Emerging Markets Capital Flight Exacerbated By Goldman and Morgan Stanley Becoming Banks

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.

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  1. RK

    So do you think that the belated TARP injections into
    the investment banks was a belated attempt to undo
    the unintended effects of their becoming banks, with
    access to the fed?

  2. Anonymous

    interesting … but any number? how much is the contraction in loans relative to the hedge fund industry?

  3. Viv

    Paulson should’ve known this, maybe there was intent behind it.Remember the sms Dick Fuld sent after meeting with Paulson and learning of his intentions which came to light later on, “kill the bad HFnds + heavily regulate the rest.”

  4. Molly

    It is not clear to me that Morgan and Goldman were immediately subject to the same capital requirements as banks – I thought I read somewhere about a ‘transition period’ – if they were/are, I should think they would have needed a substantial capital infusion, given their leverage levels. The ‘departure’ of Lehman, plus declining assets values are large factors unto themselves.

  5. wintermute

    Regulators likely knew this – but also regard hedge funds as not worth saving. They associate them with predatory capitalism (evil short-sellers etc). In fact they probably believe that hedge funds are more to blame for the credit crisis than government agencies! So they were happy to let them unravel after MS/GS coversion to banks.

    In a normal, free market, with proper banking capital adequancy requirements and controls, sensible regulatory framework and balanced govt budgets – hedge funds would be much smaller. They would be valuable in the role of price discovery – revaluing undervalued assets and culling failing companies with failing business models.

    Will we ever see such a time in the future?

  6. TV

    the capital window was shut for these guys raising money from the market.

    They are tremendously over leveraged with level 3 crap.

    They are in a death spiral.

    Hank Paulson wants to let the hedge funds have it (from his March BSC email)

    The prime brokers, by their very nature, can see hedge fund holdings.

    I wonder how a firm like GS can extract the money it needs to survive if it is against deaths doorstep, has the blessing of Hankie Pankie, and can see the positions of its highly leveraged hedge fund clients?


  7. Matt Dubuque

    Deleveraging on a massive scale was bound to occur. It was simply unsustainable. Risk was priced using inferior models and is now undergoing substantial repricing.

    To deny the inevitability of this process is to deny the objective reality of debt deflation, a delusional occurrence that I have only seen occur in the United States in the declining days of its empire.

    Matt Dubuque

  8. a

    I can’t see any reason why we should cry that hedge funds are going under. One less hedge fund is just one less conduit to enormous compensation by the few. Given that, I don’t see any reason to regret the effect on the market of the unwinding of their positions.

  9. Phil

    This is just another part of “Creative Destruction”
    Because we deal in internet speed, the demise of the hedge fund industry seems slow while the problem banks seem to be taking much longer.

    The sooner the system is cleansed (IMO a couple of years at least) the quicker the healing can start.

  10. thomas j


    You are the one who is delusional if you believe the US is the only country that was in denial regarding debt deflation or deleveraging.

    Just look at the leverage ratio of European banks for starters. They are in far worse shape than their US counterparts particularly with respect to exposure to the emerging markets — the epicenter of the current deleveraging.

  11. DDK

    Well, if this is the case, isn’t it fortunate that the unwinding of hedge funds has not caused another LTCM type of eruption?

    There have been plenty talks about the systematic threat posed by hedge funds. It hasn’t materialized.

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