is the continuing collapse of the housing market, triggered and fueled by preposterously lax lending standards, loose management, aggressive lobbying and lavish perks at the quasi-governmental giants that dominated the market - Fannie Mae and Freddie Mac.
They helped create the ravenous hunger for mortgage-backed securities, credit default swaps and other highly sophisticated by-products of the housing boom that drew hedge funds into the abyss. As a result, hedge fund redemptions of stocks and other assets will continue to put downward pressure on the market.
It wasn't supposed to be this way. Billed as purely private gambles by sophisticated investors, hedge funds now pose very public peril when the bets go bad. Designed as a strategy to reduce investment risk, hedge funds now compound risk when complex deals start to unravel and throw off unintended consequences. Powered by sophisticated computer models, hedge fund trading was meant to capitalize on, not cause, global market shifts. But now, due to their size and speed, hedge funds often accelerate wild market fluctuations.
So, when these unregulated private funds become a public problem, many see a need for greater transparency in their operations and tighter regulation of some hedge fund activities. Greater standardization, registration, disclosure and some regulatory limitations could help the industry mature and survive. Remember, the automobile started out as a purely private, wholly unregulated mode of transportation. But when widespread use of the new and powerful machines began to pose public safety issues, it became necessary to decide as a matter of public policy: who was qualified to operate a motor vehicle and how fast they could go. We seem to be at the same crossroad for hedge funds.
With as many as 8,000 funds managing up to $1.5 trillion, hedge funds are said to account for twenty to thirty percent of trading volume in stocks. They may handle even higher levels of transactions involving more specialized instruments such as convertible bonds and credit derivatives. Their trades can move markets. So this isn't just about sophisticated, high stakes investors anymore. Institutional funds and public pensions now have a huge stake in hedge funds' promises of steady, above-market returns. That means public employees and middle income senior citizens, not just Tom Wolfe's Masters of the Universe, lose money when hedge funds decline or collapse altogether.
Brittle complexity, huge transactions on computerized auto-pilot, and other structural inadequacies make hedge funds particularly, sometimes spectacularly, vulnerable to financial contagion - the downward spiral of lost value, margin calls and redemptions in the desperate search for cash. It's clear investors and regulators need to know more about fund investment strategies, leverage levels, and redemption terms to reduce the systemic risks posed by hedge funds.
The hedge fund business model may become a casualty of the downturn. Or it will adapt to new global realities. Going forward, hedge funds will have to take account of a reduced tolerance by investors and governments for an unregulated parallel financial universe of exotic derivatives run by faceless quants that exerts unpredictable gravitational forces on the open marketplace. But, again, we need to remember in the larger implosion of the housing market, hedge funds are collateral damage. We should avoid Congress' natural tendency to overreact and bayonet the wounded.
Today's witnesses bring extensive expertise and experience to our discussion of hedge funds and the current financial crisis. We appreciate their testimony.