It's the Prime Brokers Now!

I have included below an excerpt from Peston’s Picks, the blog written by Robert Peston of the BBC.

Read it and form your own opinion, but I think he is looking at a number of concurrent events and (mistakenly) trying to create direct cause and effect links that don’t exist.  Or am I reading it wrong?

Mr Peston suggests that the Ukraine and Hungary are victims of the current environment of deleveraging, a lack of credit availability, and plummeting share prices, that was caused “to a large extent, by an unprecedented shrinkage in the prime brokerage industry”.  

Two trends undoubtedly exist:

• Deleveraging across banks, fund of funds managers, hedge funds and yes, prime brokerage businesses is having a substantial impact on the markets;
• Credit seems to be only available to those that don’t need it, and even then is only grudgingly given, and at exorbitant prices;

The question arises as to how much of the deleveraging is being driven by the direct business contraction of the prime brokers as Mr Peston suggests and how much is due to other reasons?

The feedback I get is that while the investment banks clearly have been trying to reduce balance sheets for the past year, there are two more important factors.  First is simply a lack of trading opportunities that require leverage in the first instance.  This is evidenced by the huge pools of cash that many hedge funds have been sitting on for much of this year.  If you can’t spend your free cash, you don’t need leverage.  Second, many investors have been disappointed with the performance of their alternative investments.  Investors go into alternatives for two reasons:  one is for absolute returns and the second is to get returns that have low correlation with their traditional investment portfolios.  Despite the fact that hedge funds as a group have outperformed most, if not all, market indices, disappointment abounds.  Further, many judge that alternatives have also failed on the diversification issue as well.  Simply put, their traditional funds have gone down, and so have their hedge fund investments, so investors haven’t really gained any risk reduction by adding the alternatives.

I think that the contraction of the PB business is part of the overall credit crunch/liquidity crisis, but I think it is too much of a leap for Mr Peston to write that the current market environment is caused to a large extent by PB business shrinkage.

Where I do agree wholeheartedly is with his final paragraph.  Governments can't meddle in markets without causing unintended consquences.  That is why they should stay out.

Agree/Disagree – Tell me what you think!

" Ukraine and Hungary are trapped in the vice of the last phase of deleveraging, or the reduction in credit being provided by banks and other investors, and the decline in the real economy.

As for this most recent phase of the withdrawal of credit, which has caused financial crises for a series of emerging economies in eastern Europe, Asia and South America (see "Now there are runs on countries") and also global falls in share prices, it was in a way wholly foreseeable.

It was caused, to a large extent, by an exceptional and unprecedented shrinkage in the prime brokerage industry, which in turn led to a serious reduction in the volume of credit extended to hedge funds, which in turn forced hedge funds to sell assets, especially those perceived as higher risk.

This contraction in loans provide through prime brokers was the inevitable consequence of the collapse of Lehman, but also - far more importantly - of the recent conversion into banks of Morgan Stanley and Goldman Sachs.

Morgan Stanley and Goldman are - by far - the biggest prime brokers, with Morgan Stanley the number one.

But as banks, they're prevented by regulators from lending as much relative to their capital resources as they had been as securities firms.

So the US authorities should have known - and presumably did know - that by allowing Morgan Stanley and Goldman to become banks they were in effect forcing a serious contraction in the hedge-fund industry, which in turn would lead to sales of all manner of assets held by hedge funds and precipitate turmoil throughout the financial economy.

Which, as if you needed telling, only goes to show that regulatory intervention carried out with the best of intentions can have consequences that - in the short term at least - can be very painful. "