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Hedge Fund Services Become Banks Lifeline

Date: Wednesday, March 19, 2008
Author: Chidem Kurdas, New York Bureau Chief, Hedgeworld.com

NEW YORK (HedgeWorld.com)—The stock market cheered loudly on Tuesday [March 18] after Goldman Sachs Group Inc. and Lehman Brothers reported substantial drops in earnings. Shares skyrocketed because analysts had expected even worse.

Since the focus is on the dangers of evaporating liquidity and wilting mortgage assets, one item in the financial reports that really merited a cheer, namely prime brokerage, didn't get much attention.

However, Goldman Sachs Chief Financial Officer David Viniar noted during a conference call that the prime brokerage business has grown and continues to grow.

Goldman does not break out hedge fund prime brokerage as a separate category but it provided data on securities services, which includes prime brokerage, financing and securities lending to institutional clients including hedge funds.

Net revenue from securities services for the three months ending Feb. 29 was up 7% from the previous three months. By contrast, during that time Goldman's investment banking revenue dropped by 41% and trading and investments including real estate lost 26%.

For the past year through February, Goldman boosted prime brokerage revenue by 38% to $722 million. If one looked just at that percentage increase, one would be hard-pressed to discern that investment banks are going through a tough time.

But there is risk from failing prime brokerage customers. The collateral that backs loans to hedge fund clients can include mortgage securities and other credit instruments that continue to lose value and are hard to sell.

"We're careful on the financing terms, we have the appropriate margin in place and over the course of years our losses there have been extremely small," Mr. Viniar said, when asked about the collateral held by the prime broker.

"It's not that often that we have to seize assets and when we do, we're generally able to liquidate them pretty quickly," he added.

Lehman Brothers' overall net income shrank 57% from first quarter 2007. Previous article Previous Reuters Story. But while other Lehman businesses went down, equities capital markets revenue increased, driven by continued growth in prime brokerage and execution services, according to the company's earnings release.

Prime brokerage revenues grew in every region despite deleveraging in the industry and shrinking balances, Lehman Chief Financial Officer Erin Callan said on a conference call.

Trade volumes are at all-time highs as traders look to make money from extreme market volatility. Trading boosts prime brokers' commissions, but this is in part offset by other factors such as hedge funds having less to trade with because of reduced borrowing.

Merrill Lynch, the third largest prime brokerage after Morgan Stanley and Goldman, recently saw the largest volumes ever in both cash and derivatives trading, as well as in financing and clearing Previous HedgeWorld Story.

Merrill has not yet reported earnings this year.