Hedge funds are essentially defined by their ability to slip through the cracks of the American financial regulatory system. They don't do banking, so they don't need a license from a bank regulator. They don't underwrite securities, so they don't warrant scrutiny from market regulators. And they aren't open to the mass public, so they evade consumer protection regulation too.

One big goal of post-crisis financial regulation was to create a council of all the different regulators — the Financial Stability Oversight Council — to make sure that individual regulators' focus on the trees doesn't lead them to miss a forest of potential disaster. That's why FSOC decided to look at hedge funds, and its initial findings suggest a big possible problem in hedge land.

Or, rather, two different and related problems. One is that an excessively indebted hedge fund could go bust, leading to problems at the institutions that loaned it money. The other is that a large hedge fund could be forced into a “fire sale” of the assets it owns. In either case, the fund itself going bust wouldn’t necessarily be a problem for the economy, but the ripple effects it causes might be.

Thanks to new regulations put in place in the wake of the 2007-’08 financial crisis, regulators are now able to see the outlines of where trouble might arise. But the Treasury Department is warning that unless regulators are able to persuade or cajole more information out of the industry, they could be left flying blind into the next financial crisis. And with a new administration coming to power in Washington, there’s a strong risk that these warning signs will go unheeded.

Hedge fund blowups have caused trouble before

It’s easy to forget that the first great bailout of our era involved a hedge fund rather than an enormous "too big to fail" bank. The fund at issue, Long-Term Capital Management, had made some big debt-financed bets that went badly awry primarily as a result of Russia defaulting on its national debt in August 1998.

This was an embarrassing failure for some of the hottest names on Wall Street, but also a potentially catastrophic situation for a wider range of economic actors. A number of East Asian countries had entered a financial crisis situation the previous year, and the Russian default had markets across the board jittery. Policymakers feared that LTCM’s total collapse would lead to a run on other similar firms and an escalating series of losses — and that this, in turn, could cause the entire credit system to freeze up the way it ultimately did in 2008. In response, the Fed and the Treasury Department organized a rapid-fire $3.625 billion bailout of LTCM by a consortium of major banks as an alternative to an extended bankruptcy process.

At the time, it was widely remarked that since hedge funds had revealed themselves as being in need of occasional bailout, they should probably be brought under the regulatory umbrella.

But though this bailout involved the participation of government officials as organizers and guarantors, no actual taxpayer funds were expended and no congressional action was needed. Consequently, the political system moved on. Then when a financial crisis did hit in 2008, it had very little to do with hedge funds. So we got a politically ambitious regulatory overhaul that did not specifically target hedge funds. But it did create FSOC with an institutional mandate to see the whole playing field, and FSOC officials are trying to draw attention to this piece of unfinished business.

Two types of hedge fund risk

Jonah Crane, the deputy assistant secretary in the Treasury Department who serves as the executive of FSOC, spoke on November 16 about two different forms of risk that hedge funds could pose to the broader economy.

One is forced asset sales, in which problems at a fund force it to rapidly sell its assets in a way that disrupts other markets. For example, “positions held by a relatively small group of funds” could constitute “a meaningful share of certain key markets, relative to both market size and trading volume.” This raises the risk that a failure at one fund could drastically drive down the value of other funds’ assets, setting off a chain reaction in which an entire key market is devastated by mass selling.

The other is counterparty risk. Hedge funds that are not themselves significant to the overall operation of the economy nonetheless owe money to larger institutions. A hedge fund failure could end up “transmitting stress to counterparties that are large, highly interconnected financial institutions.”

Crane says that on both fronts the situation requires continued monitoring by FSOC, as well as a range of areas in which it could use more and better data from industry to understand exactly what’s going on.

One of the main areas in which Dodd-Frank has made advances relative to the pre-crisis situation is in providing much more data and situational awareness to regulators at various agencies so that they can better understand where risks exist. Ongoing data gaps are particularly worrying because financial regulation is a bit like squeezing a balloon, and the odds are good at any moment that the most alarming risks will have migrated to wherever it is you can’t see. This current work has been years in the making, and if momentum evaporates as a result of the transition, it could leave a significant lingering risk to the overall global economy.