These arrangements for determining the size of lending commitments to hedge fund clients were being put in place before the collapse of Bear Stearns. But implementation has gathered pace as investment banks seek ways to guard against the sudden loss of confidence - and resulting withdrawal of market funding - that crippled Bear.
The message is that "if our firm is in trouble, we would rather fund ourselves than fund you [hedge funds]", said a brokerage executive with knowledge of the arrangements. He added: "We would only use it if there were a real issue."
Morgan Stanley is essentially tying its promise to provide financing to hedge fund clients to the prices of credit insurance on its own debt. If the cost of the protection rises to a certain level, that would trigger a reduction in Morgan Stanley commitments to hedge funds. Goldman Sachs is understood to have a similar arrangement that uses its bond prices as a reference point for credit commitments to hedge fund clients.
The shift in lending systems is significant because investment banks are powerful forces in prime brokerage, the business of providing loans and other services to hedge funds.
Morgan Stanley's use of the credit insurance market as a basis for lending decisions underscores the extent to which the derivatives market has replaced rating agencies as the final word on creditworthiness.
It could lead to more scrutiny of the reliability of the credit insurance market.