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Morgan Stanley prime broker woes seen lasting

Published: 22 Oct 2008 17:54:18 PST

NEW YORK, Oct 22 - Morgan Stanley survived the recent panic in financial markets, but its prime brokerage business may never fully recover.

More than a third of Morgan's prime brokerage assets went out the door during the past month -- some rivals said attrition could be as large as one-half -- as investors unnerved by the credit crunch lost confidence in the bank.

Across Wall Street, hundreds of investment funds that relied on broker-dealers established accounts with commercial banks boasting stronger credit. The moves have shaken up a business long dominated by Morgan Stanley, Goldman Sachs Group Inc and Bear Stearns.

"It's a $2 trillion business and in normal market conditions, people kill themselves to move 1 percent of market share. In recent weeks, probably 35 to 40 percent of global market share has been redistributed," said Alex Ehrlich, global head of prime services at UBS. "Never has there been a more disruptive period."

For years the business of providing credit, clearing trades and providing other support to hedge funds has been a gold mine for Wall Street. As the ranks of hedge funds soared, these clients generated billions of dollars from loans, trades and services elsewhere at a bank.

Yet the collapse of Bear Stearns in March and by Lehman Brothers last month reinforced the importance of doing business with the most stable counterparties.

Notably, funds that relied on a Lehman London-based broker discovered that $65 billion of collateral was frozen when the company declared bankruptcy. Many funds still cannot get access to their money.

"At the end of the day, hedge fund investors are demanding that their hedge fund manager do more business at universal banks with higher credit quality," said Todd Steinberg, head of Americas equities and derivatives at BNP Paribas in New York.

A Morgan Stanley spokeswoman declined to comment on the prime brokerage business.

SAFETY FIRST

The focus on soundness prompted roughly 1,000 funds who did business with Goldman and Morgan Stanley to shift assets to deep-pocketed banks such as JPMorgan Chase, Germany's Deutsche Bank and France's BNP Paribas, according to industry executives.

In a quarterly financial results filing, Morgan Stanley revealed that its prime brokerage business "experienced significant outflows" since the end of August as clients withdrew cash and moved securities.

Goldman Sachs, which also was forced to raise capital and become a commercial bank, has seen much smaller attrition.

One bank benefiting from the trend is JPMorgan, which said it increased prime-brokerage assets by about 25 percent in the last few months. Some of that represented former Bear Stearns clients -- about 40 percent of balances departed back in March -- returning now that JPMorgan owns Bear Stearns.

A number of second-tier players are also gaining market share, including Fidelity Investments, State Street and Bank of New York Mellon's Pershing unit.

Even UBS, which had its own struggles this year and lost hedge fund clients, in recent months has seen in-flows of tens of billions of dollars.

More recently, the exodus slowed as U.S. government moves eased worries about a financial market meltdown, yet credit fears remain high as shown by credit-default swap markets.

The cost of insuring $10 million of Morgan Stanley bonds for five years remains high at $415,000 a year, compared with $250,000 at Goldman and just $57,000 at BNP.

That said, Morgan Stanley says some fund customers have been returning since the bank strengthened its balance sheet with $9 billion of capital from Mitsubishi UFJ Financial Group, converted to a bank and slashed leverage.

Yet Morgan Stanley Chief Executive John Mack last week said the firm's prime brokerage will likely get smaller. As much as 30 percent of the hedge fund industry is expected to disappear amid weak performance and tighter credit, he said.

"When it does, we need to re-size our prime brokerage business," Mack said in a CNBC interview.

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