The Underground History of the Current Financial Crisis

This blog is the second in a series that will examine the current economic crisis and the role technology might play in future regulation. 

In the first blog entry of this series Congressman Paul Kanjorski (D-PA) Chairman of the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises confirmed that 2009 is shaping up as a year of regulation. But as Congress looks for answers into how and why this financial crisis occurred, more hearings will most assuredly convene and squarely in its focus are the SEC, hedge funds and the financial industry. But how did we get in this predicament in the first place and why did the SEC exercise so little control over these hedge funds that have contributed so heavily to today’s economic crisis?

A hedge fund is a private pool of investment money that uses sophisticated stock trading techniques such as short selling to make a return for its investors and is traditionally a closed fund that is limited only to wealthy investors. Most people are familiar with mutual funds which are similar to hedge funds as they both invest a collective pool of money. But the big difference between the two is how they are regulated. Hedge funds are largely allowed to function without regulation whereas mutual funds are heavily regulated.

That began to change beginning in February 2005 where hedge funds were required to register under the Investment Advisers Act of 1940 since, up until this time, hedge funds had avoided this type of regulation.  The SEC made the rule change since it perceived hedge funds as being engaged primarily in the business of investing, reinvesting, or trading in securities. The SEC also noted “hedge funds typically remain secretive about their positions and strategies, even to their own investors.” 

This SEC action was designed to effectively bring hedge funds under the purview of the SEC so as to maintain communication and make them subject to reviews for fraud by giving the SEC the freedom and power to walk in and say at any time, “Let me take a look at your business practices.”

But here is where it gets interesting. In 2006 when the rule for hedge funds to register was to take effect, the District of Columbia US Court of Appeals overturned it. In short, the court said the SEC overstepped its bounds and, on June 23rd, 2006 the hedge fund rule was ordered to be vacated and remanded.  The basis of this opinion by the Court was heavily vested in what the definition of a “client” was.  The District Court found that the SEC bringing hedge funds with fifteen or more advisors under the Advisers Act was an arbitrary act on the part of the SEC. The downside to this ruling was that it once again left hedge funds unregulated. 

In May, 2007 Senator Charles Grassley (R-IA) recognized this loophole and introduced a bill titled the “Hedge Fund Registration Act of 2007.” This bill was designed to amend the Investment Advisors Act of 1940 and require hedge funds to register with the SEC.  It also strived to bring transparency to the hedge fund industry. Senator Grassley said at the time, “This bill will allow the SEC to oversee these advisers and prevent them from operating in secret.”

He also said that this type of oversight was important because hedge funds affect not just wealthy investors but regular investors and the market overall. However the Hedge Fund Registration Act bill he proposed did not become law so hedge funds once again continued to operate without any outside regulatory oversight.

In Q2 2008, hedge funds had total assets of $2.973 trillion dollars. As we now know, the collective assets of these hedge funds had the ability to result in substantial stock market moves that had an negative effect on all investors as well as our overall economy.

But more disconcerting, this lack of transparency and oversight by the SEC has led to scandals such as the recent Bernie Madoff Ponzi scheme. Even more significant, incidents like this have added further shock to the psyche and confidence of an already shaken market from out of control hedge funds. 

Right now it is in vogue to put some of the blame for the current financial crisis at the feet of the SEC. Granted, they did not do everything right. However there is clearly evidence based on the D.C. US Court of Appeals ruling that the SEC had no prior authority to regulate the hedge funds so even when the SEC or government officials like US Senator Grassley sought to make these needed changes, they were stopped in their tracks.

As the 111th Congress convenes and President Obama assumes office, they will surely debate the economy and what regulations they need to pass to avoid this scenario in the future. But in order for new regulations to have any affect and for regulators to use new technologies such as Estorian’s LookingGlass to gain insight into what is going on, courts cannot continue to undermine existing laws and Congress cannot sit on its hands until the crisis is already at a peak. 

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