Leveraged finance

Leveraged finance

The threat to corporate America

Myanmar: first-mover advantage?

Myanmar: first-mover advantage?

The opening of Myanmar to the outside world

Prime brokerage: The day the music stopped

For the hundreds of hedge funds caught up in the collapse of Lehman Brothers International’s prime brokerage, it might take years to claw back securities entrusted as collateral. Some face destruction through rehypothecation. It’s the first case of its type, and now the entire structure of prime brokerage is under scrutiny.


"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.

"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."

The case of LBIE has shed light on the difference between rehypothecation regulation in the US and Europe. In the US, prime brokers can only rehypothecate securities held on margin. In Europe, by law some prime brokers can claim ownership of all cash and securities held with them even if the account is not in debt and securities are being held long. This enables them to offer higher leverage. Not many prime brokerages take advantage of this difference in regulation but industry participants say that Lehman was particularly aggressive. James says he opened his account with Lehman Brothers in the US but it was suggested that he open an account with LBIE to enable enhanced margin. He had $9.6 million in equities in a long account with no debt that had more than 75% of securities rehypothecated. "We were not aware Lehman could borrow those stocks," says James.

He says: "The administrator is stating that to the extent Lehman rehypothecated our stocks we may have lost our proprietary interest in them and thus are now general creditors in the bankruptcy. We thought and were told our securities and our cash were segregated and further insured by Capco," says James. He also has emails showing that Lehman Brothers in the US assured him his wires would go through and that his securities would be safe. James also says he was unaware that he was dealing with a UK entity subject to different regulations because his account was set up in the US and automated and handled by US employees at Lehman Brothers. A former Lehman Brothers prime brokerage employee, however, says that the firm made it clear to all clients if the UK-based LBIE was being used and pointed to the differing regulations.

Whether or not US funds will be reluctant to use European arms of prime brokers is up for debate. James says he, for one, is reluctant, and the head of an introducing prime broker in the US says he has seen money coming back onshore. US hedge funds maintain that UK law is archaic and should be changed to protect prime brokers’ clients, and some have complained to the Bank of England.

Aaron Vermut, Merlin Securities

"There are simply fewer prime brokers out there with which fund managers feel safe putting money"
Aaron Vermut, Merlin Securities

An official at the UK Financial Services Authority says the regulator will be taking a look at rehypothecation regulation. However, the head of a European prime brokerage based in the US says that rehypothecation regulation is not the issue. "The problem with LBIE is that the corporate structure allowed the arm to be simply lopped off by the US broker/dealer instead of Lehman Brothers in the US having to take responsibility. This is not about regulation, it is about counterparty credit risk. If funds thought their counterparty was Lehman Brothers in the US and that they would be protected under US regulation, then they were given very bad advice. Lehman Brothers took the decision to let the UK arm go under. PwC had to go in. That is what happens when a firm goes bust. Similarly, the counterparty was a broker/dealer and not a bank with access to deposits – there is another risk right there. If they want to take it out on someone, take it out on the advisers who told them their counterparty risk was minimal but who are now claiming it’s simply ‘those damned Europeans and their liberal laws’".

A second head of a prime brokerage is more diplomatic, saying that it was a case of let LBIE go under or let the US prime brokerage go under, and the former was chosen. He too argues that the structure was risky. "Look at Bear Stearns. When that collapsed, the prime brokerage, BSCC, was protected as it was a daughter company and kept separate." One source close to PwC says the administrator did try to procure a sale of the Lehman business to Barclays but that the bank was not interested. "The US arm took the money out of the UK so it had no money. The firm was insolvent. PwC had to move in. If people are upset, they should blame the US arm and the questionable structure in place," he says.

Rehypothecation jitters

Regardless of where the prime broker is based, the issue of tracking down rehypothecated assets at LBIE has made some hedge funds nervous about where to hold their long securities, and whether they will allow them to be rehypothecated at all. Hedge funds in the US can agree to have their long securities rehypothecated in order to make money. This can be a couple of basis points in the case of a readily available security such as McDonald’s, or, for stocks that the market is looking to short, as much as 10% can be made on lending that security. "You can make a lot of money by lending your long securities, but there is increased scrutiny around the potential risks of participating in these programmes," says Jeremy Todd, director at Pershing Prime Services. "It’s important for firms to work closely with a service provider that has the proper operational risk controls in place to best facilitate these programmes."

Reducing the amount of securities lending is problematic in the present environment. The ban on short-selling in several countries has already sent a signal to the market that shorters are bad, and some holders of long securities such as pension funds have stopped lending stock. A senior manager at a prime broker estimates that 10% of the world’s equity has been withdrawn. That’s not too big a dent. However, if hedge funds also become reluctant to make securities available for rehypothecation, liquidity will further dry up.

"Everyone’s primary focus seems to be on liquidity, in the many forms that issue takes. The ban on short-selling had a negative impact on trading liquidity and important downstream consequences for cash reinvestment liquidity," says Greg DePetris, co-founder of independent securities lending firm Quadriserv. "As some beneficial owners responded to the ban by choosing not to continue lending securities, the overall supply of lendable securities was reduced. Then, as open loans were recalled and custodial or agent lenders were forced to return cash collateral to their borrowers, lenders were collectively attempting to sell many of the same short-term financing instruments at the same time, and more importantly when not many people were buying them. So the impact on short-term money market liquidity has also been profoundly negative. If short-selling continues to be viewed as an essential component of capital markets, then there will need to be a liquid supply of lendable securities, and the two largest pools historically have been the institutional lending community and stock held at broker dealers, so the notion of rehypothecation is clearly important."

"For safekeeping of assets, hedge funds will increasingly turn to the universal banks or the big players who have strong custodial businesses"

Michael Spellacy, Boston Consulting Group

Michael Spellacy, Boston Consulting Group
Alex Ehrlich, global head of prime brokerage at UBS in New York, says that in any event, liquidity is too tight to demand rehypothecation be stopped by the industry. "If rehypothecation is stopped, then essentially the prime broker is just lending out unsecured money. In a credit crisis, unsecured money is going to be almost impossible to find. Banks’ unsecured funding is at a premium right now."

Counterparty risk

Rather than refusing to agree to rehypothecation, hedge funds need to focus on counterparty risk. Up until now, counterparty risk has been only a minor consideration when selecting a prime broker. Now it is crucial. Andrew Lodge, managing director at Nedgroup Investments, a fund of hedge funds, says his firm has always looked at prime brokers’ credit quality when selecting hedge funds to invest in. Now, though, it is even more diligent. "The problem is that there are now fewer safe prime brokers," says Lodge, "so our exposure to prime brokers through our underlying managers is more concentrated than before. It’s a tough environment that requires constant diligence."

Goldman Sachs, Morgan Stanley and Bear Stearns held the keys to the prime brokerage gates for years but the demise of Lehman Brothers has tarnished the entire reputation of broker/dealers. "Broker/dealers are good for trade and execution, but for safe keeping of assets, hedge funds will increasingly turn to the universal banks or the big players who have strong custodial businesses," says Boston Consulting’s Spellacy. "We will see significant turf wars and, in some cases, funds are even breaking apart the prime brokerage value proposition to have long and even short positions held at a custodian, and financing and trading shared among prime brokers." Morgan Stanley reportedly lost 25% of its prime brokerage assets from the middle of October.

One head of a prime brokerage in the US says he knows of a $3 billion hedge fund that has for weeks been treating Morgan Stanley as if it were out of business by removing money and stopping counterparty trading. One hedge fund manager goes so far as to claim that the bounce in the US stock markets the afternoon before the short-selling ban was announced was not because the ban was being anticipated and therefore market concerns were eased but rather that on that particular day hedge funds were trying to get out of Morgan Stanley’s prime brokerage business at such a rate that they were buying in short positions so that they could more easily switch prime brokers.

Although concerns about Morgan Stanley’s creditworthiness have pushed clients out of the door, exits have been exacerbated by chief executive John Mack’s public demands for a ban on the short-selling of financials. "All is fair in love and war right now but so blatantly biting the hand that feeds you has put noses out of joint," says a hedge fund manager. He also says Goldman Sachs is on the receiving end of ill will from some managers because of its involvement with the short-selling ban and the bail-out. "Deflecting wrongdoing by finger-pointing to short-sellers is cowardly. And that Goldman Sachs has so much sway over the Fed, government and the SEC through its ex-employees does not ingratiate it with the hedge fund community right now. Especially when it makes so much money from that very community." Goldman Sachs makes as much as $900 million a quarter in revenues from prime brokerage, although competitors believe hundreds of billions of dollars have left the firm over the past three months as hedge funds have moved parts of their accounts elsewhere. Goldman Sachs was unable to confirm or deny the amount. The firm, which is known for being very selective on which hedge fund clients it will take on, might have to become more welcoming. When or even if the dust settles, it will be difficult for Goldman Sachs and Morgan Stanley to win back clients, say onlookers. "The two firms are obviously world class but they will struggle to build back up their clients’ confidence," says Sameer Shalaby, chief executive of Paladyne Systems, which provides multi-prime enabling technology to funds. Starting up that commercial bank component imposed by the Federal Reserve will take a while and we will see lay-offs at both concerns for some time." John Mack implied as much when interviewed on CNBC in the middle of October, saying that his firm would be reviewing the size of its prime brokerage business.

Spreading the risk

In most cases, hedge funds are trying to spread their counterparty risk by using more than one prime broker, even if using more than one costs more money, so Goldman Sachs and Morgan Stanley are still on the roster.

Sameer Shalaby, Paladyne Systems

"Perhaps the smallest hedge funds will end up being $500 million in size"

Sameer Shalaby, Paladyne Systems

It’s about time that hedge funds started moving to new prime brokers, says Chris Momsen, senior vice-president at Advent Software. "Most prudent investors will expect a hedge fund to have multiple prime brokerage relationships established and they will expect the hedge fund to have the infrastructure necessary to manage those relationships. The days when a hedge fund attracting institutional capital could rely on a single prime broker for their reporting and data collection are over."

Deutsche Bank, Credit Suisse, BNP Paribas, UBS and JPMorgan have all been beneficiaries of the move to a multi-prime broker set-up. Before the collapse of Lehman Brothers, banks were seen as the pricey option as prime brokers. "No one wanted to pay us the extra for being a bank when they could use a broker/dealer but now they appreciate the incremental risk involved in being with a broker/dealer and are OK with the extra cost," says the head of a prime brokerage division of a global bank. The massive movement of accounts has got some prime brokerages running 24/7 account opening services in the US, says one hedge fund manager.

One head of an introducing prime broker claims that JPMorgan has seen so much interest from hedge funds that it is offering zero interest on some cash accounts. Officials at JPMorgan did not respond to the allegations but other industry participants said they would not be surprised. "With short-term money rates so low and at times yields even negative, why should JPMorgan say it will pay interest on cash – particularly when managers are knocking at their doors because they are deemed one of the safest houses on Wall Street right now?"

Indeed, it might seem somewhat counter-intuitive but the blow-up of one prime broker might well increase the cost of having a prime broker at all. "There are simply fewer prime brokers out there with which fund managers feel safe putting money," says Aaron Vermut, COO of prime brokerage services and technology provider Merlin Securities. With fewer prime brokers to choose from, he says, we might in the future see increased rates and margin requirements.

Furthermore, revenues from prime brokerage look set to decline as the number of hedge funds decreases and trading slows. In the short term at least, prime brokers will be forced to increase prices to compensate for the drop in revenue. One can only imagine that regulatory requirements for prime brokers will be tightened over the coming year. One prime broker says he believes that buried in the Fed bail-out is a regulation that will prove onerous to prime brokers’ reporting responsibilities and that will be a cost burden that will have to be passed on to clients. Bail-out specialists were unable to confirm this fact. "It’s 700 pages of more Christmas decorations than the North Pole. I wouldn’t be surprised if there is something buried in there though that requires greater transparency and monitoring of buys and sells, which will no doubt increase costs," says a Chicago-based lawyer.

For hedge funds that are already suffering massive losses because of market moves, the extra costs could be enough to put them out of business.

"I wouldn’t be surprised if rates go up. For now it is the right thing for hedge funds to do – accept the rates, secure the assets and renegotiate down the line," says Shalaby. "But it will shake out the smaller hedge funds that can no longer afford to operate. Perhaps the smallest hedge funds will end up being $500 million in size."

It’s yet another hurdle for funds like the ones James runs. Of the $25 million he was running that was held at LBIE, only about a quarter is left. "I have very little left, and clients have been very supportive and have suggested I carry on managing what remains and that our assets will be recovered eventually," James says. "But I worry it may take years. And at 60 years old, I’m not sure I want to start all over again."