As the 1,400-page Senate bill on financial reform makes its way through Congress, hedge funds are increasingly worried about proposed bankruptcy rules for failed financial institutions that could make life difficult for distressed debt investors.
The latest proposed legislation would give the Federal Deposit Insurance Corporation wide latitude in determining how to treat what it terms “similarly situated creditors” when a financial institution fails.
As distressed debt investors, hedge funds are likely to be those creditors. “We’re really flummoxed as to why they are doing that,” said one hedge fund executive looking at the legislation. “Would original holders get more than those who buy in later?” If so, hedge funds that buy debt during times of distress—also referred to pejoratively as vulture investors—would be penalized.
The language—which is a relatively new addition to the bill—reminds hedge funds of the highly politicized bankruptcy of Chrysler last year, when President Barack Obama called opponents of the government-orchestrated reorganization of Chrysler “speculators” who were refusing to “sacrifice like everyone else.” Distressed debt investors believed the administration was rewriting the bankruptcy laws, which give secured lenders first-lien rights. Instead, the United Auto Workers, an unsecured creditor, came out on top, with a 55% stake in the new Chrysler. Had the company been liquidated, the hedge fund distressed investors believed that the bankruptcy courts would have awarded them more than the government was offering.
The Managed Funds Association, which is lobbying for hedge funds regarding the financial bill, says the organization “supports a resolution authority that unwinds failing firms that pose a threat to the system. We are concerned, however, that provisions that enable the FDIC to treat similarly situated creditors differently will create significant uncertainty for investors in the debt of these institutions and other creditors.
“This uncertainty likely will inhibit investors from investing in, providing capital to, or otherwise doing business with, financially weak or weakening firms,” explains a spokesman. “The heightened uncertainty will chill investments and raise costs. The follow-on effects on the market could be profound, with vulnerable firms failing more rapidly and contagion spreading to others of questionable health. Removing predictability and longstanding principles upon which market participants rely would produce the opposite of the intended goals of reduced and contained risk.”
The Senate bill says the FDIC will make its determination based on its desire to maximize the value of the assets of the failed institution and to minimize the losses from the sale of those assets.
—Michelle Celarier