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"If you gave your assets to Lehman as collateral and they lent those out, then more than one person has a claim on those assets. Everyone passes around the security, then the music stops, there is one chair to sit on and too many people who want to sit on it" |
BY THE TIME of the credit crisis, John James had been running his hedge fund company, Oak Group, for more than 20 years. He set up the long/short equity funds when he turned 40 and had built up a small and loyal client base, in addition to investing all his own money. Since inception, the fund had returned on average about 10% every year, and although this year returns were flatter because of the state of the economy, business has been good. Sadly for James, though, he used just one prime broker to hold his cash and securities, and that broker was Lehman Brothers International.
When the European prime brokerage arm of the US broker/dealer went into administration on September 15, James lost almost the entire $25 million in his funds.
Hundreds of other hedge funds have also lost the assets that were being held with Lehman Brothers’ international prime brokerage subsidiary in London, and many more lost money as trades went unsettled. GLG, RAB Capital and MKM Longboat are on the list of hundreds of hedge funds affected. Not all were as unfortunate as Oak Group, having spread their assets among several prime brokers.
The Chapter 11 filing of Lehman Brothers in the US and the resulting blow-up of Lehman Brothers International (Europe) – LBIE – has sparked a worldwide debate about the prime brokerage industry. For years, they have got fat from providing financing, trading and execution to the burgeoning hedge fund industry. Basic prime brokerage such as execution and trading is a relatively low-margin business but, says Michael Spellacy, who heads the Boston Consulting Group’s alternative investment practice, margins of more than 50% can be made from proprietary trading, financing and securities lending and FX and cash management for prime brokerage clients. Lehman Brothers as a whole earned about $1 billion in revenue a year from its prime brokerage business and, according to research by Boston Consulting Group in June, revenues of all prime brokers purely from hedge funds was $30 billion in 2007.
The system employed by prime brokers of lending money to hedge funds, using securities as collateral and lending those securities on into the market for a fee had, up to the Lehman Brothers’ bankruptcy filing, never been questioned. "No one ever expected a prime broker to fail without a bail-out or some means to keep business going and transfer accounts to another firm. We’ve never had a major counterparty simply shut down before, so this is completely uncharted territory," says Chris Addy, president of Castle Hall Alternatives.
The unwinding of onlending
James’s Oak Group used its prime brokerage in the way that most hedge funds do. It had a margin account that it used to short securities with $16 million in equity to create $22 million of long and $22 million of short positions. LBIE charged James about 7% to borrow on margin. James received 25 basis points under the Fed rate for cash held on deposit with LBIE. In this margin account, all securities and cash belong to the prime broker. The prime broker can lend out those securities (rehypothecation) and charge an interest rate to do so. In the event of a bankruptcy, hedge funds would have no right to these securities unless insured through a governing body.
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"The day before LBIE went bankrupt we asked for $8 million in cash from four funds to be wired to Chase. But when I checked the next day, only two of those wires were done. Their systems couldn’t cope"
John James, Oak Group |
James says that in the run-up to Lehman’s collapse he began to get nervous about having securities on margin with LBIE. "The day before the firm went bankrupt we asked for $8 million in cash from four funds to be wired to Chase. But when I checked the next day, only two of those wires were done. Their systems couldn’t cope with the amount," says James. "It was too late." PricewaterhouseCoopers, the administrator, had moved in and taken over control of LBIE’s assets.
James does not know who now owns the securities he had in his margin account at LBIE. The securities were lent on by LBIE, and given that LBIE is no longer in existence, James says he doubts he will ever see them again. "Without those securities, my strategy has been ruined. Had we had the securities and been able to continue trading, we would have been up about 6% over the last six weeks," he says.
The issue of rehypothecated securities is creating further problems. Take the case of Olivant, a UK-based fund that is a stakeholder in UBS. The fund has been vocal in its attempts to enforce changes at UBS but it was unable to exercise its shareholder vote because its 2.5% stake is held at the defunct LBIE.
In total, it is believed that more than $22 billion of non-cash securities were rehypothecated by LBIE.
PwC has said that it will take at least a year to work out the beneficial owners of the securities and what is owed to clients once assets and liabilities have been netted. Others, including James, are not so optimistic. One consultant to a prime broker says the entire system is a mess. "If you have ever walked around a prime brokerage operation on a Friday afternoon, you would understand the difficulty of LBIE. There are fax machines at these operations spitting out changes in collateral and where securities are going. It’s incredibly inefficient." One hedge fund consultant compares the unwinding of the rehypothecated securities at LBIE to musical chairs: "If you gave your assets to Lehman as collateral and they lent those out, then more than one person has a claim on those assets. Everyone passes around the security, then the music stops, there is one chair to sit on and too many people who want to sit on it. I cannot see how PwC is going to work that out. And I think the outcome will be that Lehman really was too big to fail."
