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Dodd-Frank Regulation of Hedge Funds and Derivatives

Journal 33: Technical Finance

Lisa C. Brice

Following the 1990s bailout of the highly leveraged hedge fund Long-Term Capital Management, financial watchdogs called for heightened regulation of the shadow banking world and increased measures to impede the threat of systemic risk. The recent U.S. financial crisis, which reached its apex in the fall of 2008 and nearly brought Wall Street to the brink of implosion, was the impetus that finally brought about change. This transformation came in the form of Titles IV and VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act which was enacted in July 2010. The legislation includes broad-sweeping reform to regulations surrounding hedge fund registration and over-the-counter derivative products. This paper will discuss the history of hedge fund and derivative regulation, the changes imposed by the Dodd-Frank Act, its impact on the industry, and whether the law will be successful at preventing future systemic risk.

Overview of the 2007-2009 financial crisis
From the summer of 2007 through March 2009, the U.S. experienced the greatest financial crises since the Great Depression, the most frightening moments of which were felt during September 2008 when a series of major financial institutions met or neared their demise: Freddie Mac and Fannie Mae were nationalized, Lehman Brothers filed bankruptcy, and Merrill Lynch sold itself to Bank of America in an effort to avoid collapse. The cause of the crisis stemmed primarily from the bursting of the housing market bubble in 2006. The preceding boom was facilitated by low interest rates, the easing of credit standards, and greater access to the same. This triggered the expansion of mortgage lending in predominately poor quality loans, such as no money down loans and adjustable rate mortgages. These factors, along with an increase in transnational flow of capital, encouraged financial innovation. Subprime home loans were packaged into risky complex structured products called collateralized debt obligations (CDOs) and sold to institutions around the world. As the rates on adjustable mortgages reset and home values fell, homeowners began to default on loans rendering the derivative products which were based on them relatively worthless. “Investors, stunned by losses on assets they had believed to be safe, began to pull back from a wide range of credit markets, and financial institutions – reeling from severe losses on mortgages and other loans – cut back their lending.”

These illiquid assets rested on the books of many major financial institutions. The reach of their effect extended even to non-traditional investment entities including, hedge funds and insurance giant American Insurance Group (AIG), which sold credit default swaps (a type of insurance against default) on CDOs and other mortgage backed securities. With so many entities trading in these products, there existed significant multilateral counterparty credits risks, meaning that the insolvency of one institution could trigger the collapse of many others.

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