UPDATE 1-Morgan Stanley, Goldman change lending systems -FT

(Adds Goldman Sachs)

Aug 18 (Reuters) - Morgan Stanley (MS.N) and Goldman Sachs (GS.N) are responding to the credit crisis with a system that uses the market's view of their own creditworthiness as a basis for lending decisions, the Financial Times reported.

Wall Street's second-largest investment bank Morgan Stanley is essentially tying its promise to provide financing to hedge fund clients to the price of credit insurance on its own debt, it said.

If the cost of the protection rises to a certain level, that would trigger a reduction in Morgan Stanley's commitments to hedge funds, the quoted people familiar with the situation as saying.

The message is that "if our firm is in trouble, we would rather fund ourselves than fund you (hedge funds)," the paper quoted a brokerage executive with knowledge of the arrangements as saying.

Goldman Sachs, which has largely avoided the credit losses hobbling its rivals, is understood to have a similar arrangement that uses its bond prices as a reference point for credit commitments to hedge fund clients, the paper said.

Morgan Stanley and Goldman Sachs did not immediately return calls seeking comment.

Last week, Morgan Stanley and JPMorgan Chase & Co (JPM.N) agreed to buy back billions of dollars of illiquid auction-rate securities and pay fines to settle charges that they misled investors about the debt's risk.

Morgan Stanley had agreed to buy back $4.5 billion of debt and pay a $35 million fine to settle the charges.

In June, it reported a 57 percent drop in quarterly earnings on weak trading, investment losses and a slowdown in investment banking, even after it realised $1.43 billion in one-time gains.

JPMorgan said last week that it had racked up $1.5 billion of losses so far in the third quarter mortgage-linked assets, reflecting deepening turmoil in credit markets. (Reporting by Saumyadeb Chakrabarty in Bangalore; Editing by Paul Bolding)