Brokerage Firms Cut Back Lending, Increasing Credit Crunch

The deleveraging continues.

MarketWatch reports that investment banks are reducing loans to customers, in particular their heretofore lucrative prime brokerage business, which is lending against hedge fund positions.

Now Wall Street itself is less able than before to extend credit. With their equity bases under stress and exposed to further hits, securities firms are reducing the size of their balance sheets. Some of this is necessary, given the higher prevailing risk and lower capital levels; some of this is precautionary, representing a new found conservatism regarding their own and counterparty risk exposures. And many hedge funds have had a bad time lately, with August, November, and January being particularly difficult months.

From MarketWatch:

Some of the world’s largest brokerage firms are reining in lending and other activities that help financial markets function smoothly because they’re facing funding problems of their own, experts said on Monday.

The actions of firms including Goldman Sachs, Morgan Stanley , Lehman Brothers and Bear Stearns are rippling through markets, making life more difficult for hedge funds and other leveraged risk takers and disrupting how some municipalities borrow money….

“Fearful lenders are tightening credit standards,” Brad Hintz, an analyst at Bernstein Research, wrote in a note to clients on Monday. “It is not a happy period of Wall Street.”…

Brokerage firms get the money they need by borrowing it in the market, while big banks like J.P. Morgan Chase get a big chunk of their funding from customers who deposit cash in bank accounts.

That means brokerage firms are more vulnerable to swings of risk appetite and aversion in capital markets. As the credit crunch has spread, investors have become less willing to lend to these firms, increasing their borrowing costs.

This can be seen in the market for credit-default swaps (CDS). These derivatives pay out in the event of default, so they appreciate in value when the perceived creditworthiness of a borrower declines.

Five-year CDS spreads on Goldman Sachs have more than doubled to 180 basis points since late December, according to Lehman Brothers data. A basis point is one hundredth of a percentage point. Morgan Stanley spreads have also more than doubled to 220 basis points. CDS spreads on Merrill, Lehman and Bear also have surged…..

With higher borrowing costs and capital being whittled away by mark-to-market write-downs, brokerage firms have started pulling back from some markets, causing broader problems.

These firms are pivotal to the smooth functioning of financial markets because they help companies and other entities finance their activities by securitizing assets, arranging initial public offerings and syndicating corporate loans.

“The subprime mess has damaged the balance sheets of investment banks and brokerage firms,” said Vladimir Belinsky, president of Hermitage Advisors Ltd. “These firms are at the core of our financial system and the extent of this is a lot worse than people thought.”

Brokerage firms’ retreat may have had the biggest effect on the $2 trillion hedge fund industry. Goldman, Morgan Stanley and Bear Stearns are the world’s largest prime brokers, leading money and securities to hedge funds.

When prime brokers lend less to hedge funds, or do so on more punitive terms, managers often have less money to invest and may even sell some positions to raise cash.

Several hedge funds have been hit by margin calls recently. This happens when securities bought with borrowed money lose value. If they drop too far, brokers require more cash be deposited in an investor’s account to support the position or else sell some of the assets….

Such disruptions in hedge fund land may be bad news for the broader market, Hintz said.

“The logical risk takers — hedge funds — are finding their sources of financing being pulled on them,” Hintz said. “These are the most willing traders to step into troubled markets. But if you don’t provide them leverage, then they can’t do it.”

Other businesses have also been hit by margin calls, particularly those operating in the mortgage market.

Thornburg Mortgage Asset Corp. lost more than half its market value on Monday after the home loan company said it got roughly $270 million of margin calls late last week and couldn’t meet some of those demands. Thornburg counterparties may declare the company in default and liquidate assets backing those financing agreements, it said….

Brokerage firms have also pulled away from auction-rate securities, which are part of the municipal bond market, raising the cost of borrowing for some municipalities…

“In the past, the brokerage firms would step up,” Belinsky said. “But because of their weakened balance sheets, they haven’t stepped up now.”…

“All these things are tied together seemingly with bungee cords,” Hintz said. “When you pull on one cord, it takes a little time, but all the other parts of the system get pulled down, too.”, too.