But the Fed, so far, has shown little interest in getting involved with hedge funds. "Broadly speaking, the best way to make sure hedge funds are not taking excessive risks or excessive leverage is through market discipline," such as having banks police them and limiting who can invest in them, Federal Reserve Board chairman Benjamin Bernanke told a House committee in late July.
Most other Fed governors agree. One, Randall S. Kroszner, believes commercial banks "are much more aware" of the counterparty risk and that hedge funds are less leveraged after the infamous 1998 meltdown of Long-Term Capital Management.
What You Can Do
Given the resistance at top levels, it's unlikely that fast action from the government will help keep deals fully under wraps. But there are some approaches CFOs can take now to limit exposure. "At the end of the day, it's the company's responsibility to monitor what happens as they bring someone under the tent," says Freescale treasurer Heinlein.
Number one, experts say, is to build relationships with a few select banks and to be loyal to them. "If you can minimize the number of banks you're working with and the number of accounts you have, there's less potential for leakage to happen," says Dan Carmody of treasury consulting firm TreaSolution Inc. Others suggest finance executives find out how much revenue the bank derives from non-investment-banking activity, and consider using boutique investment banks that focus more narrowly on deals. Heinlein also recommends using commercial banks whenever possible "to help keep the investment banks honest," since their clients typically do not include hedge funds.
The second key ingredient in keeping secrets secret is to closely track movements in stock, bond, and credit-derivative prices. "Private-equity and hedge funds can always trade in an offsetting product, so that is always a risk," says Heinlein. "On the other hand, the company always has a right and even an obligation to sniff that out." He tracks Freescale's credit-default swaps in part to look for suspicious activity and in part to see how efficiently the company's bonds are trading.
Finally, Heinlein recommends that, when the situation permits, companies should structure deals with fast turnarounds, such as overnight bond deals, to minimize the likelihood of leaks. Above all, remember Benjamin Franklin's wise words the next time you set up a deal with your bankers: "Three can keep a secret if two are dead."
Alix Nyberg Stuart is senior writer at CFO.
Who's on First?
Banks routinely bundle corporate loans and sell them off, often to other banks or hedge funds, as a way to manage risk. The problem with those derivatives, though, is that slow transaction-clearing processes and the resulting backlog make it unclear who is legally responsible for paying up in the event of a credit default. Should banks be left holding the bag for multiple bankruptcies, their reserves would quickly be depleted, raising fears of a systemwide meltdown.
Such fears spurred the New York Federal Reserve Bank to call a meeting of 14 large banks last fall, asking them to standardize and computerize the process, rather than rely on an outmoded system based on scraps of paper and ad hoc negotiations. By the end of June, the number of uncleared transactions more than 30 days old had been reduced on average by 80 percent, and backlogs at large firms showed a marked decline. Some 60 percent of all swaps now go through the Depository Trust and Clearing Corp., the main clearinghouse for the derivatives, up from 15 percent two years ago.
But don't breathe easy just yet. "Taking care of the backlog [via automation] certainly won't be a panacea," warns Dimitri Papadimitriou, head of the Levy Economics Institute at Bard College. "When we get caught up, we might find that banks' exposure is much larger than we thought." — A.N.S.
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