Thursday, May 03, 2007

Well, we just had an Amaranth

The now on, now off worry over inadequate regulation of Hedge funds have come back to haunt the Federal Reserve, if not the global financial system. Though I am a card carrying member of anti regulation brigade (let the buyers beware), I believe in fair game so far as sharing what I know or have heard. The Amaranth paint hasn’t quite dried.

Not many who have survived the nightmare of 1998 hedge fund crisis that threatened the global financial system led by implosion of LTCM could forget the high correlations among hedge fund returns that suggested concentrations of risk around a few trading positions.

The Fed's latest worry arose from what it described as a rising correlation between the actual returns of hedge funds, which could point to similar trading strategies that excessively concentrate risk on too few market positions according to a paper written by Tobias Adrian, capital markets economist at the central bank.

Similar trading strategies can heighten risk when funds have to close out comparable positions in response to a common shock, the economist Adrian wrote.

Back in 1998, the New York Fed helped bring together Wall Street tycoons who eventually cobbled together enough funds for an unprecedented $3.6 billion bailout.

But with the crisis averted, the hedge fund industry bounced back with a vengeance, increasingly rapidly over the last decade in both size and scope to an estimated $1.4 trillion.

Still, many officials including New York Fed President Timothy Geithner have shied away from calling for explicit regulation, arguing instead that the large banks who lend to hedge funds should police themselves to make sure no one lender gets in too deep.

Hedge funds borrow large sums of money in order to take aggressive bets on financial markets. Many operate heavily in the derivatives market, estimated at around $17 trillion, raising fears about possible future shocks.

The full story (or worry ?) be found here.

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