WASHINGTON – The Obama administration's aggressive plan for strict scrutiny of hedge funds and other freewheeling investors, part of the biggest expansion of financial restraints since the Great Depression, is drawing instant opposition from Republican lawmakers and the rules' targets. And skeptics are questioning whether the new rulebook would work anyway.
Wall Street wizards have proved adept at designing complex financial products to sidestep existing regulations. And Vincent Reinhart, former director of monetary affairs at the Federal Reserve, says, "You're going to see firms try to figure out how to be under the radar."
For example, private equity investors might try to buy large hedge funds and chop them into funds that would be small enough to operate unregulated, Reinhart said.
Treasury Secretary Timothy Geithner, unveiling the plan Thursday, said the nation's economic crisis demands bold action.
"We need much stronger standards for openness, transparency and plain commonsense language throughout the financial system," he told the House Financial Services Committee.
The administration's proposals, which require congressional approval, include:
• Imposing tougher standards on financial institutions that are judged to be so big that their failure would threaten the entire system.
• Extending federal regulation for the first time to all trading in financial derivatives — exotic instruments such as credit default swaps that are blamed for much of the economic carnage.
• Requiring larger hedge funds and other private pools of capital, including private equity and venture capital funds, to register with the Securities and Exchange Commission.
• Creating a regulator to monitor the biggest institutions. Geithner did not say which agency should wield such authority, but the administration is expected to favor the Federal Reserve.
• Empowering the government to take over major nonbank financial firms such as insurers and hedge funds if deemed necessary.
Committee Chairman Barney Frank, D-Mass., and many Democrats on the panel backed the proposals, while Republicans assailed them as too far-reaching.
Private analysts also questioned whether Geithner's plan would succeed in safeguarding the financial system.
"We're not in this mess because we need new rules," said Bill Fleckenstein, a Seattle-based hedge fund manager who accurately predicted the housing bubble. "We need to enforce the rules we already have," he said. "What we had was a complete breakdown by all our regulators. They simply didn't do their jobs."
And Fleckenstein said he didn't think requiring big hedge funds to register with the government would prevent devastating frauds like Bernard Madoff's Ponzi scheme.
"You could register all 10,000 hedge funds, and it probably would just overwhelm the regulator," he said.
Timothy Brog, portfolio manager of New York-based hedge fund Locksmith Capital Management, said stricter rules won't work properly if regulators become bogged down in policing individual funds rather than monitoring the investment products they trade. These include derivatives and mortgage-backed securities.
"It's not hedge funds that are a problem," Brog said. "The problem is the instruments they are trading. A $100 million hedge fund is not going to have a material effect on the overall market."
The outline of the regulatory plan was announced a week before President Barack Obama was to meet for talks with the Group of 20 major industrialized and developing countries to discuss solutions to the global crisis. European countries have said the U.S., where the financial problems began, must toughen its regulatory system.
The administration's plan also includes a provision that Geithner and Federal Reserve Chairman Ben Bernanke discussed before the committee on Tuesday: to give the administration expanded powers to take over major nonbank financial institutions, such as insurance companies and hedge funds.
That power is aimed at preventing a repeat of the problems surrounding insurance giant American International Group Inc. AIG sparked a furor with news that it had distributed $165 million in bonuses to its financial products group. That unit specialized in trading credit default swaps, the derivatives that drove the company to near-collapse last fall.
The administration sent Congress a bill calling for the expanded powers to seize control of nonbank institutions late Wednesday. Frank has said this measure could win approval within weeks. And he said the administration's broader regulatory overhaul could win House approval by summer.
But Republicans wondered whether the overhaul would give federal regulators too much power.
"Forgive me if I am a skeptic ... when I hear that if we only have a systemic regulator it will never happen again," Rep. Scott Garrett, R-N.J., told Geithner.
Sen. Charles Schumer, D-N.Y., a member of the Senate Banking Committee, praised Geithner's proposal as a "good first outline." But he said it would probably require "some major consolidating and rearranging" of regulatory agencies. Four separate agencies now regulate banks — a system critics say produces overlapping lines of authority.
At a Senate Banking Committee hearing, SEC Chairman Mary Schapiro and key senators agreed it could be harmful for any one regulator to become too powerful.
"The devil is in the details," Schapiro said, adding she was concerned that "we don't create a monolithic entity."
To try to build support for the proposal, Obama is to meet Friday with major bank executives.
The proposal on credit default swaps and other derivatives would regulate the trading far more extensively. Some derivatives, such as stock options, already are regulated because they are traded on exchanges. The administration would expand regulation to derivatives that now trade mainly in the over-the-counter market, outside regulatory scrutiny.
Credit default swaps are contracts to insure against the default of certain debt. They played a key role in the downfall of investment banking giant Lehman Brothers Holdings Inc. last fall and nearly destroyed AIG.
Larger hedge funds, private equity funds and venture capital funds above a certain level in assets would have to register with the SEC. Regulators would examine their books to determine if they should face greater scrutiny.
Hedge funds have grown explosively in recent years while operating secretively. They have lured an increasing number of ordinary investors, pension funds and university endowments — meaning millions of people now unwittingly invest in hedge funds indirectly.