naked capitalism

I somehow managed to fail to connect the dots on this one. When Morgan Stanley and Goldman, the far and away two biggest prime brokers (as in lenders to hedge funds) became banks, tougher regulatory requirements forced them to curtail hedge fund lending significantly.

To give you an idea of the concentration in this business, Morgan, Goldman, and number three (until late 2007) prime broker Bear Stearns had among them 70% market shares, with some sources saying as high as 75%. So with all three now regulated as banks, the reduction in credit availability, even absent adverse market conditions, margin calls, and redemptions, is considerable.

From Roger Peston at the BBC (hat tip reader Doc Holiday):

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.