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.Since a manager of a hedge fund had no way to measure thefl uctuations of those investments, the manager assumed that their value10/1/200810/8/200811/5/200812/3/200810/15/200810/22/200810/29/200811/12/200811/19/200811/26/200812/10/200812/17/200812/24/200812/31/2008 Short Selling, Hedge Funds, and Leverage 125was rising steadily.He also found that the correlation of 13 differenthedge fund strategies had increased significantly between 1994 and2000.This increased correlation was likely driven by the rapid flowof capital into hedge funds during this period, making differentiationof strategies ever more diffi cult as market positions increased in size.Therefore, it seems likely that, during October and November of 2008,hedge funds were heavy sellers of the liquid stocks in their portfolios inorder to meet collateral obligations and investor redemptions.SummaryThe U.S.stock market plunged by over 38 percent in 2008, inflictingheavy damage on firms and families.The majority of this plunge resultedfrom fundamental problems in the American economy and financial insti-tutions.But some part of this plunge was likely the result of three relatednonfundamental factors: short selling, hedge funds, and deleveraging.Short sales involve betting that a stock s price will decline.Shortsales have constructive functions such as ferreting out adverse informa-tion and hedging a long portfolio of securities.But they can be subjectto abuses, notably, bear raids in which short sellers create artificial pres-sures designed to reduce a stock s price.In response to the burst of short selling in September, 2008, theSEC adopted two sensible rules.One required short sellers to line upborrowed shares before making their sales.A second required shortsellers to submit weekly reports on their short positions.The thirdmeasure, a temporary ban on all short selling of fi nancial stocks, wasineffective in preventing further declines in stock prices; it also reducedliquidity and raised trading costs for these stocks.Instead of temporary bans, the SEC should reinstate the uptick rule,which was repealed in the summer of 2007 based on a pilot study ofquestionable validity.The SEC has proposed two different approaches toreinstating the uptick rule.One would be triggered only if the price ofa stock drops precipitously within a day.But this is likely to be too late;the downward spiral has already begun.The better approach would be topermit short selling if a specified price test were met.A short sale couldoccur only at a price above the highest national bid to buy the stock. 126 t oo bi g t o s a ve ?Hedge funds are the most important and most active short sellersin the United States.They are unregulated pools of capital, raised frominstitutions and wealthy individuals, that can employ any investmentstrategy with any amount of leverage.Their managers are typically paida base fee of 2 percent of assets per year plus 20 percent of the fund scapital gains.Hedge funds assets are supplied to a signifi cant degree byfunds of hedge funds (FOFs), which often sell interests of $100,000 orless.Funds of funds select a diversified portfolio of hedge funds and areusually paid an additional base fee of 1 percent of assets per year plus10 percent of the FOF s aggregate capital gains.Hedge funds should be allowed to make private offerings to insti-tutions and wealthy individuals if these investors meet appropriate tests.Specifically, the SEC should adopt its proposal requiring individual cli-ents of privately offered hedge funds to have at least $2.5 million ininvestable assets as well as to meet the current income and net worthtests.By contrast, many clients of FOFs are small or less sophisticatedinvestors who need extensive SEC-mandated disclosures.More gener-ally, the SEC should take the lead in developing a uniform methodol-ogy and consistent format for reporting the investment performance ofhedge funds.As hedge funds have grown larger and taken on more leverage,many have pointed out the need for more governmental oversight ofvery large hedge funds to prevent adverse effects of their failures onthe fi nancial system.But little has been done until recently, when theleaders of major hedge funds offered in principle to submit nonpublicreports on their activities to the Federal Reserve.Such reports, whichshould be fi led only by the largest hedge funds, should focus on theamount of leverage taken by hedge funds, and the related issue of theirability to sell assets quickly at current prices.These reports should alsohighlight any concentrated long or short positions in the hedge fund sportfolio, and identify its main counterparties for trading.More broadly, managers of hedge funds above a certain size (expressedin terms of assets under management) should be registered under theInvestment Advisers Act, as the U.S.Treasury suggests.Registration wouldnot limit their investment strategies or incentive fees, but it would subjectthese managers to regular SEC inspections.Nevertheless, this registration Short Selling, Hedge Funds, and Leverage 127requirement should not generally be extended to managers of all otherpools of capital, such as private equity and venture capital funds.In 2008, Congress stopped hedge fund managers from deferringfor more than 12 months the recognition of income on their fees bykeeping them invested in offshore vehicles.Congress should go further,as the Obama Administration has proposed, and tax the incentive fees ofhedge fund managers at ordinary income rates rather than lower capitalgains rates.Incentives fees are a form of compensation for investmentservices, rather than a form of capital appreciation.Excess leverage was a key factor in aggravating the financial cri-sis in general and pushing down stock prices in particular.The ratioof average assets to capital rose signifi cantly between 2004 and 2008at large banks, investment houses and hedge funds.The steep declinein overnight repurchase agreements during the fourth quarter of 2008shows a huge wave of deleveraging occurred at that time.Deleveraging was driven by two main factors.As the financial crisiscontinued, credit became scarce and collateral requirements increased.Hedge funds and other borrowers were forced to sell assets to raisemore collateral or pay back their loans [ Pobierz całość w formacie PDF ]