Ground Floor: If you're the kind of trader who believes the market can regulate itself, then you won't have liked the recent vote by the US Securities and Exchange Commission (SEC) to require hedge funds to register with the agency as investment advisers.
Until now hedge funds have happily (and sometimes not so happily) plied their trade free from some of the more annoying requirements under which other investment advisers have to operate, such as examinations by the SEC itself.
As always, the immediate concerns are that this will prove a costly exercise for the traders and will require them to beef up their accounting procedures. The Managed Funds Association has suggested that each member may pay around $300,000 in registration costs as well as having to hire compliance officers and backroom staff. And (again as always) the new requirements are said to be a "burden" on the industry.
The ability to make money regardless of whether the market goes up or down should surely mean that hedge funds have the spare cash to splash on a little bit of compliance. And an industry that is supposed to have around $1 trillion in assets should also be required to be regulated in some way. After all, hedge funds themselves have led us to the brink on more than one occasion. (I don't want to always mention Long Term Capital Management but let's face it, they sure hang around in the memory.) Not everyone on the SEC thought it was necessary to bring the funds closer to their chests, with one member, Cynthia Glassman saying that it was the "wrong solution to an undefined problem".
And maybe it is. But hedge funds are highly leveraged and have a greater ability to offer a shock to the system than almost any other type of investment vehicle. Though they are praised for innovation, it could be that we don't always need the products that they sell. And surely we should wonder at some of the website ads like "How I made 124 per cent on Fannie Mae when the stock fell 8.4 per cent".
Making 124 per cent on Fannie Mae should really be rather difficult. After all it's a quasi-federal type of organisation whose business, according to its website, is "The American Dream". Actually what it does is provide enough cash in the market to ensure that Americans can buy their piece of real estate. You can't borrow money directly from Fannie Mae, but the agency issues bonds into the market to raise cash to provide liquidity to loan providers. The bonds that the agency issues are benchmarked against US Treasuries and, in fact, the Treasury department actually approves the debt issuance. So basically Fannie Mae borrows money at a level somewhat higher than the US government itself, but much, much cheaper than it would otherwise cost.
It's paper is rated AAA by the rating agencies even though (unlike hedge funds) it is still exempt from regulation by the SEC (as well as from state and local taxes). Rather like the hedge funds, however, it's asset base is over $1 trillion.
Buying paper from Fannie Mae was always an easy way to bump up the yield on your bond portfolio while hardly increasing your risk at all.
In times when bond yields were are their lowest and traders were squeezing everything they could to get a few extra basis points on yield, the paper was a mere ten to fifteen basis points over treasuries. But as equity markets took a turn for the worse so did spreads on corporate paper, Fannie Mae included. Over the past year the spread has been around forty to fifty basis points. And now it's edging wider. That's because the Justice Department is investigating a possible accounting fraud at the agency which may force it to restate results and revise its capital structure. The SEC is also conducting an informal enquiry. Ann Korologos, the presiding director, said that Fannie Mae was taking seriously the charges that the agency did not comply with GAAP accounting practices for their derivative products. (And so would I - those derivatives again!) Fannie Mae is also accused of employing an improper "cookie jar" reserve as well as suffering deficiencies in internal controls (one case concerned deferring expenses to achieve targets which would trigger bonuses) and maintaining a corporate culture which emphasised stable earnings at the expense of accurate financial disclosures. Basically, executives fudged the numbers so that they'd get bigger bonuses.
Last year, Fannie Mae's sister company, Freddie Mac (another agency) found itself in hot water over "earnings smoothing techniques" which led to executives being shown the door. The CEO retired, but later the investigators insisted that he was actually fired - thus costing him around $20 million in foregone earnings. Fannie Mae could equally see some people being dumped.
But where does this leave investors? As well as issuing paper to raise money, Fannie Mae is also quoted on the stock exchange. Despite what you might think by reading the hedge fund advertisement, earnings at Fannie Mae have grown around 18 per cent over the past five years. When the possibility of the fraud was announced, the shares fell by nearly 10 per cent.
With trillions of assets at stake, they can't be allowed fail - the consequences for the mortgage market, as well as for investors, would be unthinkable. But even a hedge fund trader must surely have to work hard for 124 per cent in these more difficult times. It could be a white knuckle ride for everyone.
www.sheilaoflanagan.net
