In an amazing instance of collateral damage, the new bankruptcy law that took effect in October 2005, designed to enable banks to wrestle more money from overextending credit card users, hascaught hedge funds in its net.
The old law exempted many types of bank securities lending, such as repo agreements, to be included in a Chapter 11 bankruptcy, which allows the borrower to file a plan of reorganization and hopefully emerge as a surviving entity. The alternative is liquidation.As John Dizard points out in the Financial Times, this will hit troubled hedge funds and other leveraged borrowers hard.
This is a much more serious matter than most might realize. One of the scenarios that regulators are worried about is that we could face a new version of the LTCM meltdown spread across multiple large hedge funds, and that would be more difficult to manage than the earlier crisis, which was concentrated in a single player. Today, that possibility is even more worrisome because forced selling of assets that have not been trading, like illiquid CDOs, might force investment banks to remark their positions and more important, of collateral against which they are lending, potentially leading to margins calls and creating a vicious circle of forced sales producing more forced sales.
The new bankruptcy law greatly increases the likelihood of this ugly set of events coming to pass. Dizard warns us that the remarking of positions as a result of the painful last couple of months has not yet worked its way through the system.
From the Financial Times:
In the US, the 2005 revisions to the bankruptcy law made big changes in how debtors such as leveraged hedge funds and private equity funds are able to manage their way through a downturn in their fortunes. In many cases, they simply won’t be able to manage, full stop. The 2005 law was nominally drawn up by the Republican Congress, but was really written by the banks. Years of contributions and informational seminars for lawmakers in Hawaii paid off. The public controversy at the time of the law’s passage centered on the reduced protections for consumers, but applauding Republican hedge fund managers should have taken a closer look at what was going to happen to them.
Sean Mathis of Miller Mathis & Co, a New York firm specialising in corporate reorganisations and bankruptcies, says: “They have created so many exceptions to the protections [debtors had] under bankruptcy law. If you have a repo agreement, or any kind of counterparty agreement with a bank, those are exempt from the stays under the bankruptcy law.”
So for many hedge funds, or in many cases, private equity funds, there will be no bankruptcies leading to reorganisation. These will, effectively, be replaced by liquidations. Fund managers and investors will see assets seized by the banks and prime brokers on the other side of the counterparty agreements. They can file for Chapter 11 if they want to, but the only assets they’ll be protecting are the pencil sharpeners and the expensive net leases.
Don’t think that your assets are safe from offsets or seizure because they’re still above water, according to your calculations. It’s the bank or prime broker’s valuations that count. Read those counterparty agreements again. You will see that you will lose the argument. This is a serious problem in market sectors that depended on mark-to-model, or marking to a market in which liquidity has disappeared.
“In some cases,” says Julia Whitehead, a workout adviser at Miller Mathis, “the default notice from the bank will have two lines in it. Their view is that they have nothing to explain.”
You may wonder why you haven’t heard much about this yet. The answer is that in many cases the marks in the credit investing world have not been taken yet for the messy third quarter. Also, the leveraged investors have the benefit of bureaucratic inertia at their brokers and banks. Not forever.
Some funds may think they can protect themselves, and preserve some asset values, by filing for protection in their offshore domiciles, such as the Caymans. And, indeed, there are provisions in US bankruptcy law, under Chapter 15, for the courts to recognise the protections offered creditors by foreign courts. But the creditors, ie, the banks and prime brokers, can get around even that palm frond of protection by arguing that the Centre of Main Interest, or Comi, is back in the US. Then the lenders are back in command.
If you’re a populist, say a civil servant, savouring a moment of Schadenfreude over the coming downfall of the hedgies, consider this: your pension fund has probably invested with them. If the funds can’t come up with the money to pay for your retirement, tax increases will be needed. Will all of those go through? Or will you just get the pencil sharpeners and net leases?
The banks and brokers will be hurt by the credit crisis. But they might also pick up a lot of undervalued assets, at investors’ expense.