Friday, October 31, 2008

Lehman Europe and Prime Brokerage Counterparty Risk

(Felix Salmon) Euromoney has allowed free access to its November cover story on Lehman Brothers Europe for this weekend only, so go there now and read it while you can. It starts off at much the same place as John Hempton's blog entry from a couple of weeks ago, about the critical importance of the US Securities Exchange Act of 1934. Here's Hempton, on the consequences of the act:

The result. Whilst Lehman brothers went bust, Lehman's US broker dealer did not. This pretty well saved the US hedge fund industry.
Europe however was a different story. Lehman Europe failed - and the clients of the European broker dealer (read a good proportion of the London hedge fund community) are now queuing as unsecured creditors of Lehman. Many funds have folded. Far more have been nicked. Whilst the US hedge fund business is currently looking dazed, confused and a little problematic, the UK business is on life support.
In some sense this is the end of the City of London.

Euromoney's Helen Avery gives some real-world examples, foremost among them Oak Group's John James, who has seen substantially all of his assets disappear into the maw of his prime broker, Lehman Brothers International Europe. And the losses were human, too: after hedge fund Olivant found itself unable to vote its stake in UBS because it was held by LBIE, its CFO threw himself in front of an 100mph train at Taplow station in England during rush hour.

The numbers involved are huge: Avery says that more than $22 billion of its clients' securities were "rehypotehcated" by LBIE, thereby essentially turning those clients into unsecured creditors of LBIE when it went bust.

Avery does add a layer of complexity to Hempton's take on things: while the US legal regime is certainly friendlier to prime-brokerage clients than London law, a lot of the problems ultimately stem from the fact that Lehman Brothers in the US took all of LBIE's money out of the UK just before it folded. In other words, if LBIE hadn't had a rapacious parent which stripped LBIE of all its assets in its final hours, none of this might have happened.

What's more, although UK prime brokers regularly allow themselves to rehypothecate (ie, onlend) their clients' securities, US prime brokers also do exactly the same thing, after first asking their clients' permission. Their clients often say yes, because they can essentially make free money on their long positions by allowing their prime broker to lend them out to short-sellers.

As a result, even US hedge funds are more alert than ever to the issue of their prime brokers' counterparty risk. That means a move away from broker-dealers like Morgan Stanley and towards large commercial banks with a big deposit base, like JP Morgan Chase. Morgan Stanley probably isn't crying too much over the loss of its prime-brokerage clients, since it wanted to derisk anyway. But it's yet another big change in the international financial architecture: prime brokers always used to be investment banks; now those banks are either history or being sidelined, while players such as Credit Suisse, UBS, Deutsche Bank, and BNP Paribas are seeing their prime-brokerage operations grow.

What will ultimately happen to the securities onlent multiple times by LBIE? Will they ever find their way back to their original owners? It's possible, but the best case scenario is that it will take many years. The worst-case scenario is that the money is gone forever, into the $100 billion black hole of insolvency which suddenly opened up when Lehman went bust. If that much money is being lost, it stands to reason that Lehman's hedge fund clients will count themselves among the losers.

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