The quiet before darkness descends on the hedgies

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Hudson: “That’s it man, game over, man, game over! We’re in some real pretty s*** now! What the f*** are we going to do now? What are we going to do?”

Newt: “We better get back, ’cause it’s going to be dark soon, and they mostly come out at night ... mostly.” Aliens (1986)

Yes, leveraged fund people, it will be dark soon, and they will be coming out. The bankruptcy bar, the liquidators ... There are two types of investors and portfolio managers now in the markets: those too young to have learned from past downturns, and those with out-of-date lessons.

Europeans, for example, would appear to have lots of reasons to be smug about their positions relative to those of their overleveraged American counterparts. Oh, but who took the dubious American paper? The American public? No, they sold much of what they had. The answer: Europeans, disproportionately. And while the US has a central bank that has, so far, ineffectually managed its lender-of-last-resort function, at least it has a central bank with a LLR function, with close ties to a central government treasury. Unlike its predecessors in euroland, the European Central Bank’s discretionary powers in a crisis are much less clear.

Most Asian countries’ financial sectors have better governance at the national level than in the past. (We’ll see what governance the Japanese have, when they get a new government.) They’re well prepared for the last crisis, with high forex reserves. But what assets were being bought with those reserves? “AAA” paper? “A” paper? “BBB” paper? What letter is attached to them now? Oh, and never mind what happens if the Chinese policy initiatives fail. What if they succeed in ending the excesses in the investment boom? Any knock-on effects in the region, do you think?

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 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 centred 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 your assets are safe from offsets or seizure because your calculations show they’re still above water. It’s the bank‘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.”

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 – 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 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 pay for your retirement, tax increases will be needed. Will all of those go through?

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.

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