Prime Broker lending

Dodd Frank is making a lot of noise about making sure that Banks and Broker dealers should put up enough collateral to fund their exposures. The setting up of exchanges to clear Otc trades is supposed to solve the "credit crisis" problem. But the real funding for Brokers and hedge funds happens in what is called the "Prime Brokerage " market. This is the cesspool that the regulators should really be regulating. All the money from the safe Banking vehicle, along with their excellent credit, gets channeled into their Broker dealer arm and on to this Prime Broker market. Here they sell this credit for Prime Broker fees from hedge funds and others, in exchange for funding.

So what you may ask, is the big deal ? This is some complicated mechanism that market participants use to fund their positions. Well the big deal is leverage, poor credit management and large exposures. The very problems that caused the crisis.

Lets start from the beginning. When a speculator, Hedge fund A, takes a position in a Bond, they do not put up the entire face value of the Bond. They borrow the money and buy the Bond, then enter a repurchase agreement with one of the Banks where they sell the Bond today and buy it back tomorrow, then take the cash and pay off their borrowing. Is that too complex - lets take a step back. I want to go long a Bond, but I borrow money from my banker friend to buy it, and then I do a trade with him selling it every night and buying it back in the morning. The difference in price between what I sell at night and buy it back in the morning equals interest that I pay my Banker friend for his kindness. If I do this with stocks, it is a little more expensive. Basically you buy the stocks, pay for it in cash, then you can lend the stock out in the stock lending market up to a maximum of 50% of the value of the position. You get 50% of your cash back, and pay down your borrowing by 50%.

The point of all this is that if you have the credit and relationships in the market, you can take any positions you want. When a Bank lends money, it needs to keep at least 8% of the face amount as regulatory capital. There are all kinds of rules being setup through Basel II & Basel III to make the Banks safe. But the real risk, which is in the Broker dealer market (remember Lehman was a broker- dealer) is simply not addressed. The Repo borrowing that I described above is not limited to “safe” Treasury Bonds. Basically, any kind of junk paper that is issued by the Banks through securitization, ends up in the Repo market. If a Broker/Bank issues a dud note backed by subprime mortgages, a hedge fund that bought that note would then turn around and give the same note back to the Bank, and ask for cash in the Repo market. The Bank/Broker that has one arm that issues the note and another arm that funds borrowings in the Repo market, cannot refuse to take back its own paper as collateral.

So net result is that the speculators can take all kinds of dangerous and illiquid positions and then have the Banks fund it through the Repo market. The Repo and Stock Loan funding markets need to be regulated to ensure that speculators do not take excessively risky positions. Leaving this market up to the self-regulation of Banks is leaving the Barn door open after the last set of horses have bolted and you just spent a ton of money buying new horses. The Bankers have every incentive to put the Bank at risk in exchange for prime broker fees. Hey, if the Bank blows up, we all know the terrible consequences. Basically you get a large Bonus for pulling the Bank through troubled times while Uncle Sam will step in to pick up the check.

Hey Dodd-Frank, nevermind over regulating the banks. Look at the Broker-dealer, Hedge fund Prime brokerage funding nexus.