Obama and Geithner's New Hedge Fund Regulation Fosters Environment for Next Madoff

It has been reported that on June 17 the Obama administration is reported to release its new plans for broad financial regulation. This will reportedly be followed by the June 18th testimony of Timothy Geithner before the House Financial Services Committee.

Reuters reports that it is likely that the administration plan will effectively carve up the existing regulatory framework into four agencies. These will be:
1)the FED
2)the FDIC
3) a new entity which will be the merger of: Office of Thrift Supervision and the Office of the Comptroller of the Currency
4) another new entity which will be the merger of the: SEC and CFTC

Here's an outline of how it is supposedly all supposed to break down:

THE FED
The new plan will support putting the Federal Reserve in charge of broadly overseeing systemic market risk.

While the Fed may lose some of its oversight powers over consumer protection (such as credit cards and insurance issues) it will likely gain several new regulatory powers including supervisory powers over: broker dealers, private equity, derivatives and hedge funds.

The FED's Advisory Committee
The FED would be backed up by a so-called, "advisory committee" (similar to the President Working Group on Financial markets) to assist in monitoring system risk.

THE FDIC
The proposal will give new power to the Federal Deposit Insurance Corp. (FDIC) to oversee the unwinding of troubled financial institutions.

OFFICE OF THRIFT SUPERVISION AND THE OFFICE OF THE COMPTROLLER OF THE CURRENCY
It has also been speculated that the Obama administration will propose merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency. So effectively instead of the current four bank regulatory agencies, we would be left with three larger ones.

THE SEC + CFTC
It has also been reported that a likely merger of the SEC and CFTC is likely - this new entity would oversee: investor protection and market integrity. Although other reports have come out, including this one by Bloomberg, suggesting that Geithner may not support such a merger. Such public dissent by Geithner is nothing new as continued turmoil seems to persist between Geithner and President Obama's chief economic advisor, Larry Summers.

Where is the Unsystemic Risk (Aka: Operational Risk) Regulatory Oversight?

While it has also been reported by CNBC that republicans are preparing their own version of financial system regulatory overhaul, on the surface it seems that these plans have essentially completely ignored, or severely minimized, the risks association with the operational risks in hedge funds.

Operational risks (i.e. - legal and compliance risks, valuation and accounting risks, reputational risks, asset verification, third part independence etc.) are exactly the types of risks that led to the Madoff scandal and the recent deluge of hedge fund frauds and Ponzi schemes. Ignoring such risk fosters a lax regulatory environment that could foster the next Madoff.

It seems as if the voices of the hedge fund industry lobby groups such as AIMA and the MFA, at least in the US, were loud enough to steer the discussion away from operational risk.

Where are the investor advocate groups touting the importance of enhanced operational risk disclosures for hedge funds and private equity?

With regards to alternative investments these proposed plans are essentially the polar opposite of the gist of the European Union's directive which - while still not focusing on operational risk - places a great deal more emphasis on overall transparency, risk reporting and monitoring.

How many more Madoff's will it take before the US, and the rest of the world, begins to dedicate the appropriate focus towards truly monitoring operational risk?

Many compliance and legal professionals in the US feel that a good first step would be with the SEC enhancing form ADV disclosures, but it seems as if this is a low priority on Mary Schapiro's to do list.

A Mini Regulator Not A Super Regulator
The planned merging of the SEC and CFTC, with the combined oversight of the Fed, effectively creates a super regulatory agency for the hedge fund industry.

With respect to operational risk in the alternatives space, this is the wrong approach.

Operational risk data collection and on-going monitoring from hedge funds and private equity will best be served by an experienced regulator focused on the nuances and specifics of the hedge fund industry. Lumping hedge funds together with all other financial institutions (such as banks, mutual funds, thrifts, insurance companies etc.) is simply the wrong approach. Too many small operational issues will slip through this broad regulatory net. These smaller issues may not be deadly in isolation but in aggregation they can snowball into a Madoff like blizzard for the financial markets.

A better approach would be a smaller regulatory agency (or dedicated division of a larger regulator) with the nimbleness and detailed knowledge and experience necessary to properly oversee and monitor operational risk in

[caption id="" align="alignleft" width="192" caption="Harry Markopolos"][/caption]

hedge funds. To quote Harry Markopolos (the man who knew Madoff was a fraud) - they should have enough experience to "have gray hair or no hair."

Unfortunately for US investors, and perhaps fortunately for the hedge fund industry lobbies, who generally it seems oppose such increased transparency and disclosure requirements are not in the plan for the short term regulatory framework.

A Continued Hedge Fund Exodus from Europe?
This proposed lax operational risk disclosure environment, the failing of increased hedge fund regulation on the state level (i.e. - recent news of Connecticut's recent decision to let proposed hedge fund legislation, which would in part

[caption id="" align="alignright" width="92" caption="Crispin Odey"][/caption]

enhance disclosure requirements, die for the time being) combined with the hedge fund industry's disdain over the EU directive, may add more fuel to the talks of a European hedge fund exodus, from hedge fund manager's such as Crispin Odey, from UK to the US. Hopefully, the US is appropriately planning for the impending deluge.

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The Lawyer, the Professor and the hedge fund fraud

Another day, another scandal. The SEC yesterday froze the assets of a Texas based PrivateFX Global One Ltd. after charging the firm with fraud. Specifically, the charges state that Robert D. Watson and Daniel J. Petroski, allegedly forged bank statements to inflate returns. The strategy managed by the firm was ironically called “Alpha One” and claimed to generate profits through their proprietary foreign-currency trading software program that they called “Alpha One.” The CFTC has filed similar charges.

Mr. Watson resigned last month from Texas A&M, where he had been an Executive Professor of Finance at the Mays Business School. Looks like he submitted his resignation a bit too soon. Mr. Petroski is both a lawyer and a certified public accountant. It is reported that the firm had raised approximately $19 million from investors.

Echoing signs of Madoff the firm allegedly told investors that it never had a losing month and returned an annual 23%. Interestingly Watson and Petroski are also accused of creating phony account statements and records for SEC investigators. Obviously, they were not phony enough to fool the SEC.

This is a classic case where basic due diligence, asset verification and independent custody would have been key elements in preventing a fraud. There is nothing inherently wrong with black box FX trading models run by professors with snazzy names but investors need to look past the smoke and mirrors. Here’s a simple rule that has gained acceptance in recent months - if a hedge fund manager cannot break down their strategy in plan simple terms to explain how they are making money don’t invest – period.

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Don't Ask, Don't Tell: SEC Kowtow's to Blackstone's Refusal to Disclose

MARCH 31, 2009

According to Bloomberg, Blackstone and Fortress have different opinions about how much information they need to disclose to the SEC. The specific issue in question relates to the disclosure of the performance of their respective hedge funds.

Blackstone (the world's largest private equity firm) told the SEC, in not so many words, that they did not feel
they fell they need to publicly disclose the performance of its buyout and hedge funds in the firm's financial reports.

Specifically, the SEC had requested last year that both firms publish "performance information" including:
*the name of each fund
*the date it was formed
*assets under management
*net return for each period

One of the most interesting parts of this story is that the SEC in their request utilized Blackstone's and Fortress' own words to strengthen their argument:

1) Fortress (January 26) - provided information
Fortress' CFO (Daniel Bass) stated it would “augment our disclosure” by providing a performance table for “all significant funds” in its annual report.

2) Blackstone (December 5) - did not provide information
Laurence Tosi (CFO - formerly COO of Merrill Lynch's Global Markets & Investment Banking group), responded by telling the the SEC thanks but no thanks. “The individual rates of return have no direct impact on our financials and therefore we question the relevance to our investors” he is reported as stating in a letter to the SEC.

That being said Fortress' information disclosure was not 100%, as the company failed to provide annual performance figures for buyout funds that were still making investments or were less than a year old. The SEC stated in a January 30 letter that the agency had finished its review and had "no further comments" - which is SEC speak for this review is essentially finished.

It seems odd to me that a firm, regardless of its size, should get to dictate to the SEC what it will and will not be disclosing. We are presented with two very similar situations in Blackstone and Fortress, yet the SEC apparently has what it deems to be an acceptable double standard here. While criticizing the SEC seems to be fashionably en-vogue these days (and in most cases with good reason) applying different disclosure standards to different groups simply doesn't make sense on face value here.

From a due diligence perspective, I would be very hesitant to invest in the publicly traded shares of either company when such information is not disclosed universally. Due diligence is fueled by information which is obtained via transparency. In this case, Fortress seems to be willing to come to the plate and provide information, while Blackstone does not. But Blackstone isn't to blame, if the SEC is unwilling to implement consistent disclosure standards.

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Hedge fund regulation, operational due diligence, Transparency act, Geitner, SEC

MARCH 30, 2009

Hedge fund's seem very nervous about the upcoming G20 summit in London.

So nervous in fact that in a rare sign of unity in this often fragmented space three of the most prominent
industry groups have committed to work towards a global hedge fund standard via a letter to the Financial Stability Forum. The three groups are:

1) Alternative Investment Management Association (AIMA)
2) President's Working Group (aka Plunge Protection Team)
3) Managed Funds Association

The AIMA plan seems to mirror the Financial Services Authority model - so once again it appeared as if the U.S. SEC would be left trailing the rest of the world, but then U.S. President Obama stepped in to state that the U.S. would not lag behind European efforts. Even in times of unity there appears to be discord and the Hedge Fund Standards Board (a European group trying to make its methodology the standard) is still absent as yet.

Within the G20 itself there is a lack of agreement on exactly how to regulate hedge funds. The French government reportedly has referred to the issue as a, "philosophical debate." Like the original incarnations of Tim Geitner's plan, specifics are still lacking from industry organization plans and will likely be filled in by the G20 itself.

The broader hedge fund community voicing its opinion to embrace regulation is commendable if even slightly disingenuous.

Hedge funds will be reregulated and it appears now that the hedge fund community has come to terms with this
and is jumping on the bandwagon lest it appear to be uncooperative and fall prey to an unsympathetic, heavy handed regulatory regime.

If hedge funds are so in favor of regulation why is the industry so quick to react to news of G20 regulation both with the US and abroad? Is it simply fear of the unknown or perhaps a desire to prevent regulating the industry out of existence?

My guess is the answer falls somewhere in-between.

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Hedge Fund Regulation Doesn't Matter: An Artificial Operational Due Diligence Floor

MARCH 27, 2009

The new proposed hedge fund regulations suffer from a number of missed opportunities to raise operational due diligence standards for both "professional" hedge fund allocators such as fund of hedge funds and consultants as well as for individual investors.

Corgentum Consulting has released a new paper entitled, "Hedge Fund Regulation Doesn't Matter: An Artificial Operational Due Diligence Floor." This paper provides an overview of some of the primary shortcomings and pitfalls of the proposed legislation.

It is available here and was recently referenced at Conde Nast Portfolio.

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