Morgan Stanley loses nearly a third of prime brokerage assets last week

Morgan Stanley lost close to a third of assets in its prime brokerage last week, amounting to hundreds of billions of dollars, as hedge funds panicked after the collapse of Lehman Brothers and moved to rival banks.

The losses, confirmed by several people familiar with the business, will deal a big blow to Morgan Stanley as its prime brokerage is one of its most profitable and successful businesses.

The flight of cash and stock out of the division occurred as spreads in the credit default swap market ballooned, but has since slowed to a trickle, these people said. Morgan Stanley declined to comment.

Several of Morgan Stanley's hedge fund clients said they were likely to return to the bank once markets stabilised. The prime brokerage, which provides hedge funds with custody and loans and assists short selling, is highly rated by many managers.

Many of the world's biggest hedge funds moved their assets to commercial banks regarded as safer last week, as they and their investors worried that Morgan Stanley could follow Lehman into trouble.

"The primary thing our investors have been trying to understand is counterparty risk," said the head of one large London fund.

Morgan Stanley's London prime brokerage lost closer to half its assets, as hedge funds worried about fellow funds caught up in the collapse of Lehman who found they could not access assets in Lehman's European arm.

The withdrawal of client assets is likely to make Morgan Stanley's business less profitable by restricting its ability to fund loans to hedge funds from balances left by other hedge funds.

But the prime brokerage business - which reported record quarterly profits this week - appears to have stabilised after the proposed US government bail-out led to soaring markets.

Rival bankers and several hedge funds said many are continuing to talk to competitors about adding additional prime brokers, but the sense of urgency has dropped.