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Financial Services Eyes Hedge Funds, but Doesn’t Rush Into Legislation

House Financial Services Chairman Barney Frank (D-Mass.) is questioning whether a recent trend of pension plans investing in hedge funds merits new legislation to protect Americans’ retirement savings.

Lawmakers have expressed concern over hedge-funding investing after Amaranth Advisors, a Norwalk, Conn.-based hedge fund whose investors included pension plans, lost $6 billion last fall by betting — incorrectly — that natural gas prices would soar last year.

Jeffrey Matthews, a general partner at Greenwich, Conn.-based Ram Partners, testified before Frank’s panel Tuesday that although the fund did fail, the collapse didn’t affect the market much.

“It is true that Amaranth’s investors, including public sector pension funds, lost a great deal of money. But the people who managed those funds should have known the risk, yet they invested anyway,” Matthews said. “A $10 billion fund could evaporate in a matter of months and yet aside from a couple of wild weeks in the natural gas pits, the system didn’t even blink.”

Unlike mutual funds, hedge funds are large and lightly regulated pools of private capital with investors who are typically wealthy individuals and large institutions. Their structure allows managers to share in gains of the invested funds. Hedge fund managers agree that it’s the private structure of such funds that gives them the flexibility to take greater risks.

Still, concern has risen about the large amount of leveraging that hedge funds use to amplify the size of their bets. The debt from such investments, critics say, could affect the financial marketplace if deals go wrong.

In June, a federal appeals court rejected a rule proposed by the Securities and Exchange Commission that would have required hedge funds to submit to inspections. In February, the president’s Working Group on Financial Markets announced that hedge funds are working well and do not need regulating. Instead, the group, sanctioned by the Bush administration, called on hedge funds and investment banks to follow a set of nonbinding principles.

Still, concerns about the lack of industry-wide transparency is causing alarm about the funds.

“Absent industry-wide disclosure, the only reliable information we have is the purely voluntary disclosure to data vendors,” New York University finance professor Stephen Brown testified at Tuesday’s hearing.

Some have suggested that hedge funds be required to register with the SEC. In the Senate, Iowa Republican Sen. Chuck Grassley has introduced legislation that would require just that.

“In my view, registration doesn’t work.” argued Rep. Richard Baker (R-La.) at the hearing. “All it says is that you’ve got a label on your door and you could still be a bad actor.”

Rep. Spencer Bachus (R-Ala.), the panel’s ranking member said, “There is always the potential for a single event, such as massive losses at a large, complex financial institution, to trigger a cascading effect that could impact the broader financial markets and ultimately the global economy,” Bachus said. “An overly prescriptive, rules-based approach to regulating these private pools of capital could stifle innovation, and drive hedge funds and their capital offshore.”

Before deciding whether it’s necessary to legislate, Franks said that his panel will hold more hearings. He said he hopes that a representative from the presidential Working Group on Financial Markets testifies. Future hearings also would address insider trading and record retention.

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