WASHINGTON - Wild mood swings on Wall Street are nothing new, but the recent quaking in financial markets has a worrisome new wrinkle: It's being driven more by what isn't known than by what is.
That's because a huge share of the money that's flowing through U.S. financial markets is being invested by giant "hedge funds" that aren't subject to much regulation. No one really knows what they own. And there's a chance that some of what they own is worthless.
The funds - managed pools of investors' money, often supplemented with huge borrowings from banks - often bet on highly speculative and exotic financial derivatives, such as "options," which more regulated mutual funds aren't allowed to buy. That poses risks to all the U.S. financial institutions that are tied to them, as much of Wall Street is. It poses risks to the broader economy as well, and those risks are impossible to measure because no one knows how risky hedge-fund assets are.
The big systemic risk is that "people don't know anything about (hedge fund) activities," said Steven Brown, a finance expert at New York University's Stern Business School.
"When you have a complete lack of disclosure, everybody is locked in the same category, and the sins of the few are visited on the many," he said.
Brown was quick to add that he doesn't expect cataclysmic problems to emerge, but that in the absence of transparency, they might. That possibility magnifies the anxieties on Wall Street and contributes to the markets' volatility.
The Dow Jones Industrial Average hit a record high of 14,000 points July 19. Almost every day since, it's jolted up and down in huge swings.
Hedge funds controlled $1.6 trillion in assets as of the end of June. That's equal to about 10 percent of the total value of the New York Stock Exchange. Much of what they own was bought with money they borrowed from big banks, sometimes up to 80 percent of their holdings.
If the banks can't collect the debts that hedge funds owe because the assets that the funds bought turn out to be worthless, then the banks are in trouble. If the banks are in trouble, so is the economy.
Some analysts think that the problem - along with its solution - is rooted in transparency, or the absence of it. Most investment funds must report details of their finances to the government, which shares much of the information with the public.
Hedge funds have been excused from this transparency principle, and now some analysts think that's a mistake.
When hedge funds were created under the Investment Company Act of 1940, they deliberately were limited to the wealthiest Americans, who could absorb losses.
They're different now. For one thing, there are a lot more of them. There were 530 as recently as 1990; today there are almost 7,500, according to Chicago-based Hedge Fund Research Inc.
A more important difference: They're not just for millionaires anymore. Pension-fund managers invest pension assets in them now. So do university endowments. They do so because when they're successful, hedge funds pay big dividends. But when they're not, every investor in them is at risk, just as in regulated funds.
"It has evolved into something quite different than just rich people," Bowsher said. "There are a lot of ordinary people who are going to be hurt if these big private funds go under. Then, the question really is, should there be more transparency?"
Some analysts think that Washington, D.C.'s failure to make hedge funds obey rules of transparent disclosure, just as mutual funds do, is a failure of public policy to protect the public.
"I think that there has been a serious regulatory failure, and the depths of the problem will become clearer when we see the next financial crisis, which may not be far off," said Dean Baker, an economist with the liberal Center for Economic Policy and Research.
To be sure, Alan Greenspan and Ben Bernanke, the previous and the current chairman of the Federal Reserve, have said that direct regulation of hedge funds is unnecessary.
Similarly, a presidential work group concluded in February that existing market discipline and investor awareness of risks are sufficient. So did one under former President Clinton. Former Wall Street bankers shaped both administrations' economic policies.
Increasingly, however, some lawmakers aren't sure that such a laissez-faire attitude is right.
"I think we have an uneasy consensus that there's a potential problem here that we wish we were more sure about how to approach," Rep. Barney Frank, D-Mass, the chairman of the House Financial Services Committee, said during a July hearing on potential risks from hedge funds.
"I don't think anybody can be confident that all is entirely well here, but neither is there any obvious thing we ought to be doing," he concluded.
Such indecision over how to head off possible economic danger is normal in Washington, D.C. U.S. economic history shows that regulators rarely move ahead of a crisis. They didn't before the stock-market crash of 1929. They didn't during the savings-and-loan meltdown in the 1980s. And they didn't before Enron's accounting scandal in 2001.
Only after the scandals exploded - and claimed many innocent victims - did the government move to stiffen regulation of market activity. BC-Fed-Interest Rates-Optional,860
Fed leaves key interest rate unchanged; concerns about inflation play into decision
By JEANNINE AVERSA
AP Economics Writer
WASHINGTON (AP) - Borrowers looking for some interest rate relief will have to keep on waiting.
Although Federal Reserve policymakers held interest rates steady Tuesday, they gave themselves some wiggle room for a cut down the road should economic conditions take a turn for the worse.
"Financial markets have been volatile in recent weeks, credit conditions have become tighter for some households and businesses and the housing correction is ongoing," said the Fed, its first acknowledgment of the recent conditions that have shaken Wall Street and Main Street. "Downside risks to growth have increased somewhat."
The Fed did throw "investors a bone," one analyst said, even though it stopped well short of saying a rate cut was imminent.
Fed Chairman Ben Bernanke and his central bank colleagues expressed hope that the economy will safely make its way. The policymakers also clung to their belief that the biggest potential danger to the economy is that inflation won't recede as they anticipate.
Against these economic crosscurrents, the Fed left an important interest rate at 5.25 percent on Tuesday. In turn, commercial banks' prime interest rate for certain credit cards, home equity lines of credit and other loans - would stay at 8.25 percent.
The central bank's key rate hasn't budged for more than a year. Before that, the Fed had raised rates for two years to fend off inflation.
On Wall Street, investors bid stocks higher. The Dow Jones industrials gained 35.52 points to close at 13,504.30.
Analysts believe the Fed probably will leave rates alone at its next meeting on Sept. 18. However, economists and investors now think the odds are growing that the Fed might lower rates by the end of this year - if the economy shows signs of faltering and if inflation isn't worrisome.
For now, the Fed stuck to a forecast that the economy is likely to expand at a moderate pace in coming quarters. They also said they expected "solid growth in employment and incomes" - vital ingredients to the country's economic health.
The Fed "didn't completely satisfy investors but they did throw investors a bone," said Mark Zandi, chief economist at Moody's Economy.com. "They indicated that if things continue to weaken in financial markets, they will respond."
The Fed was faced with a delicate dance, analysts said. To maintain credibility, it needed to acknowledge recent market gyrations, fears about a worsening housing slump and worries about a spreading and painful credit crunch. At the same time, it needed to send a comforting message but not be viewed as overly optimistic or pessimistic.
"They acknowledged and rightly so, the elephant in the room - problems in the credit market. But they didn't feed it any peanuts by cutting rates," said Stuart Hoffman, chief economist at PNC Financial Services Group. "But the statement gives the Fed a little more flexibility - a crack in the door - for them to cut rates later on" if the economy loses traction, he said.
The meltdown in the housing and mortgage markets has caused home foreclosures to climb to record highs and has forced some lenders out of business. Fears that credit problems will infect the broader financial system and the economy have fed market turbulence over recent weeks.
The free flow of credit is important to the smooth functioning of the national economy. Increasingly restrictive lending conditions can put a damper on peoples' ability to buy big-ticket items such as homes, cars and appliances. And it can crimp businesses' capital investment and hiring. That reduced appetite by businesses and consumers would slow overall economic activity.
"People on Wall Street have been undergoing tidal waves," said Bill Cheney, chief economist at John Hancock Financial Services. "The Fed could hardly ignore that ... but I don't think the Fed's view of the economy has changed materially. The Fed statement seemed designed to reassure and to calm," he added.
On inflation, the Fed policymakers again noted improvements. But they indicated they would need to see a steady string of better readings before they would downgrade their inflation risk.
Gasoline prices receded in early August but remain past $3 a gallon in some cities.
Meanwhile, core inflation - excluding food and energy prices - has moderated. These prices rose 1.9 percent over the 12 months ending in June, down from a 2 percent annual gain for May.
A government report Tuesday showed productivity got a lot stronger in the second quarter, helping to restrain the growth of employers' labor costs. Analysts, however, believe the improvements on both fronts might be short-lived.
After nearly stalling in the first quarter of this year, economic growth rebounded in the April-to-June period at a solid 3.4 percent pace. That bounceback came despite a drag on economic activity from the sour housing market and a much smaller appetite by consumers to spend. Growth through the rest of the year is expected to be slower.
Given that, the nation's unemployment rate - at 4.6 percent in July - is expected to climb close to 5 percent by year's end, analysts say.