Considering the next wave of restructuring and bankruptcy may seem like shopping for snow tires in July. However, Texas lawyers would be wise to contemplate the possibility. The rise of hedge funds, with their extensive borrowing from banks to fund their investments, will make the next round of bankruptcies particularly painful. Banks will find themselves exposed to a much higher level of risk than they would have tolerated on traditional loans.

Some may think that any talk of a wave of bankruptcies and restructurings is premature. The default rate for debt obligations is at an all-time low. An unprecedented level of liquidity in the marketplace has supported this low default rate.

But the majority of this money is not coming from the traditional capital source: banks. Rather, as noted in Stern Business by finance professor Edward Altman of New York University's Leonard N. Stern School of Business, the rise in liquidity and decline in the default rate have coincided with a rise in the number and relative size of hedge funds.

When an economic downturn comes, this change in the capital markets' complexion could have a great impact here in Texas, which the Texas Hedge Fund Association notes ranks third behind New York and California for assets under hedge fund management.

Over the past several years, the term "hedge fund" has come to mean almost any type of strategic investment fund. The original hedge fund, established in 1949 by A.W. Jones, was a fairly simple vehicle combining short- and long-selling with leverage -- borrowing money from a bank to buy stock on a set future date for a predetermined price and then re-selling that stock; the investment strategy is betting that the stock price will either rise or fall.

The nature of hedge funds has changed drastically over the past 60 years. Modern hedge funds utilize many types of investment strategies ranging from simple to complex. In fact, the use of so many different investment strategies by single funds has blurred the lines between hedge funds and other types of investment funds. Short- or long-selling may not even be part of their investment strategy any more.

Modern hedge funds could have a tremendous impact on the next restructure wave simply because of their expanded role in the capital markets. First, there are simply more hedge funds than ever before, The International Monetary Fund notes in their quarterly magazine, Finance and Development, that there are close to 9,000 hedge funds, managing more than $1 trillion in assets. This is a considerable increase from the 2,800 hedge funds that managed just $2.8 billion prior to the last wave of restructures in the late 1990s.

Second, hedge funds have a more dominant market share than they did in the past. Nontraditional lenders, such as hedge funds, now account for nearly 70 percent of the volume of leveraged loans -- higher risk loans -- while banks represent only 20 percent. Merrill Lynch reports these percentages are almost exactly the inverse of those from a decade ago. Thus, hedge funds have effectively taken a dominant share of the lending market.

Businesses also will feel the impact of hedge funds through the tremendous amount of liquidity provided to the market and the new investment devices used to provide that liquidity. Like Jones' fund, modern hedge funds have used innovative investment strategies and the ability to leverage to provide this liquidity to the capital markets. As a result, hedge funds have become the dominant source of capital in the markets.

Hedge fund dominance has led to increased competition among lenders, which in turn has led to even cheaper and easier to acquire capital in the market place. Hedge funds, swollen with cash, are always looking for investment opportunities, sometimes overlooking the wisdom or economics of the particular deal. From a borrower's perspective, this is a capital bonanza, providing the necessary capital for expansion and mergers and acquisitions.

One of the latest but more simple investment strategies has been second lien financing, which at its core is nothing more than a level of secured financing with priority behind the primary or first level of financing. Second lien financing has become an attractive alternative for borrowers, because it typically offers better terms than other forms of debt. Much of the capital funding for these loans flows from hedge funds.

A second more complex vehicle is the collateralized debt obligation (CDO). CDOs are debt obligations -- sometimes bonds and sometimes loans -- that hedge funds pool together. These hedge funds then sell the securities representing investments in the entire pool to investors. Generally, the pooled loans have low credit ratings, but by pooling them the CDO is able to achieve a higher rating. These higher ratings allow institutional investors such as pension plans, insurance companies and banks to purchase them.

Regardless of investment structure, however, the real heart of any hedge fund strategy is increased leverage. Hedge funds can leverage their investment capital by purchasing securities on margin, which is basically purchasing securities using money borrowed from the broker. They also achieve leverage by using devices such as CDOs. The most direct leverage that hedge funds achieve is through collateralized borrowing. In short, hedge funds leverage by borrowing money from banks. Unfortunately, as Federal Reserve Chairman Ben S. Bernake notes in a speech given to the Federal Reserve Bank of Atlanta's 2006 Financial Markets Conference, meaningful and consistent measurement of hedge fund leverage is not easy to determine.

All of this makes for a volatile situation. Hedge funds are highly leveraged lenders, lending more money in the U.S. economy than ever before. This flood of capital has created competition for investment, and that, in turn, has eliminated many of the traditional safeguards and protections banks require when lending.

Hedge funds then make these stripped-down loans to less creditworthy borrowers. Finally, all this cheap and easy-to-acquire liquidity has given borrowers the ability to borrow their way out of trouble and has created leverage of unprecedented levels on the borrowers' side.

When defaults begin to rise, investors will feel the impact, which presumably they expected as an investment risk. Hedge funds will feel the pinch, too, and gradually they will tighten credit markets, creating more defaults.

Before long, these defaults will begin to cause failures at the hedge funds themselves. Because of high leverage, a shift in the market could create a failure at any number of hedge funds. Observers saw this dynamic recently in the failures of several notable hedge funds, including Amaranth Advisors LLC, which, according to reports from TheStreet.com and The New York Times, lost 60 percent of its value within a single week because of bad investments in natural gas.

But the impact of hedge funds failures will not end with the funds themselves. In fact, much like past restructure waves, the banks are likely to be the parties exposed to the final financial risk, because they have been the primary source of leverage to hedge funds. According to Bloomberg, this was the result in Amaranth, where J.P. Morgan Chase & Co. and Citadel Investment Group LLC took control of the remaining assets after the fund's failure.

If that pattern holds true elsewhere, the banks will have to sort through investments that lack their customary protections and that have greater leverage than ever before. The irony here is great, especially considering that it was the banks' own aversion to risk -- and therefore their reluctance to take on investments such as those the funds now make -- that gave rise to today's funds in the first place.