Prime broker ranks shaken up for good by crisis

NEW YORK (Reuters) - Last year's market meltdown loosened Wall Street's decades-old grip on the prime brokerage business, and ferocious competition over supporting hedge funds means the old ranks may be shaken up for good.

The collapse of Bear Stearns and Lehman Brothers sparked a run on Morgan Stanley (MS.N) and to a lesser extent Goldman Sachs Group Inc (GS.N), prompting hedge funds to move cash and securities to more stable appearing banks like Credit Suisse (CSGN.VX), Deutsche Bank (DBKGn.DE) and JPMorgan Chase & Co (JPM.N).

Goldman and Morgan Stanley quickly righted this year as markets snapped back, yet the second-tier players have no intention of giving up their newly won premier status, according to a series of interviews with Wall Street's top prime brokerage executives.

"You had an industry that changed at a glacial pace for 20 years go through two years of rapid change," said Barry Bausano, a Deutsche Bank co-head of global prime finance. "Over the past few months, the cement has set."

Behind every hedge fund is at least one prime broker, which lends cash and securities as well as provides custody and other services. It is a high-margin business, one that will generate an estimated $8 billion this year and $10 billion next year, according to the research firm Tabb Group.

Hedge funds also taketh away, as seen last year when anxious fund managers fled the struggling Bear and Lehman and accelerated their collapse. In the darkest days of September, hedge funds worried Morgan and Goldman would be next.

Global Custodian magazine said 44 percent of hedge funds reduced balances with Goldman and 70 percent pulled back from Morgan Stanley.

According to Hedge Fund Intelligence, Goldman earlier this year was top of the heap with $108 billion in Americas hedge fund client assets, followed by JPMorgan at $97 billion, with Morgan Stanley slipping to third with $66 billion.

What emerged was a new order, where JPMorgan, Credit Suisse, Deutsche and Swiss bank UBS AG (UBSN.VX) which picked up meaningful market share in 2008.

"There is much more of an even distribution of business," said Glen Dailey, head of prime brokerage at Jefferies Group Inc (JEF.N), a middle-market firm that also picked up share.

JPMorgan, which acquired a nearly bankrupt Bear Stearns in March 2008 and emerged as a Wall Street leader, gained a top domestic U.S. prime brokerage business that was gutted when hedge funds fled Bear. By the end of last year, JPMorgan says it had lured back many clients and gained new business.

"We had a tremendous amount of new business come in as a result of the flight to quality." said Louis Lebedin, JPMorgan's co-head of prime brokerage. "In terms of exposure to the top 100, the $1 billion-plus funds, we've tripled our share to the highest it's ever been."

Now that most fund managers maintain accounts with two or three prime brokers, partly as a result of last year's collapses, Lebedin said JPMorgan is promoting iSophis, a technology that lets fund managers monitor positions across the various brokers. The big bank also is expanding into Europe and Asia, markets where Bear had little presence.

Another winner of the financial crisis, Credit Suisse, has cautiously added assets from about 70 fund firms, giving it 470 clients, global prime services head Philip Vasan said.

"The lion's share of the business we took in came from existing clients, clients who knew us and felt we had maintained a steady hand," he said.

Vasan also predicted that clients would not return to their old providers now that markets have improved. "The business that came to Credit Suisse in the fall has stayed at Credit Suisse," he said.

FIGHTING BACK

One of the more compelling stories, then, is whether Morgan Stanley can rebuild its prime brokerage business and repair some relationships. Last fall the investment bank cut back prime brokerage and slashed headcount as hedge funds suffered their worst losses and record redemptions.

Hedge fund managers quietly also say the bank made things worse for itself by disparaging short-sellers and seemed to drag its heels delivering on withdrawal requests.

Now Morgan Stanley is rebuilding under Alex Ehrlich, who was recruited from UBS. He told Reuters Morgan Stanley is investing heavily in prime brokerage.

"Are clients coming back? Dramatically, emphatically yes," said Ehrlich. "We are extremely focused on regaining ground."

Morgan Stanley reported that hedge fund balances climbed 10 percent in the second quarter and 14 percent in the third. Ehrlich said the firm's growth rate since last November, when government intervention calmed markets, exceeds that of rivals.

Goldman also saw hedge fund balances plunge, though the firm insists they did not lose many top customers.

John Willian, who took over Goldman's consolidated global securities services, futures and execution division last fall, told Reuters the bank's prime brokerage has grown.

"Our share of the market is roughly unchanged and slightly up since before the financial crisis of 2008. We're continuing to expand our business across several areas," he said.

Goldman Chief Financial Officer David Viniar recently told analysts that the bank's hedge fund balances were down by half, on par with the industry, but moving higher.

The firm was not completely unscathed, as seen with the withdrawal of Stanley Druckenmiller's Duquesne Capital. Willian dismissed the number of clients leaving as "a non-event."

Goldman, which like Morgan Stanley scrambled last fall to raise capital and contended with balky debt markets, cut back on supporting capital-intensive convertible debt funds. Some clients were encouraged to go elsewhere.

Willian said Goldman intends to take advantage of its new bank holding company structure to offer new services. Notably Goldman is expanding administration services for clients. The Madoff fraud and other scandals have made third-party reviews of hedge funds a requirement among investors.

UBS, meanwhile, saw business losses and then gains in the same year. UBS even completed a management swap last year when it recruited Morgan Stanley's Stuart Hendel to replace Ehrlich as its global prime brokerage chief.

The Swiss bank said it also added clients during the past year, gains that followed months of departures triggered by UBS's crippling credit losses and several scandals in its wealth management and private bank operations.

"During the Lehman crisis, we had inflows. We did not see outflows," said Jon Laub, head of U.S. prime brokerage at UBS. "We were part of the back and forth, out of the broker-dealers and into the banks."

All of which sets up what will be an especially competitive prime brokerage world in the coming year, as Goldman and Morgan Stanley use their new bank powers and healthier balance sheets to repair bridges and fight back.

"We won't get every client back, but there will a lot of clients who will listen. More than half have already returned," Morgan Stanley's Ehrlich said. "I hope people don't expect us to roll over, because we won't." (Reporting by Joseph A. Giannone, editing by Gerald E. McCormick)