When Prime Brokers Fail E-Book

J. S. Aikman

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg
• Sprache: Englisch

Seitenzahl: 375

Veröffentlichungsjahr: 2010

Beschreibung

An informative primer on the new landscape of leading prime brokers

Before the recent financial crisis, both regulators and market participants disregarded the complex and dangerous nature of the relationship between prime brokers (the banks) and their clients (the funds). In When Prime Brokers Fail, J. S. Aikman examines the convoluted structure of this relationship, the main participants, and the impact of the near collapse of prime brokerages on the financial world.

Filled with in-depth insights and expert advice, When Prime Brokers Fail takes a close look at the unheeded risks of prime finance and lays out the steps required for managers to protect their funds and bankers to protect their brokerages.

• Examines the challenges, trends, and risks within the prime brokerage space
• Discusses the structural adjustments firms will need to make to avoid similar disasters
• Analyzes the complex relationship between hedge funds and their brokerages and the risks that multiply in extraordinary markets
• Covers new ways to manage an inherently risky business and the regulations that may soon be introduced into this arena

Engaging and informative, this timely book details the intricacies and interdependencies of prime brokerages and the role that these operations play in our increasingly dynamic financial system.

Leseprobe

Table of Contents

Praise

Title Page

Copyright Page

Dedication

Acknowledgments

PART I - The Business

Chapter 1 - Extraordinary Markets

Lessons Learned

Euphoria and Crisis

An International Crisis

Understanding Prime Finance

Chapter 2 - Fundamentals of Prime Finance

Lending and Borrowing

Prime Finance Services

The Current Market

Chapter 3 - Strategy and Opportunity

Corporate Strategy

Business Strategy

Prime Broker Due Diligence

Goal

PART II - The Players

Chapter 4 - Hedge Funds

Original Hedge Fund

Objective: Absolute or Relative

Hedge Fund Structures

Limited Direct Regulation

Income: Trading vs. Investment

Private Investment Strategies and Transparency

Investment Strategies

Long or Short Positions

Tax Efficiency

Special Investors

Illiquid Investments and Control

Incentives

Conclusion

Chapter 5 - Hedge Fund Managers and Investment Advisers

Fund of Hedge Funds

Hedge Fund Manager

Manager Fraud: Madoff

Conclusion

Chapter 6 - Prime Brokerages

Synthetic Prime Brokerage

Due Diligence on Prime Brokers

Chapter 7 - Prime Brokerage Business Model

Prime Broker Agreement

Chapter 8 - Securities Lending and Financing

Stock Loan Economics

The Benefits of Short Sellers - The practice of stock loan and ultimately ...

Stock Loan Due Diligence

Rehypothecation

Why Lend Stocks?

Risks of Stock Loan

Stock Loan Custodians

Repurchase (Repo) and Financing Transactions

Chapter 9 - Executing Brokers

U.S. and Global Considerations

Terms of Business

Executing Broker Market

Commission Sharing

What Is Commission Sharing?

Conclusion

PART III - The Risks and Rewards

Chapter 10 - Life Cycles

Planning and Establishment

Capital Introduction and Capital Raising

Launch

Growth

Maturity

Termination

Chapter 11 - Risk Management

Prime Brokerage Risk

Risk in Prime Finance

Counterparty Risk

Systemic Risk

Holistic Approaches to Risk

Chapter 12 - Legal and Compliance Issues

Prime Broker Regulation

International Prime Brokerage

Markets in Financial Instruments Directive

The Regulatory Concerns

Chapter 13 - What the Future Holds

Long-Term Capital Management

Extinction and Resurrection

Hedge Funds

Trust and Fraud

Financial Entrepreneurship

Financial Innovations: Derivative Market and Securitization

Systemic Risk

Enforcement and Authority Over Systemic Risk

Regulation

Appendix A - Prime Broker List

Appendix B - List of Securities Lenders

Appendix C - Prime Broker Due Diligence Questionnaire

Appendix D - Useful Links—Prime Finance

Bibliography

Glossary of Useful Terms

About the Author

Index

Praise for

When Prime Brokers Fail

The Unheeded Risk to Hedge Funds, Banks, and the Financial Industry

“When Prime Brokers Fail is an excellent primer on the new landscape of leading prime brokers that emerged from the credit crisis. Jonathan Aikman has accurately captured the massive shift in the prime brokerage industry that occurred as a result of the need for banks within an increasingly global and complex hedge fund industry.”

—JONATHAN HITCHON Co-Head of Global Prime Finance, Deutsche Bank

“As someone who has worked on both sides of the street over the past fourteen years this is the first time I have seen such a succinct layout of the way things really are. Whether you have been in the business for twenty years or are just interested in how the machine really works, this is a must-read.”

—STEPHEN BURNS Director of Electronic Equity Trading, Wellington West Capital Markets

“Jon Aikman’s book provides a great review of the world of prime finance and its interaction with hedge funds. It is an essential guide to understanding why so many hedge funds failed during the 2008 crash, and why so many will continue to fail in the future.”

—FRANÇOIS LHABITANT, PhD Chief Investment Officer, Kedge Capital Professor of Finance, EDHEC Business School

“Aikman does a masterful job of examining and explaining the intricacies and interdependencies of prime brokerages and the role that these operations play in our increasingly complex financial system. In providing this thorough analysis, Aikman lends valuable insights into how the financial crisis, hedge funds, and regulations have impacted the area of prime finance and the broader banking and investing market. This book will be a valuable tool for students of finance, regulators, and practitioners from novice to veteran for years to come.”

—PETER J. SHIPPEN, CFA, CAIA President, Redwood Asset Management Inc.

“This is a must-read text for every hedge fund manager, investment banking executive, and prime brokerage professional. Our team searches daily for new great resources on prime brokerage to help build our web site on the topic, and this is hands down the #1 most educational resource on the challenges, trends, and risks within the prime brokerage space that we have ever come across—well over $10,000 worth of advice and valuable explanations contained here.”

—RICHARD WILSON Founder of Prime Brokerage Association and PrimeBrokerageGuide.com

Copyright © 2010 by J. S. Aikman. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada.

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Library of Congress Cataloging-in-Publication Data:

Aikman, J. S. (Jonathan S.)

Includes bibliographical references and index.

ISBN 978-1-57660-355-0

1. Hedge funds. 2. Brokers. 3. Investment banking. 4. Investment advisors. 5. Financial services industry. 6. Financial risk. I. Title.

HG4530.A395 2010

332.64’5—dc22

2009053602

For Penny Aikman-Freedom:

“To strive, to seek, to find, and not to yield.”Lord Tennyson, Ulysses

Acknowledgments

This work is an initial effort to explore one of the most complex, obscure, and increasingly important parts of international finance. As the Chinese proverb states, “It is better to light a candle than to curse the darkness.” I have been fortunate to stand on the shoulders of giants in completing this work, but all errors, omissions, and shortcomings are my own.

Thanks to the various individuals who assisted my understanding with their experience, intelligent discussion, insightful comments, and relevant criticisms. A special thanks to Jonathan Hitchon and Barry Bausano, Co-Heads of Global Prime Finance at Deutsche Bank, and many others from Deutsche Bank. Eric Sprott of Sprott Asset Management provided invaluable insights into the markets, derivatives, and its financial institutions. Special thanks to Stanley Hartt, Chairman of Macquarie Capital Markets Canada Ltd. for his astute analysis of the markets and the challenges for the future. Thanks to Steven Lofchie, partner at Cadwalader, Wickersham & Taft LLP for his profound insights and his invaluable work Guide to Broker Dealer Regulation; and thanks to the many other managers and professionals at BONY Mellon, JPMorgan Chase, and other leading firms. I wish to express my profound thanks to the many top managers and professionals in international and domestic prime finance and executing brokerage services that I have had the pleasure to know and learn from, including Nick Rowe, Neil Swinburne, Christopher Monnery, Jeanne Campanelli, Matthew Brace, Timothy Wilkinson, John Quaile, Jonathan Asher, and the inimitable James K. Cunningham.

I would like to acknowledge and thank my editor, Evan Burton, and other professionals at Bloomberg Press. Evan’s expertise, diligence, and judgment improved the book immeasurably, and I am very grateful for his efforts. Also, thanks to Kevin Commins, Mary Daniello, and the other professionals at John Wiley & Sons. There are a host of others whose courteous assistance and intelligence assisted with this work, including Nabil Meralli, Chris Fearn, Stephen Burns of Wellington West Capital Markets Inc., Peter Shippen of Redwood Capital and Ark Fund Management Ltd., Bill Fearn, Stacey-Parker Yull, Allan Vlah, Thomas Sarantos, and Victoria Ho, and many others. Also, this work required a significant amount of research from both international and U.S. resources. Matthew Anderson was a diligent researcher for many daunting tasks.

There are many other friends, family, intellectuals, professors, and organizations that also deserve my gratitude for their influence and support, including Oxford University, the Saïd Business School, Brasenose College, Queen’s University, the University of Toronto, Rotman School of Management, Bloomberg Press, the Chartered Alternative Investment Association, Canadian Hedge Watch, Professor Mark Ventresca, Professor Chris McKenna, Dr. Michael Ruse, Dr. Richard Spratley, and finally my friend and mentor, Dr. Robert M. Freedom.

PARTI

The Business

1

Extraordinary Markets

The euphoria of the equity and debt markets that caused investment banks like Bear Stearns, Merrill Lynch, and others to take massive proprietary and operational risks is gone. These risky assets were taken on leverage and as a result, the five major independent investment banks have been transformed, bankrupted, or acquired. Lehman Brothers went bankrupt. Merrill Lynch and Bear Stearns have been acquired by Bank of America and JPMorgan Chase respectively. The premier remaining prime finance firms, Goldman Sachs and Morgan Stanley, are no longer independent. The capital base of the investment banks was risked and lost. The critics and risk managers who warned of the hazards of mixing leverage with speculative investments were terminated, excluded, and vilified prior to the global financial crisis.

The euphoria of the markets, or euphoric episode, has historical precedence. Speculation has been here before and undoubtedly shall return again, whether it is “tulips in Holland, gold in Louisiana, real estate in Florida. . .”1 Once the pendulum of diligence and risk management has swung in favor of a new technology, commodities, or new “riskless” financial instruments that offer easy wealth, then greed will undoubtedly rise in some new, unanticipated form. After all, the financial markets are driven by individuals with a vested interest in their success.

Figure 1.1 Leading Prime Brokers and Lehman

As the economist John Kenneth Galbraith noted, after the Great Depression, “the euphoric episode is protected and sustained by the will of those who are involved, in order to justify the circumstances that are making them rich. And it is equally protected by the will to ignore, exorcise or condemn those who express doubts.”2

However, to blame any one party for the global crisis is overly simplistic, and fails to identify the underlying factors and causes of the current financial crisis. It also fails to yield an understanding of how to reduce the probability of a recurrence or an even worse scenario. The speculation, leverage, and vulnerability of investment banks and financial firms was exposed by the crisis.3 The consequences of highly improbable scenarios were felt by all investment banks, prime brokers, and hedge funds in some form (see Figure 1.1).

Lessons Learned

Today the international economic environment of euphoria has been punctured. Investor and public confidence and trust in the financial system have eroded considerably. That is hopefully a polite way of saying that the bubble has burst, and we are left with the sober task of reviewing the lessons to avoid yet another crisis. A variety of different reports have reviewed the causes, factors, and effects of the financial crisis.4 In the financial crisis, we learned that:

• Investment banks can and do fail.

• The failure of investment banks, and prime brokers, threatens risks to hedge funds, investors, banks, and ultimately systemic failure.

• Hedge funds provide diversification (and some spectacular results), but do not provide absolute returns in bull and bear markets.

• Hedge fund and broker-dealer managers have been responsible for simplistic frauds on sophisticated clients and advisers.

• Ratings agencies have been unable or unwilling to assess risk accurately.

• Banking and securities regulators were not able to protect the public, investors, or the financial system even with extraordinary regulatory actions.

• Leveraged financing and a massive derivatives market pose a danger to the stability of major banks, financial institutions, insurance companies, pension funds, and even governments.

• Financial innovation and leverage are both important sources of financing but may pose individual, firm, and systemic risks.

• The assessment of risk has been misguided and systemic risks created by interlinkages have not been transparent or understood.

There was a slow chain of antecedents and consequents, causes and effects that impacted the global financial system. The financial reckoning took some time to arrive, but like a tsunami, it was foreseeable to those who looked for the signs, or had an interest in its arrival.5 The global economy has now contracted broadly and deeply. The current crisis in the global economy, financial markets, and international banking system is profound, with no simple solution.

Euphoria and Crisis

The euphoria of private equity, leveraged buyouts, and massive mergers and acquisitions which drove the capital markets into 2007 has disappeared. The bubble in the U.S and U.K housing markets, consumer spending, and easy access to credit fueled the subprime crisis, which brought about catastrophic contractions in liquidity and financing in the debt markets starting in the summer of 2007.

The result in the markets was a massive shift away from mortgage-backed and asset-backed securities and their derivatives. Those individuals and institutions left holding subprime securities had a new name for them: “toxic waste.” The mortgage market downturn in the United States and increasing default rates led to the credit crunch, which in turn led to other consequences, particularly for prime brokers and hedge funds.

In early 2008, Bear Stearns was a leading prime broker. In attempting to catch a falling knife, Bear Stearns’s hedge funds tried to call the bottom of the market. Bear Stearns was hit broadside by the subprime blow-ups of its proprietary hedge funds and other mortgage-backed securities. Their distress caused many financial firms to reduce or eliminate counterparty risks. Prime broker clients removed significant assets from Bear Stearns, fearing that bankruptcy would impact their collateral assets. The impact of the toxic assets on its balance sheet, and a declining prime broker business, made the discount acquisition by JPMorgan Chase, with the support and financing of the U.S. federal government, the only reasonable option other than bankruptcy.

On May 30, 2008, Bear Stearns was acquired by JPMorgan Chase.6 Bear’s toxic assets were subsumed into JPMorgan Chase’s balance sheet with assistance and guarantees from the federal government.7 The Bear Stearns prime broker business continued on under JPMorgan Chase, and hedge funds soon returned their business. The prime finance market continued with business as usual until September 2008.

On September 7, 2008, two of the most significant financial events in modern history occurred. The public did not seem to focus on Fannie Mae and Freddie Mac possibly because of their status as semigovernmental organizations. Their distress and conservatorship did not immediately signal the crisis that was to follow. However, for the balance sheet of the U.S. federal government, whether one cuts a check (decreases assets) or assumes the liabilities of an organization (increase liabilities), the financial impact is the same. The sudden conservatorship of Fannie Mae and Freddie Mac were truly colossal financial and political events. With combined liabilities of approximately 6 trillion dollars, the financial risks of these entities were shifted to the U.S. federal government. The federal government’s action prevented a total collapse of the housing, mortgage and debt markets, but their efforts would not prevent collateral damage to investment banks, financial firms, capital markets, and the OTC derivatives market.

Lehman Brothers

Lehman Brothers was considered by many to be the most vulnerable of the major bulge bracket investment banks. The concern for the future of the bank was public and widely discussed in the media given its public failures to raise capital or find a suitable partner.8 Yet many observers remained optimistic to the end that Lehman Brothers would find a partner. There was no white knight to save the struggling investment bank, however, as there had been for Bear Stearns and would be for Merrill Lynch.

At close of business on September 12, 2008, Lehman Brothers Holding Inc. (LEH) ended trading at $3.65. On that day, Lehman Brothers international operations took extraordinary steps to rehypothecate customer collateral assets and utilized them for financing with a series of stock loan and repo transactions. This is not surprising as the investment bank was struggling for financing. Lehman Brothers did not receive a bailout from the federal government. At the end of the day, the international prime broker, Lehman Brothers (International) Europe, transferred approximately $8 billion from London to the parent holding corporation in New York. The cash swept out of the United Kingdom and other international locations was not returned. Hedge funds assets and other clients had their assets rehypothecated, liquidated, and the cash sent out of the jurisdiction. This was reportedly a normal sweep of cash and securities back to New York in extraordinary times. However, it effectively wiped out the international investment bank and its international clients, some of which were banks, financial firms, and hedge funds.

The Lehman Brothers parent holding corporation had the power to decide which of its hundreds of discrete subsidiaries would receive financing. On Monday morning Lehman Brothers Holding Inc. (LEH) started trading at $0.26, down approximately 93 percent. Some Lehman Brothers entities would receive financing to continue active operations at least for a limited period, while other entities were forced into bankruptcy immediately. The return of the collateral assets remains the source of contentious litigation as the clients and creditors to the international investment bank were effectively left with unsecured claims against a bankrupt firm with minimal assets and extensive liabilities. The battle to return collateral has been further fueled by the rather awkward disclosure that the discount acquisition by Barclays Capital of Lehman Brother’s U.S. brokerage operations resulted in a reported windfall profit of $3.47 billion.9

The long, slow path of Lehman Brothers to bankruptcy pointed out the frailty of unfavored independent broker-dealers and the effects of imposing market discipline over systemic risks. It also exposed the vulnerability of the independent investment banks which were not deemed to pose systemic risk. Not since the junk bond kings, Drexel Burnham Lambert had a major broker-dealer become bankrupt. The Lehman Brothers bankruptcy appeared to be justified in order to restore market discipline leading up to the event and even at the time of the initial bankruptcy filing on September 15, 2008. The potential for systemic failure and contagion was not immediately clear.

Further, the experience of Bear Stearns may have made investors, financial firms, and hedge funds complacent that a government bailout or eleventh hour acquisition was forthcoming. A variety of investors had started negotiations with Lehman Brothers, but for one reason or another, had passed on direct assumption of the business. In light of the massive liabilities to the derivatives and debt markets, potential suitors preferred to scavenge the remaining assets (including many skilled Lehman Brothers’ employees) rather than acquiring a distressed business poisoned with toxic assets and a troubled business model.10

Lehman Brothers’ market capitalization and businesses dropped rapidly prior to its bankruptcy. Ultimately, Lehman Brothers revealed how interconnected the banks, financial institutions, and hedge funds had become. The Lehman Brothers bankruptcy had a catastrophic effect on prime broker clients, stock lending funds, and money market funds which provided liquidity to the markets and were significant holders of ultrasecure short-term U.S. government debt. Lehman Brothers’ bankruptcy created broad trading and massive derivative exposures for many of its counterparties. Similarly, credit default swaps on Lehman Brothers created huge gains for some hedge funds and created corresponding liabilities for less fortunate counterparties, such as AIG.

After Lehman Brothers’ collapse, brokers and banks stopped trusting each other. Hedge funds stopped trusting the investment banks and their prime brokers. No hedge fund, prime broker, or investment bank wanted exposure to any other party. Hedge funds reduced their leverage significantly, and the deleveraging cycle of the investment banks and other firms continued. Investment banks reduced lending and the leverage available to clients, and banks ceased lending and borrowing from each other.11 Normal financing transactions ground to a halt after September 16, 2008.

The Run on Money Market Funds

When the damage was revealed the markets panicked. There was a flight to safety. Investors sought only the safest investments; traditionally short-term U.S. government debt was such a safe haven. Money market mutual funds are huge purchasers of U.S. short-term debt, and on September 16, 2008, the Reserve Primary Fund, the oldest money market mutual fund, reported substantial exposures to Lehman Brothers. These exposures to Lehman Brothers reduced the money market mutual fund’s net asset value (NAV) to approximately $0.97. By dipping below a NAV of $1.00, the Reserve Primary Fund had “broken the buck.” Although this is only a small loss, it is an extremely rare occurrence, and it had a massive impact on already nervous and falling markets. If the most liquid and safe investments could lose money, then was any investment safe? Other money market mutual funds soon came under similar pressure from investor redemptions. The run on money market mutual funds and securities lending funds had begun and involved some of the most systemically important firms, including the Bank of New York Mellon.12 U.S. money market funds were redeemed at a record pace. The run on money market mutual funds contracted liquidity and threatened to cause the liquidation of other funds such as the Putnam Investments Prime Money Market Fund.13

The money market funds are important sources of liquidity for the international markets and especially for broker-dealers. The run on money market mutual funds resulted in massive contractions in liquidity as redemptions threatened to swallow up available cash reserves. Updates and assurances from money market mutual funds attempted to allay concerns, including statements of exposures to various notable market counterparties, such as AIG, Morgan Stanley, Goldman Sachs, and Washington Mutual.14 Notwithstanding these assurances, institutional investors continued redemptions as the shocking revelation that U.S. money market mutual fund investments were potentially worth less than holding cash set in.15 The money market mutual funds reported that initial waves of redemptions came from institutional investors. Due to the mechanics of their redemption waiting periods, redemptions from retail investors had not even been processed but loomed in the following week.

In response, the U.S Department of Treasury announced an emergency program to insure the holdings of any eligible money market fund to guarantee that if the fund dropped below a NAV of $1.00, it would be restored to $1.00.16 The run on the money market mutual funds was stemmed by the insurance program, as the Treasury guarantee of the money market funds was effectively a guarantee that the fund would always be as good as holding cash. Thus institutional and retail investors ceased redeeming money market investments. This was a particularly important step for the U.S. government as the liquidation of the U.S. money market funds would have dumped significant amounts of U.S. short-term debt on the international market. The run had the potential to cause a total collapse of the U.S. debt market and may have resulted in a run on treasuries and ultimately the U.S. dollar if the money market funds were liquidated and contagion spread. This in turn would have posed systemic risk by preventing the government from financing multitrillion-dollar bailouts and stimulus packages, potentially leading to the collapse of the international reserve currency.

A run of a different kind occurred with prime brokers. The remaining two elite prime brokers—Morgan Stanley and Goldman Sachs—had massive collateral holdings in their prime finance businesses. Their clients, the hedge funds and other investment funds, reduced leverage, sold out of their positions, and withdrew collateral at alarming rates. This was an indirect run on the prime brokers, who were forced to return cash and collateral that had previously been used for financing them. The run on the free-standing investment banks saw clients move assets to perceived safe havens, including custodians and universal banks. The universal banks that benefited were able to offer security, transparency, and the potential for support from governments in the United States and internationally.

Many U.S. financial firms had reportedly been targeted by short sellers. In some cases, the significant drop in the value of financial firms was attributed to abusive short sales, while in other cases it was merely investors liquidating long positions, and falling equities markets globally. On September 19, 2008, the SEC issued the first short-selling ban for an expanding list of U.S. securities firms, banks, and other financial institutions. The various regulators around the world followed suit in a haphazard cascade of similar, but distinct, short-selling restrictions. The short-selling ban was designed to limit the pernicious acts of abusive short sellers who were pounding falling financial stocks with additional short positions, and even naked short sales. The result was a spiraling decrease in the value of the bank and financial stocks around the globe. The short sellers were not stopped from creating short positions, which had a variety of other structures, derivatives, and financial instruments to achieve their investment goals. However, the short-selling restrictions did impact the financing of the broker-dealers. Broker-dealers were unable to utilize stock loan and repo transactions to finance operations on the stocks, and this further limited the available financing at just the time when they could afford it least. The result of a run on the prime brokers by clients removing collateral and their inability to finance with remaining stocks deprived the independent investment banks of necessary sources of financing.

There was pervasive confusion and fear throughout the international financial system and markets in September 2008. Of particular concern to hedge funds were the solvency, security, and transparency of Goldman Sachs and Morgan Stanley. One week after the largest bankruptcy in U.S. history, Lehman Brothers’ $683 billion in assets, both Goldman Sachs and Morgan Stanley were registered as bank holding companies. Why was the transformation to deposit-taking financial institutions necessary? The structural changes were required in part for financing. It was necessary as hedge funds, investment banks, and other counterparties stopped lending and borrowing from these independent investment banks. The hedge funds continued to withdraw their collateral assets as they had with Lehman Brothers and Bear Stearns, and institutional counterparties restricted or eliminated exposures. A combination of concerns captured investors, and forced hedge funds into a prisoner’s dilemma. The fear of a deep-freeze of collateral assets similar to what happened at Lehman Brothers, hedge fund manager’s concerns about fiduciary duties to their investors, and ongoing efforts to mitigate and diversify risks against prime brokers all led to removal of collateral assets and a run on the prime brokers. The removal of collateral assets is critical for prime brokers as fees, expenses, and financing are derived from these collateral assets. The other banks, hedge funds, corporations, and institutions stopped lending and borrowing as liquidity evaporated and counterparty default concerns became pervasive and paramount. Deleveraging of the banks and prime brokers and the removal of hedge funds’ collateral assets increased in this tumultuous period.17 After the dust settled, we have some insight as to where the hedge fund assets, cash and securities, were transferred. Notable beneficiaries of the change in the prime finance market were large universal banks, and significant amounts of the business transferred to the perceived safety of European banks with U.S. affiliates.18

In the extreme liquidity crisis after Lehman Brothers’ bankruptcy, the financing model of the independent U.S. investment banks failed. The only remaining lender was the lender of last resort, the Federal Reserve. However, only banks with secured financing such as triparty repo agreements may have access to the Federal Reserve window. On September 21, 2008, the elite prime brokers, Goldman Sachs and Morgan Stanley, were transformed into bank holding companies, a previously unthinkable option. This last registration, while apparently minor, was a significant event in that it changed the investment bank’s regulatory regime and allowed for direct financing by the Federal Reserve.

The important lesson Lehman Brothers revealed was that independent investment banks were highly leveraged and vulnerable to liquidity shocks. Hedge funds were exposed to significant counterparty risk to their prime broker, particularly in the international sphere where domestic protections were absent. Hedge funds liquidated positions, reduced leverage, and withdrew collateral and funds from the remaining independent investment banks.19 The concern for clients’ collateral spiraled into a category five securities run. By the end of October 2008, all the free-standing investment banks were extinct and hedge funds were sitting on record amounts of cash.

The Lehman Brothers bankruptcy was a catalyst for the financial crisis in the fall of 2008. The crisis precipitated catastrophic effects for prime brokers, investment banks, financial institutions, and the international equity and credit markets. Other victims of the financial carnage included MBIA, Wachovia, and Washington Mutual, and many smaller banks. There were just as many near misses as well. Many other firms and banks were financed only by the grace of the Federal Reserve, FDIC, and U.S. federal government initiatives such as the Troubled Asset Relief Program (TARP). These firms include AIG, Chrysler, General Motors, GMAC, American Express, and many others.20 The other aspects of the bailout were financed by raising more debt. Thus without stemming the run on major money market funds and other systemically important banks and firms, the entire U.S. financial system would have been placed in jeopardy.

Broker-dealers, investment banks, and universal banks were challenged in 2008. Many hedge funds were totally annihilated in the crisis. The breadth and number of hedge funds that became distressed, redeemed, voluntarily closed, or blew up was unprecedented. There were legal, operational, and investment pitfalls. Some funds made catastrophic investment decisions to remain highly levered in volatile markets. Others managed to navigate the storm in the markets, to avoid failures of prime brokers, and rejected investments in toxic assets were still redeemed by nervous investors. Institutional investors pulled more and more capital from the alternative investment asset class in both struggling and successful funds. The fear of complete global meltdown, coupled with frauds and failing trust, became pervasive in the financial industry. It did not help that, on average, the hedge fund industry lost capital. While there were notable exceptions of superior management and exceptional returns, the poor industry average performance and egregious cases of fraud led to record redemptions. The myth that hedge funds perform well in both bull and bear markets was dispelled. However, it is important to note that hedge funds did not precipitate, nor were they central to, the crisis.

Many institutional investors redeemed hedge fund investments across the board. Nowhere were the strains or implications of unprecedented markets felt more than in the area of prime finance. Although it is not a cause of the crisis, prime finance is the intersection of investment banks and hedge funds, and their investors. Prime finance is the axis point of many important actors on the world financial stage. Prime brokers are primarily responsible for leverage and may provide liquidity to the individual investors, hedge funds, and markets. The complexity of the relationship should reveal that the prime brokerage model is largely a safe and preferable form of secured financing. In fact, the prime finance model is designed to protect prime brokers and the larger financial industry from failing hedge funds. Although the hedge funds borrow from prime brokers, they also provide important sources of financing for them in the form of cash and collateral securities posted with the prime broker. The interrelationship and complexities of the services provided are among the most complicated in international finance.

The effects of a prime broker failure require a detailed examination of the fallout from Lehman Brothers. The Lehman Brothers bankruptcy was an international failure. It revealed the complexity of the prime finance market and the need for clarity, transparency, and security over assets held with prime brokers. Major hedge funds with billions in assets were caught wrong-footed and had their assets frozen with Lehman Brothers in the United States and internationally.

An International Crisis

The Lehman Brothers bankruptcy was an international failure that continues today. The parent holding company, Lehman Brother Holdings Inc. (LBHI), took only days to fail, but the cascade of effects will take years to come to completion.21 Lehman Brothers Inc. (LBI) was a subsidiary of LBHI. LBI was the primary trading vehicle in the United States and stood as one of the largest broker-dealers in the world. The European broker-dealer, Lehman Brothers (International) Europe (LBIE) was brought down early while the U.S. prime finance operations continued for a number of days. LBIE is a U.K. limited liability company largely responsible for trading and financing activities in Europe and internationally.

When LBHI declared bankruptcy in the United States on September 15, 2008, under Chapter 11 of the U.S. Bankruptcy Code, a huge range of other subsidiaries and Lehman Brothers’ vehicles were drawn into the bankruptcy.22 The many other vehicles relied upon the parent holding company for daily financing. LBIE relied on LBHI for funding. LBHI had regular sweeps of cash to and from the parent company in the United States. The collapse into bankruptcy of LBHI had the effect that all the other Lehman entities that relied upon LBHI for funding were forced into insolvency with it.

Many of the more than one thousand hedge funds which held collateral assets within Lehman Brothers were prime broker clients. The effect of the bankruptcy has been catastrophic for many funds which have been forced to liquidate remaining assets and terminate operations.23 Some funds tried lobbying governments and exigent litigation to free their collateral assets from the bankruptcy.24 It was estimated that approximately $40 to $65 billion in collateral assets were frozen and may be unrecoverable in the LBIE bankruptcy.25

Many of these hedge funds had relationships with both LBI, the U.S. broker-dealer, and LBIE, the non-U.S. international broker-dealer. There were prime broker and margin lending agreements in place with many of these funds. In some cases, under the prime broker agreements, LBI maintained the Prime Broker Account and LBIE maintained the Margin Lending Account. LBI in turn transferred the collateral securities to LBIE, which was authorized to make loans and provide other ancillary services. The collateral assets posted with LBIE served as collateral to secure any obligations from lending or the provision of services. Like other prime brokers, the Margin Lending Agreement provided that LBIE was authorized to lend the securities to itself or others, to pledge, repledge, hypothecate, and rehypothecate the collateral assets. The power to do so was largely unrestricted except as contractually agreed. However, LBIE was required to pass through any payments, distributions, or dividends paid on the collateral assets.

The administrators of LBIE in the United Kingdom were faced with the overwhelming task of overseeing the bankruptcy administration of a multibillion-dollar international trading company, making Lehman Brothers the largest and most complex bankruptcy in history.26 When the U.K. administrator in bankruptcy applied for directions on amounts held on trust or any proprietary claims to the bankruptcy court, the bankruptcy court ordered the trust and proprietary amounts held to be identified and separated from the property of the bankrupt. However, this was a more difficult task than originally anticipated.

When the U.S. and U.K. bankruptcies occurred, many were surprised by the complexity and differences in the two regimes. One of the challenges was to manage expectations of the creditors in fundamentally different systems. In the U.S. bankruptcy regime, there is a generally accepted predisposition to allow reorganization of a business as a “going concern.” Lawyers lead efforts to restructure the business in the United States. In the United Kingdom, the administration is dealt with by accountants and the majority of bankruptcies result in liquidation.

Hedge funds were facing devastating markets and broad redemptions. There were delays and confusion resulting from the Lehman Brothers collapse. Four investment funds sought the assistance of the bankruptcy administrator in the United Kingdom and asked the bankruptcy court to return their collateral. The bankruptcy effectively froze the positions of the hedge funds indefinitely. Several hedge funds with assets located at Lehman Brothers attempted to compel the bankruptcy administrator to return collateral assets on an expedited schedule while their identities remained strictly confidential.27 It was feared that if their identities were revealed, investors would immediately redeem their investments and hedge funds business would be finished. The initial expedited efforts to return assets were unsuccessful. The administrator pointed out that LBIE had more than one thousand prime brokerage clients that had assets frozen in the bankruptcy administration. The hedge funds that attempted to have the assets returned on a priority basis were rejected. They stood in a similar position to other creditors, and their collateral securities had been utilized by Lehman Brothers prior to the bankruptcy.

The difficulty for the administrator of the bankruptcy is that all the prime broker clients, hedge funds, and others stand in a similar position. The bankruptcy judge reiterated the detailed due diligence on Lehman Brothers’ books:

[The administrators] say that in order to determine whether to accede to a client request for the re-delivery of securities and monies provided by way of collateral, they must carry out a variety of tasks:

(1) Investigate and obtain definitive information on closing, reversing, unwinding or otherwise dealing with any unsettled trades which may affect the client’s account, (2) ascertain the client’s holding of securities and monies in accordance with the LBIE database once it has been fully updated, (3) conduct a reconciliation of LBIE data and records held by LBIE’s custodians and resolve any difference or disparities, (4) establish whether and how securities may have been reused, (5) establish whether and how monies provided by way of collateral are held, (6) determine the extent of any indebtedness of the client to LBIE and any other Lehman Group entity and whether there are other reasons for the exercise of LBIE’s lien over the securities, and (7) establish whether other clients had interests in the stocklines of the securities held in each custodian account in case there should be a competing claim to the securities in the event of a shortfall.28

This detailed analysis is required to ensure that competing claims are recognized and that creditors are dealt with fairly and equally. One problem with immediately returning securities is that the LBIE books were a moving target, with assets and liabilities constantly changing. For example, there were more than 140,000 failed trades as a result of the bankruptcy, which resulted in additional claims for and against LBIE.

Also, the actions of LBIE prior to the bankruptcy effectively moved all assets, rehypothecating and lending out securities and utilizing them for financing transactions. The resulting cash from financing securities was transferred to the U.S. parent company at the end of September 12, 2008, leaving nominal assets in LBIE. The problem for the prime brokerage clients was in the location of securities and details of related transactions. The bankruptcy judge outlined the problem for applicants in seeking to have their assets returned immediately.

[The Administrators] state that, like many other LBIE prime brokerage clients, the applicants held long and short market positions, had borrowed securities to cover short positions and had long assets which were re-hypothecated. They explain that, under the contractual arrangements entered into with the applicants, LBIE was entitled to use the applicant’s assets as collateral for loans to its clients, to lend securities to cover the settlement of short sale transactions, to pledge securities to market counterparties in order to collateralize obligations and to lend the securities to other market counterparties. They state that from the data available it would appear that as of 12 September 2008, being the last available date at which information from the LBIE database is available, LBIE had extensively exercised its right to re-use collateral securities that the applicants had provided and that, from enquiries made, some of those securities may have been transferred to LBI with whom the applicants had their main prime broking relationship and that other securities may have been provided to other third parties as collateral for other transactions. They also explain that LBIE holds, in segregated client accounts with third party custodians, securities which have been provided to it by way of collateral and that the client account in question is simply a pooled fund of assets which may belong to a number of different clients. They explain that it is segregated only in that it contains assets beneficially owned by clients rather than LBIE itself.29

The collateral assets which were extensively reused as collateral for other financing transactions were now the property of the counterparty. The bankruptcy of Lehman Brothers was an event of default. The event of default crystallized financing and made the collateral the property of the other party which could not be claimed back. With a significant amount of collateral being extensively utilized immediately prior to bankruptcy, the terms and good faith of the transactions will be questioned in future litigation, but these actions moved collateral assets with LBIE to other counterparties, including LBI. Finally, there were difficulties in how the collateral assets were held with Lehman Brothers. Efforts to segregate client accounts that end up in pooled client accounts are of limited value.

[The administrators] are not able to say with certainty whether securities can be returned in full to any given client or whether a shortfall exists which must be shared pro rata across all client holdings. . . . They explain that until the reconciliation of each stockline or each custodian-held client account is carried out, a process which they say will take a long time, it will not be possible for [the administrators] to return assets to clients.30

The collateral assets were held with third-party custodians. Client assets were segregated from proprietary firm assets. However, client assets were allegedly lumped together in a pool of clients’ assets or pooled client accounts. The value of a segregated account is diminished and undermined if the client assets are not clearly separated and distinguishable from other client assets. The segregated client accounts may ultimately prove to have sufficient assets; however, it is possible that due to the extensive rehypothecation and utilization of client assets, along with transfers to the other Lehman Brothers entities, recovery will not be possible.

There is also a jurisdictional challenge for the clients who hold accounts from both LBIE and LBHI. The jurisdiction of the collateral holding may fall to either the English regime (which dictates that PRIMA prevails) or the American regime in which the explicit agreement in the Account Agreement governs the assets, subject to U.S. law and the dictates of The Hague Securities Convention.

The Lehman Brothers bankruptcy has led to massive changes in the prime broker market and counterparty risk assessments. Lehman Brothers’ default stands as an important example of the challenges in addressing multinational issues in prime brokers in the future.

Lehman Brothers also changed the way the parties to prime finance assess risks. Traditionally, prime brokers have been concerned about hedge funds blowing up, not the other way around. From LTCM’s blow-up in 1998, to Bear Stearns’ distress in the spring of 2008, systemically important firms were not allowed to fail. A major bulge bracket investment bank has long been considered “too big to fail.” The failure of Lehman Brothers and its prime brokerage business led to a paradigm shift.

The unthinkable scenario of a leading prime broker failure quickly became a stunning reality on September 15, 2008. Suddenly, hedge funds that ignored the lessons of failures like Refco and Bear Stearns were finally forced to ask primary questions about prime brokers and to differentiate between the creditworthiness of prime broker counterparties, that is, between independent prime brokers and universal banks. What is the probability of the credit default of the prime broker? What transparency is there into the prime broker entity? What is the governing regulatory regime? And how are the various assets held by a prime broker differentiated, segregated, and accounted for? Prior to Lehman Brothers, all prime broker counterparties were thought of as the same. Suddenly, it was critical to differentiate between prime brokers and establish clear and unambiguous answers for worst case scenarios.