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The Effects of the Credit Crunch on SIVS and Hedge Funds
December 18, 2007

For some time, it had been accepted that there would be a turn in the credit markets. July saw the speculation brought to an end as the sub prime saga unfolded, causing havoc across the international credit markets. Of those affected, it was Structured Investment Vehicles (SIVs) and hedge funds that bore the brunt of the impact. In this Q&A White & Case partners Dan Hamilton, Stephen Phillips & John Reynolds comment on the effects that the credit crunch has had on these funds.

Q: Why were SIVs and hedge funds so badly affected by the credit crunch?

Phillips: One downside of the increasing sophistication of global structured finance is that the problems of the US sub prime market spread beyond the domestic lenders that initially made significant loans to households with poor credit histories. This has been via asset-backed securities (ABS), predominantly collateralised debt obligations (CDOs), meaning that those most exposed to these securities were the worst affected by the credit crunch.

CDOs, like any other securitisation, are bonds secured on a pool of income producing instruments. They disperse the risk of default of these instruments amongst other market participants by slicing up the income of those debt instruments into a number of tranches. Whilst insurance companies and pension funds tend to buy the least risky, most highly rated tranches, which are the last to suffer loss in the event of default of the underlying assets, hedge funds, by contrast, have tended to purchase the highest yielding, but most risky, so-called "equity" tranches. As the price of the CDOs and ABS (whether backed by sub-prime loans or not) plummeted, a number of hedge funds came under intense pressure. Many equity investors sought to redeem their investments when the problems became apparent. Brokers, who understandably choose to tighten their lending criteria in periods of market volatility, began making margin calls, at very short notice, meaning that those hedge funds that had allowed themselves to become highly levered had to sell off their assets at a depressed value, in order to meet the tightened lending criteria. Alternatively, if funds failed to honour margin calls brokers were able to seize collateral and sell it on in the market, leaving funds left to file for insolvency.

SIVs, also investors in ABS, have similarly become troubled. The most simple SIVs are often funded by two classes of notes; higher yielding first loss notes, at the low end of the investment grade spectrum which fund between about 5 per cent and 15 per cent of the portfolio, and a larger portion senior of low-yielding, AAA-rated paper which can be short-term asset-backed commercial paper, or notes with a life of up to three months. SIVs are often required to 'mark to market' the value of their underlying investments on a regular basis. The credit crunch caused trouble for SIVs firstly because the short-term asset-backed commercial paper market effectively seized up, cutting off their incoming cash flow supply, and secondly, many were forced to sell assets to maintain their leverage within pre-set levels when the net asset value of the portfolios declined.

Q: Why have SIVs and hedge funds found themselves in such an uncomfortable position in terms of funding?

Hamilton: Looking at SIV and hedge fund funding, the balance of power is much more favourable towards the lenders/investors. Hedge funds are extensive users of prime brokerage arrangements, using margin loans, repos and other techniques. Under a classic repo, a hedge fund will sell certain securities to its prime broker and, at a specified later date, will purchase those securities back at an agreed future rate. The effect is of a secured loan. The prime broker can also usually make margin calls if the value of the underlying security continues to fall. The danger for the hedge fund is that if it fails to re-purchase the security, or to pay up on a margin call, its counter-party keeps the underlying asset which formed the subject of the repo. The repurchase arrangement means that the legal ownership of the underlying asset has been transferred to the broker and so there does not need to be any complicated security enforcement if the fund fails to repurchase under the repo. The same results can be achieved on simple secured loans using appropriation techniques under the little-known Financial Collateral Arrangements (No.2) Regulations. Switching to SIVs, the documentation is very prescriptive, offering the SIV no flexibility in taking remedial action when it gets into trouble, emphasising how the structure of these vehicles favours the lenders/investors.

Q: How easy is the security enforcement procedure for brokers/creditors?

Phillips: The security enforcement is relatively straightforward in the case of hedge funds. The most usual form of enforcement is for brokers to sell the collateral that they hold on their books, such as Collateralised Debt Obligations (CDOs), meaning that security enforcement tends to be a fairly easy process, thus placing any hedge fund in a weak position when it is looking to restructure its debts.

An interesting piece of legislation relating to this is the Financial Collateral Arrangements (No.2) Regulations 2003 ("Regs") (secondary legislation implementing a European Directive, but which is not yet widely used), which enable the "appropriation" of collateral without the need for a court process; this is an enforcement measure which may be available to prime brokers, however, it would appear that many brokers have not included provisions relating to the Regs in their brokerage agreements. Given the events of the summer we would expect that brokers will now be focusing on these Regs and ensuring that their standard terms and conditions will allow brokers to take the benefit of the Regs, to the extent that they are able.

Q: Are there are any examples of where these Regulations have been used in practice?

Reynolds: The Regulations are often incorporated in loan security documentation. They are also an obvious additional enforcement device for Prime Brokers, as Stephen has said. As far as we are aware, though, there has been no court decision on them in the UK. We are currently representing a party in litigation in the British Virgin Islands where the scope and application of the Regulations is the central issue and so it appears that the first authority is from the High Court of BVI. The key point in that decision (which is crucial to the case in question) is that the security holder (the party seeking to appropriate) must become the "absolute owner" (rather than equitable owner) of the security in order to appropriate; a mere determination to appropriate is insufficient. That case is currently on appeal to the Eastern Caribbean Court of Appeal and it is expected that, whatever the outcome of that appeal, it will be appealed to the Privy Council in London in due course.

Q: What has been the main issues for SIVs and hedge funds when it comes to their assets?

Phillips: The main issue for SIVs and hedge funds that need to sell the assets that they hold in their portfolios is obtaining a valuation, since the current market makes it difficult or, in some cases, impossible to value these assets. The current lack of demand in the market for such assets, means that their valuation is very low. This has led to some hedge funds being caught in a 'liquidity trap', where margin calls have been made by brokers, leading to fire sales by hedge funds (or SIVs) in order to meet these margin calls.

Q: Are we likely to see a surge in litigation and if so, what is the basis for these claims likely to be?

Reynolds: We are undoubtedly going to see cases brought on the back of the credit crunch. What is important to note is that a claim does not need to be a good claim to be of strategic value. Weakly supported claims may be used as a tactic to get the other party to renegotiate and we have seen a number of instances of this in recent the last couple of months. The most likely claims to arise will be: misrepresentation, where a party may claim that they have been 'missold' the securities (the first of these has just been reported from Australia); and claims that collateral has been sold at an undervalue given the recent wave of sales of hedge fund and SIV assets. It is also possible that there will be claims relating to the rating of notes and the action taken in consequence of unfavourable ratings.

Q: What are the main restructuring issues going to be?

Hamilton: Speed and lack of control are the two main problems that SIVs and hedge funds face when trying to implement a restructuring proposal. Terms in hedge fund brokerage agreements and the SIV documentation tend to lead to the requirement to sell assets when their value falls. This has led to a massive sale of assets, such as CDOs, which has depressed the already weak price. Any restructuring process is likely to focus on preventing distressed firesales. Furthermore, the senior, commercial paper investors in a SIV will want to see sales continue to allow their debt to be paid as it falls due. Investors lower in the ranking will want to slow down the disposals to preserve value for all investors. Similarly, hedge fund investors usually have a right to withdraw their investments at fairly short notice. This puts further pressure on the fund if its lenders and shareholders are demanding cash at a time when asset prices are rock bottom. Some hedge funds have been saved by receiving the support of third party investors and we expect a wave of rationalisations - bigger funds taking over smaller funds or investment banks buying hedge funds. Recent attempts to create value of SIVs has meant the receivers have been appointed and sought guidance from the court not to sell the assets, and banks have been looking at ways of converting SIVs into more traditional conduits or taking the assets back on balance sheet to avoid critical value destruction. Additional problems facing SIVs are that investors tend to be relatively new to non-investment grade markets and therefore have the expectation that they will get paid back and not at a lower rate than their original investment. In addition there are the practical issues to consider in filing for insolvency of a hedge fund or a SIV which carry out investment activities across multiple jurisdictions, but may not actually carry out any activities in their country of incorporation.

Dan Hamilton is a partner in, and the head of, the London Financial Restructuring & Insolvency(FRI) Practice. Dan’s practice is in the field of corporate and financial restructuring, non-contentious insolvency and general bank finance. He advises banks and other creditor groups on restructuring or recovering problem loans and on new lending as well as acting for companies in financial difficulties. He acts for administrators, receivers and liquidators in all aspects of corporate insolvencies.

Stephen Phillips is also a partner in the London FRI Practice. Stephen advises banks (at senior, second lien and mezzanine level), bondholders and steering committees on restructuring, corporate and banking matters.

John Reynolds is a partner in the London Dispute Resolution Practice. John has a broad commercial litigation and arbitration practice with a particular focus on banking and finance disputes. He represents banks and other financial institutions in relation to the many aspects of their business where a dispute arises or there is a risk of dispute.

"Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with any of the above partners, contact Reilly Starr at rstarr@whitecase.com.

Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.

	In the Media
Expertise Banking Capital Markets Commercial Litigation Financial Restructuring and Insolvency International Arbitration Mergers & Acquisitions Corporate Lawyers Stephen Phillips John Reynolds Locations London	The Effects of the Credit Crunch on SIVS and Hedge Funds December 18, 2007 For some time, it had been accepted that there would be a turn in the credit markets. July saw the speculation brought to an end as the sub prime saga unfolded, causing havoc across the international credit markets. Of those affected, it was Structured Investment Vehicles (SIVs) and hedge funds that bore the brunt of the impact. In this Q&A White & Case partners Dan Hamilton, Stephen Phillips & John Reynolds comment on the effects that the credit crunch has had on these funds. Q: Why were SIVs and hedge funds so badly affected by the credit crunch? Phillips: One downside of the increasing sophistication of global structured finance is that the problems of the US sub prime market spread beyond the domestic lenders that initially made significant loans to households with poor credit histories. This has been via asset-backed securities (ABS), predominantly collateralised debt obligations (CDOs), meaning that those most exposed to these securities were the worst affected by the credit crunch. CDOs, like any other securitisation, are bonds secured on a pool of income producing instruments. They disperse the risk of default of these instruments amongst other market participants by slicing up the income of those debt instruments into a number of tranches. Whilst insurance companies and pension funds tend to buy the least risky, most highly rated tranches, which are the last to suffer loss in the event of default of the underlying assets, hedge funds, by contrast, have tended to purchase the highest yielding, but most risky, so-called "equity" tranches. As the price of the CDOs and ABS (whether backed by sub-prime loans or not) plummeted, a number of hedge funds came under intense pressure. Many equity investors sought to redeem their investments when the problems became apparent. Brokers, who understandably choose to tighten their lending criteria in periods of market volatility, began making margin calls, at very short notice, meaning that those hedge funds that had allowed themselves to become highly levered had to sell off their assets at a depressed value, in order to meet the tightened lending criteria. Alternatively, if funds failed to honour margin calls brokers were able to seize collateral and sell it on in the market, leaving funds left to file for insolvency. SIVs, also investors in ABS, have similarly become troubled. The most simple SIVs are often funded by two classes of notes; higher yielding first loss notes, at the low end of the investment grade spectrum which fund between about 5 per cent and 15 per cent of the portfolio, and a larger portion senior of low-yielding, AAA-rated paper which can be short-term asset-backed commercial paper, or notes with a life of up to three months. SIVs are often required to 'mark to market' the value of their underlying investments on a regular basis. The credit crunch caused trouble for SIVs firstly because the short-term asset-backed commercial paper market effectively seized up, cutting off their incoming cash flow supply, and secondly, many were forced to sell assets to maintain their leverage within pre-set levels when the net asset value of the portfolios declined. Q: Why have SIVs and hedge funds found themselves in such an uncomfortable position in terms of funding? Hamilton: Looking at SIV and hedge fund funding, the balance of power is much more favourable towards the lenders/investors. Hedge funds are extensive users of prime brokerage arrangements, using margin loans, repos and other techniques. Under a classic repo, a hedge fund will sell certain securities to its prime broker and, at a specified later date, will purchase those securities back at an agreed future rate. The effect is of a secured loan. The prime broker can also usually make margin calls if the value of the underlying security continues to fall. The danger for the hedge fund is that if it fails to re-purchase the security, or to pay up on a margin call, its counter-party keeps the underlying asset which formed the subject of the repo. The repurchase arrangement means that the legal ownership of the underlying asset has been transferred to the broker and so there does not need to be any complicated security enforcement if the fund fails to repurchase under the repo. The same results can be achieved on simple secured loans using appropriation techniques under the little-known Financial Collateral Arrangements (No.2) Regulations. Switching to SIVs, the documentation is very prescriptive, offering the SIV no flexibility in taking remedial action when it gets into trouble, emphasising how the structure of these vehicles favours the lenders/investors. Q: How easy is the security enforcement procedure for brokers/creditors? Phillips: The security enforcement is relatively straightforward in the case of hedge funds. The most usual form of enforcement is for brokers to sell the collateral that they hold on their books, such as Collateralised Debt Obligations (CDOs), meaning that security enforcement tends to be a fairly easy process, thus placing any hedge fund in a weak position when it is looking to restructure its debts. An interesting piece of legislation relating to this is the Financial Collateral Arrangements (No.2) Regulations 2003 ("Regs") (secondary legislation implementing a European Directive, but which is not yet widely used), which enable the "appropriation" of collateral without the need for a court process; this is an enforcement measure which may be available to prime brokers, however, it would appear that many brokers have not included provisions relating to the Regs in their brokerage agreements. Given the events of the summer we would expect that brokers will now be focusing on these Regs and ensuring that their standard terms and conditions will allow brokers to take the benefit of the Regs, to the extent that they are able. Q: Are there are any examples of where these Regulations have been used in practice? Reynolds: The Regulations are often incorporated in loan security documentation. They are also an obvious additional enforcement device for Prime Brokers, as Stephen has said. As far as we are aware, though, there has been no court decision on them in the UK. We are currently representing a party in litigation in the British Virgin Islands where the scope and application of the Regulations is the central issue and so it appears that the first authority is from the High Court of BVI. The key point in that decision (which is crucial to the case in question) is that the security holder (the party seeking to appropriate) must become the "absolute owner" (rather than equitable owner) of the security in order to appropriate; a mere determination to appropriate is insufficient. That case is currently on appeal to the Eastern Caribbean Court of Appeal and it is expected that, whatever the outcome of that appeal, it will be appealed to the Privy Council in London in due course. Q: What has been the main issues for SIVs and hedge funds when it comes to their assets? Phillips: The main issue for SIVs and hedge funds that need to sell the assets that they hold in their portfolios is obtaining a valuation, since the current market makes it difficult or, in some cases, impossible to value these assets. The current lack of demand in the market for such assets, means that their valuation is very low. This has led to some hedge funds being caught in a 'liquidity trap', where margin calls have been made by brokers, leading to fire sales by hedge funds (or SIVs) in order to meet these margin calls. Q: Are we likely to see a surge in litigation and if so, what is the basis for these claims likely to be? Reynolds: We are undoubtedly going to see cases brought on the back of the credit crunch. What is important to note is that a claim does not need to be a good claim to be of strategic value. Weakly supported claims may be used as a tactic to get the other party to renegotiate and we have seen a number of instances of this in recent the last couple of months. The most likely claims to arise will be: misrepresentation, where a party may claim that they have been 'missold' the securities (the first of these has just been reported from Australia); and claims that collateral has been sold at an undervalue given the recent wave of sales of hedge fund and SIV assets. It is also possible that there will be claims relating to the rating of notes and the action taken in consequence of unfavourable ratings. Q: What are the main restructuring issues going to be? Hamilton: Speed and lack of control are the two main problems that SIVs and hedge funds face when trying to implement a restructuring proposal. Terms in hedge fund brokerage agreements and the SIV documentation tend to lead to the requirement to sell assets when their value falls. This has led to a massive sale of assets, such as CDOs, which has depressed the already weak price. Any restructuring process is likely to focus on preventing distressed firesales. Furthermore, the senior, commercial paper investors in a SIV will want to see sales continue to allow their debt to be paid as it falls due. Investors lower in the ranking will want to slow down the disposals to preserve value for all investors. Similarly, hedge fund investors usually have a right to withdraw their investments at fairly short notice. This puts further pressure on the fund if its lenders and shareholders are demanding cash at a time when asset prices are rock bottom. Some hedge funds have been saved by receiving the support of third party investors and we expect a wave of rationalisations - bigger funds taking over smaller funds or investment banks buying hedge funds. Recent attempts to create value of SIVs has meant the receivers have been appointed and sought guidance from the court not to sell the assets, and banks have been looking at ways of converting SIVs into more traditional conduits or taking the assets back on balance sheet to avoid critical value destruction. Additional problems facing SIVs are that investors tend to be relatively new to non-investment grade markets and therefore have the expectation that they will get paid back and not at a lower rate than their original investment. In addition there are the practical issues to consider in filing for insolvency of a hedge fund or a SIV which carry out investment activities across multiple jurisdictions, but may not actually carry out any activities in their country of incorporation. Dan Hamilton is a partner in, and the head of, the London Financial Restructuring & Insolvency(FRI) Practice. Dan’s practice is in the field of corporate and financial restructuring, non-contentious insolvency and general bank finance. He advises banks and other creditor groups on restructuring or recovering problem loans and on new lending as well as acting for companies in financial difficulties. He acts for administrators, receivers and liquidators in all aspects of corporate insolvencies. Stephen Phillips is also a partner in the London FRI Practice. Stephen advises banks (at senior, second lien and mezzanine level), bondholders and steering committees on restructuring, corporate and banking matters. John Reynolds is a partner in the London Dispute Resolution Practice. John has a broad commercial litigation and arbitration practice with a particular focus on banking and finance disputes. He represents banks and other financial institutions in relation to the many aspects of their business where a dispute arises or there is a risk of dispute. "Talking" features White & Case lawyers answering questions about emerging legal and business issues. For more information or to schedule an interview with any of the above partners, contact Reilly Starr at rstarr@whitecase.com. Any information contained in this interview is for educational purposes only. It should not be construed as legal advice.