HEDGE FUNDS FEEL THE HEAT AFTER NEW YORK FED CHIEF'S WARNING

Global Finance, Dec 2004 by Green, Paula L

UNITED STATES

The increasingly competitive hedge fund industry is feeling the heat from US regulators again, but this time the criticism zeroed in on the prime brokers that sometimes lend these funds their money.

The head of the Federal Reserve Bank of New York last month urged brokers-which can sometimes include major banks-to tighten the credit standards that are woven into the overall due diligence process they use when doing business with hedge funds.

"This is particularly important in those cases where there has been innovation in the manner in which credit is extended," said Timothy F. Geithner, president and chief executive officer of the reserve bank. "A reinforced due diligence process also is critical in assessing the operational capabilities of the hedge funds, the quality of their risk management process and execution and compliance infrastructure."

The trillion-dollar global hedge fund industry has come under increasing scrutiny from government regulators as the amount invested in the volatile investment vehicles soars and they accept more capital infusions from pension funds.

Geithner made his remarks in New York City at a meeting co-sponsored by the financial management unit of the Securities Industry Association and the American Institute of Certified Public Accountants. He didn't blast the fund advisers and their managers in his speech, however, acknowledging that hedge funds have helped strengthen the US financial system by serving as sources of liquidity during periods of increased stress. But he did raise the specter of the Long-Term Capital Management debacle of 1998, pointing out that hedge funds still can be a source of potential risk to the financial system as the amount sunk in the investment vehicles grows and their interactions with major dealers becomes increasingly complex.

Raising concerns that banks have been relaxing their standards when dealing with hedge funds, Geithner added: "First, progress has been uneven across the major dealers. Second, there are signs of some erosion in standards in response to competitive pressures, reflected in some lowering of initial margin requirements and a relaxation in other credit terms." He also urged banks to adopt higher standards given the "increasingly complex relationships that firms have with hedge fund counterparties." They have been warned... Paula L. Green