SEC looking at hedge fund borrowing

By Joseph A. Giannone

WASHINGTON (Reuters) - Regulators in the United States and Europe are probing banks and securities firms to see if they are setting careful limits when lending to hedge funds, U.S. Securities and Exchange Commissioner Paul Atkins told Reuters on Tuesday.

The SEC, the Federal Reserve Bank of New York and the U.K. Financial Services Authority last month met with top lenders to the hedge-fund industry asking about the amount of collateral required by prime brokers for loans. Officials from Germany, and Switzerland are also taking part.

"Mainly (we're seeking) comfort as to what their lending practices are, collateralization, that they have robust value-at-risk models, that they are gauging accurately what the risk is at the hedge funds, that they understand what their counter-parties and creditors are doing," Atkins said, speaking at the Reuters Regulation Summit.

"The goal is to have people talking to each other, to see who's lending what to whom," he said.

In the next week or two, he said, commissioners will meet with SEC market regulation staff on the agency's consolidated supervisory entity program, which includes a group of economists that looks at prime brokers. The group is focused on issues of lending, counter-party risk and collateralization at the largest broker dealers, he said.

Prime brokerage has become one of Wall Street's most lucrative businesses, fueled by explosive growth in hedge funds over the past decade. Brokers and banks generate more than $8 billion a year in fees by lending these cash and securities to these private investment pools, as well as executing trades.

Atkins, the longest-serving SEC commissioner and a former staff attorney at the agency, noted part of the problem in the 1998 collapse of Long Term Capital Management was that lenders were caught off guard by exposure to certain markets.

By comparison, he said, prime brokers were better prepared and protected when Amaranth Advisors LLC, another Connecticut-based hedge fund, collapsed in September after losing $6.4 billion on energy trades.

Prime brokers "were well collateralized it turns out. Good for them and good for their systems," Atkins said. "I point to that as an example of where the system works."

The latest probe, Atkins said, represents efforts by the SEC and other regulators to stay ahead of the curve with regard to system risks in the marketplace. It is not likely, though, to result in a new set of lending rules, he said.

"I can't imagine we will come out with a rule that says 'XYZ is what you have to do' in different circumstances with counterparties," Atkins said. "This is more 'What is good business practice?'"

More useful down the road, he said, is to improve disclosure by market participants.

"It seems if we can push forward and make sure that the right hand knows what the left hand's doing, that people are involved to a good extent, that the government brings people together so they know what's going on, then that's a very positive thing for the market," Atkins said.