Economics of Contempt

Interesting story in Dealbook about how large nonbank financial firms are arguing to the Financial Stability Oversight Committee (FSOC) that leverage should be the key consideration in determining which nonbank firms should be deemed "systemically important," and thus subject to increased regulation by the Fed. (Dodd-Frank requires the FSOC to determine whether nonbank financial firms should be subject to Fed supervision based on a list of factors in § 113(a)(2), the first of which is "the extent of the leverage of the company.")

I guess this makes sense: banks (and broker-dealers) are naturally the most highly leveraged financial institutions, so if the FSOC determines that leverage is the most important consideration, then almost every large nonbank financial firm could point to how much less leveraged they are than the banks. Obviously asset managers and private equity funds would love it if the FSOC focused on nonbank firms' leverage.

This is a particularly interesting argument for hedge funds though. As Dealbook rightly points out, hedge funds, despite their reputation, are in fact generally not very highly leveraged — most hedge funds have leverage ratios between 2 and 3. (Most hedge funds are still equity-focused funds, where leverage is much lower.) But the issue isn't whether most hedge funds are systemically important; the issue is whether any hedge funds are systemically important, and if so, how many. And there certainly are hedge funds that run with high enough leverage, and are large enough, to be considered "systemically important." Regulators seem to be focused on funds that could suffer particularly sharp reversals ("panic-inducing" reversals, if you will), so I would expect those big global macro funds to get a very close look. My hunch is that the FSOC will also look quite closely at the big quant funds (e.g., RenTech, D.E. Shaw) — because let's be honest, they're a complete mystery. And they also have complex trading relationships with the various dealer banks, which at least has the potential to make the meltdown scenario look exponentially scarier.

It's unlikely that the FSOC will adopt the kind of narrow focus on leverage that buyside seems to have in mind, but it's a good effort nonetheless. I'll have more to say about the criteria I think the FSOC should use soon.