Hedge funds fret over bank counterparty risks

Date: Friday, October 28, 2011
Author: Tommy Wilkes, Reuters

* Some hedge funds change prime brokers after CDS spikes

* JP Morgan, SEB, HSBC see rise in business

* Post-Lehman reforms mean moves are still small

LONDON, Oct 27 (Reuters) - Hedge funds, with memories of the havoc wreaked by Lehman's demise still fresh in their minds, are moving away from banks singled out by markets as higher risk, giving rivals a chance to grab lucrative business serving these key clients.

Banks such as JP Morgan , HSBC and SEB have all seen hedge funds soliciting the services of their prime broking desks, which lend money to these specialist asset managers and provide back-office services.

"We have seen a significant increase in hedge funds moving business over to us recently, especially since September," said Chris Barrow, global head of sales for prime services at HSBC.

Three $1 billion-plus funds moved business to the British bank in a single day earlier this month, Barrow said.

The collapse of Lehman Brothers in 2008 exposed hedge funds to billions worth of frozen trades they were unable to close, often also finding that assets they thought were safe had been lent out to other parts of the bank. These worries have returned with the Euro zone debt crisis.

If a prime broker runs into problems related to its parent company, hedge funds may suddenly be asked to pay back their loans, forcing the fund to conduct a firesale of assets, potentially at knock-down prices.

Most funds now conduct their trades across multiple prime brokers, and demand more assets are held in safer, segregated accounts, limiting for now the extent of big shifts from one broker to another.

Nevertheless, the lessons from Lehman are prompting some funds to spread their business more widely, which could challenge the dominance of heavyweights such as Goldman Sachs and Morgan Stanley in an industry that generated around $10 billion in revenues in 2010.

Hedge funds, keen to placate investors still angry about past losses, are now closely watching the cost of insuring bank debt against default as a gauge of counterparty risk. This is measured by derivatives known as credit default swaps (CDS).

"I'd expect people to have been monitoring it... and some people will definitely have done something about it," said one hedge fund executive, asking not to be named.

The cost of insuring the debt of banks such as Morgan Stanley and Bank of America Merrill Lynch is now double that of some rivals.

"It's a major issue," said one investor in hedge funds. "No-one wants to be put in the same situation again (as with Lehman). The wounds are still too fresh."

DON'T PANIC

Morgan Stanley, one of the largest players in the fiercely competitive industry, saw the cost of insuring its debt, based on 5-year CDS, rocket towards 600 basis points in early October.

It has since fallen to around 320 bps, but this is still more than double levels seen in July, according to finance industry data provider Markit.

Societe Generale , which jointly owns prime broker Newedge with Credit Agricole , has seen its 5-year CDS rise to around 270 bps from less than 130 bps in July, though the spread was falling on Thursday after Europe's leaders struck a deal to provide debt relief for Greece.

Bank of America Merrill Lynch's 5-year CDS is more than 300 bps.

The 5-year CDS spreads for JP Morgan and Credit Suisse -- which has expanded in prime broking -- have also risen in recent months, but still trade at less than 150 bps.

The trigger for funds to move may be a specific level, which prime brokers and hedge funds say can be a CDS spread upwards of 300 basis points, or higher.

Morgan Stanley and Newedge declined to comment.

The re-emergence of so-called counterparty concerns as a result of the euro zone debt crisis has also had an impact outside the hedge fund community

Large agencies and companies have also been shifting their derivatives exposure, particularly from the U.S. investment banks.

DOMINANT PLAYERS

Sensing the appeal to hedge funds of a strong counterparty, some banks are now winning more business away from the traditionally dominant players.

Atilla Olesen, SEB Enskilda's Head of Prime Brokerage and Securities Finance said the Swedish bank was winning business from managers citing counterparty concerns.

"Sometimes it is the whole book and sometimes it is part of the book, depending on strategy and geography," he said.

JP Morgan, which captured Bear Stearns prime broking desk when it bought the bank in 2008, launched a complete prime services for European hedge funds in June.

The firm had seen some transfers, said a source familiar with the situation, but the moves were "not massive", reflecting a wide consensus that while some assets were being moved, the quantities were nowhere near 2008 levels.

The bank declined to comment.

JP Morgan was the biggest prime broker by assets in the second quarter of this year, capturing almost 28 percent of the market, ahead of Goldman Sachs' 20 percent and Morgan Stanley's 14 percent, according to data from Hedge Fund Research.