November 23, 2024
Editorial

TRIM THE HEDGE FUNDS

Two big hedge funds that were worth $20 billion two weeks ago are suddenly on the brink of collapse. Ripple effect could threaten other investments. The crisis in hedge funds suggests, as one analyst puts it, that it is time to trim them.

Until now, these money pools that promise huge profits to wealthy investors have been only lightly regulated. That’s because the investors are thought to be rich enough to bear any losses. But so-called “funds of funds” are enticing the less wealthy to buy into the supposed bonanza at entry fees as low as $25,000 instead of the usual $1 million or so.

Hedge funds have mushroomed since the mid-1990s and now number more than 9,000 and have more than $1.2 trillion under management. They have been growing at about 10 percent a year. Typically, they charge a management fee of 1 percent and take 20 percent of earnings. Any losses are borne by the investor. And withdrawing invested funds requires advance notice and a time lag.

The current troubles of the big investment bank Bear Stearns show what can happen when things go wrong. Its two funds are named High Grade Structured Credit Strategies Fund and High Grade Structured Credit Strategies Enhanced Leverage Fund. Both are leveraged. The one with enhanced leverage has the worst trouble.

Leverage means operating with borrowed money, so that wins and losses are multiplied. Bear Stearns and some of its executives had put only $40 million into the two funds. They raised more than $500 million from wealthy individuals and from “funds of funds” that brought in money from the less wealthy. The rest came in billions borrowed from lenders, including the nation’s biggest banks.

The crisis came when the housing market stopped booming and subprime mortgages, issued to home buyers with poor credit histories, began going into default or foreclosure. The funds’ multi-billion-dollar bets on the market began going sour. The big lenders began to get nervous. Whether the unease will spread to other hedge funds remains in doubt.

This growing mess concerns more than just the extremely rich. Trouble could spread to the less wealthy who are invested in funds of funds. And if any big fund goes belly up, Wall Street may call for a Treasury Department bailout. That would make American taxpayers the goat, as has sometimes happened in past financial collapses.

Anticipating such developments, the Securities and Exchange Commission has been evaluating irregular trading patterns that could threaten individual investors. But it seems reluctant to increase its regulation of the funds.

That’s too bad. Transparency would inform investors more about the risks they are taking and what they are getting for their money. Stricter regulation would provide some protection from a spreading financial collapse.


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