After the Fed began to raise short-term interest rates on Feb. 4, major hedge funds that had bet rates would decline were forced to sell large amounts of bonds and stocks to cover their positions. Some analysts say the flood of securities into the market further depressed stock and bond prices, causing the markets to overreact to the Fed's modest inflation-fighting effort.
Levitt said hedge-fund activities probably speeded the nearly 10 percent drop in stocks and the 14 percent fall in bonds in the last two months. But, he added, they were not the sole cause of the turmoil. He said he had asked hedge-fund operators to furnish information voluntarily on the securities they own and their trading strategies.
Prior to getting that information, he said, "it would be premature to conclude" that new regulations were needed.
Chairman Henry B. Gonzalez (D., Texas) called the hearing before his House Banking, Finance and Urban Affairs Committee to determine whether hedge funds and the derivative securities they use pose a threat to the banking industry and financial markets.
Derivatives, which are also used by banks, brokerage houses, pension funds and other big players in the securities markets, have become a little- understood, multitrillion-dollar industry. The simplest derivatives are options, in which an investor purchases the right to buy or sell a stock or bonds for a set price over a given time.
In recent years, far more complex derivatives have been invented allowing investors to speculate internationally in stocks, bonds and currencies. Initially designed to help hedge, or reduce, risks, they can also be used in high-risk schemes to increase profit.
On Tuesday, Gonzalez introduced a bill that would require banks to disclose their derivatives activities.
George Soros, a hedge-fund operator who reportedly suffered immense losses in the first quarter, testified that Congress should be concerned about the growing role of derivatives.
The problem with many of these schemes, Soros said, is that they assume a given derivative can, for instance, be sold to implement the strategy. But when the unexpected happens - as when the Fed raised interest rates - there may not be enough buyers. Some investment strategies increase risk tenfold or twentyfold, he said.
"The explosive growth in derivative instruments holds other dangers," Soros said. "There are so many of them, and some of them are so esoteric, that the risks involved may not be properly understood even by the most sophisticated of investors - and I'm supposed to be one."
