Yesterday, we commented critically on a remark by JP Morgan CEO Jamie Dimon in an interview on LBO lending published by Bloomberg, and a reader was kind enough to point us to another Dimon interview, this time in Der Spiegel. “Keeping the Hedge Funds in Check.” It’s a refreshing read, if for no other reason than the interviewer asks Dimon some pointed questions (the contrast with the typical deferential US interview is noteworthy).
This section caught my attention:
SPIEGEL: Your optimistic view of financial markets is not shared by many governments. They are worried that a crisis could strike the global financial system if several hedge funds were to collapse, which would have serious consequences for the real economy.
Dimon: The regulatory agencies must naturally keep an eye on the systematic risk that occurs when many hedge funds go broke. Bank control systems have become much better, but hedge funds have become much larger. Governments have to ask themselves if they are getting enough information.
SPIEGEL: And they are asking this. But the answer is no.
Dimon: Those in charge of regulating financial markets should sit down together. This can only be solved on the international level. US Treasury Secretary Henry Paulson is working on proposals aimed at defining good practices for the sector.
SPIEGEL: Many hedge funds have so far refused to give the US government information about their investments.
Dimon: But what exactly do the regulators want to know? Give me an example.
SPIEGEL: They want to know, for example, where exactly the funds are invested.
Dimon: Why? It would be wiser to have information about the indebtedness of each fund. This would make it possible to more effectively evaluate the stability of the financial system. Information about individual investments and potential bans make no sense. The government should not determine who is allowed to buy what.
Does Dimon seriously believe that seeing only the liability side of a balance sheet tells you anything? If so, I question his ability to oversee JP Morgan properly.
The hedge fund industry has never offered a coherent reason for not letting regulators see its positions, except perhaps generalized paranoia (letting prime brokers, who also have competing hedge funds and proprietary trading desks see their books is another matter).
Dimon’s argument, that regulators might bar specific purchases, is quite a stretch. No one is suggesting that regulators might place limits on how hedge funds trade, but better understanding might lead to regulators to insist, say, on more investor disclosure, or perhaps certain restrictions on counterparties (or more required disclosure, perhaps on an aggregate basis, to counterparties) which might have the indirect effect of limiting certain types of activity. But the regulator’s goal is protecting investors and assuring the safety of the system, and for hedge funds to claim their profits and privacy take precedence is specious. Why no one has contested this logic is beyond me.
And there are plenty of reasons to think hedge funds have self serving motives for not letting regulators under the tent. Many observers wondered, for example, how Bear Stearns could possibly have reported its hedge funds had equity of $638 million for the Enhanced Leverage (read: newer and riskier) Fund and $925 million for the other fund as of March 31 and have the Enhanced Fund fall to zero and the other fund fall by 91% in a mere two months (recall that the funds did not report for May 31 and are reporting for June on a delayed basis. They’ve been in workout mode since the crisis hit in mid June, so one would have expected the bulk of the deterioration to have occurred by then (that is, the positions would have been liquidated from that point on). That implies all that value was lost in a mere two and a half month. While that is possible, skeptical minds have wondered whether the positions were overvalued in March.
So back to Dimon. Per the Bear example, it’s much easier to think of bad reasons rather than good reasons for hedge funds to be secretive, namely that they are pulling the wool over the eyes of their creditors and investors. They have every reason to exaggerate their profits when illiquid markets give them latitude in how they mark their positions (and with dealers offering different, sometimes massively different quotes, it’s probably not hard to shop for favorable bids, in case they want to be conservative and have third party verification, but few bother with that step). If a fund can get through a year cycle and get its upside fee and all hell breaks loose the next year, there is no clawback. The investors take their lumps. So the incentive to cheat, or more politely, engage trading practices to goose year end results are considerable. And if hedge funds had to report positions to regulators, say on a monthly basis, that would be a very useful record indeed if a fund went awry.