Prime hedge fund worries

Date: Wednesday, November 26, 2008
Author: Scot Blythe, Advisor.ca

The collapse of Lehman Brothers didn't just take down the whole investment banking model of Wall Street; it also put the squeeze on a significant number of other investments, including principal-protected notes and hedge funds.

Lehman's PPNs, while notionally powered by various stock indexes, were actually senior unsecured obligations for a company now in bankruptcy. Noteholders will join a long list of creditors, unless the banks that sold the notes decide, as in Canada's asset-backed commercial paper turmoil, to make clients whole.

Similarly, its London unit, Lehman Brothers International, served as the prime broker for some offshore hedge funds. More than half the collateral hedge funds put up to cover short sales were "re-hypothecated," that is, they were mixed with brokerage assets and loaned, for a fee, to other investors. Those collateralized securities are now frozen with PricewaterhouseCoopers, LBI's British administrator, as it sifts through claims to determine beneficial owners.

That unprecedented failure has caused many to rethink securities lending, which facilitates short sales, and to take a hard look at the credit quality of the prime brokerage. It also affected some offshore funds at one prominent Canadian manager, Salida Capital. It also shows up regulatory differences between prime brokerage in the U.S. and Europe. In Europe, all the cash and securities held in an account can be used as property of the brokerage, even if the account holder has no debt or short exposure. By contrast, U.S. and Canadian prime brokers can only re-hypothecate, or "onlend," securities held on margin.

In the current financial crisis, it is short selling that has attracted the most attention, with the executives of many failing or beaten-up companies blaming hedge funds for their market losses. One consequence was that when the United States unveiled its financial industry bailout in September, 799 stocks were put on the do-not-short list. Many other regulators followed suit, including Canada, with banned short sales in 19 stock issues.

Fears of instability generated by short sales are overblown, says longtime Canadian hedge fund manager Chris Guthrie. In both New York and Toronto, the market cap of the short interest — outstanding shares sold short — is roughly 2% of the total market cap of all stocks.

In fact, Guthrie, who was speaking yesterday at a panel discussion organized by the Canadian chapter of the Alternative Investment Management Association, says short sales are relatively underused in the Canadian marketplace.

And that, he argues, makes for market inefficiencies. He cites the U.S. Securities and Exchange Commission, which has acknowledged that short selling contributes to price discovery, mitigates market bubbles, increases liquidity, promotes capital formation, facilitates risk management and hedging, and limits upward market manipulation.

Securities lending is a small part of overall market activity, says James Slater, senior vice-president of capital markets at CIBC Mellon, a custodial bank.

For an institution that has signed on to a securities-lending program, the incremental income, he argues, is one of the purest forms of alpha returns, with very low risk. While it is a form of leverage, Slater likens it to the "oil that keeps the securities market going."

In a securities loan, an institution, using a custodian as an agent, receives a fee from a broker, usually a prime broker, bank or investment dealer, who puts up collateral, generally government securities, but, increasingly, cash. While the title of the security is transferred, there is no actual disposition of the securities for tax purposes.

Assets that can be lent globally amounted to $14.6 trillion at the beginning of September. That has fallen to $11.7 trillion by the end of October, thanks to market losses, Slater says. In Canada, the lending universe constituted $1.1 trillion in September and is now down to $897 billion.

But that's one set of figures; the more interesting set is the amount of securities — both bonds and stocks — that are actually on loan. Right now, it's $2 trillion worldwide and $118 billion in Canada. Not all of that amount is used for short sales; Guthrie calculates it's only $15 billion.

Some loans accommodate trading or synthetic strategies. Also, repos — repurchase agreements — are used for short-term financing. Finally, brokers use loaned stock to make orderly markets between buyers and sellers.

"We used to take great pride in the fact that we have a borrower default — until Lehman," Slater adds.

Now, the Lehman bankruptcy has focused worries for institutional securities lenders in a number of areas. Foremost is the possibility of counterparty default, and along with that, the strength of the indemnities provided by counterparties to insure against losses.

But "prime brokers also need to clear up some of the urban myths," says Colin Bugler, managing director and head of global prime brokerage at RBC Capital Markets. "It's never been a well-understood part of the industry."

The prime broker is so called because it consolidates client accounts into one master account while providing clearing, settlement and custody services, securities lending, leverage and consolidated reporting. A prime broker fulfills the functions of both the traditional custodial account and the traditional brokerage account.

Bugler says the prime broker business model is based on financing and securities lending, with one caveat: securities are not loaned to the hedge fund but delivered to a counterparty and drawn from the firm's inventory or margined securities, or from outside lenders such as custodians and other broker dealers.

The outside lender, therefore, has exposure to the prime broker rather than the hedge fund.

But the current credit crisis has highlighted systemic flaws in the prime brokerage model. That model set margin requirements assuming normal liquidity in markets, and risk modelling did not account for illiquidity.

In addition, the cost of collateral was thought to be close to zero and so too was hedge fund credit exposure to the prime broker. As well, inter-prime broker lending was taken for granted and assumed to take place at benchmark rates. That mechanism seized up in September as banks and dealers stopped lending to each other in overnight markets, and Libor gapped up.

As a consequence, prime brokers have raised the fees they charge for borrowed securities, while the lenders themselves are seeking higher-quality collateral, such as cash. In the future, Bugler also expects more regulatory scrutiny of leverage and tighter margin requirements.

That's something a hedge fund manager like Guthrie would welcome. He thinks "the industry has a lot to do to get the dialogue going," not least in "opening up what is a legitimate process."

Filed by Scot Blythe, Advisor.ca, scot.blythe@advisor.rogers.com