'Black Box'
Neither Morgan Stanley nor its competitors in prime brokerage -- Goldman Sachs Group Inc., JPMorgan Chase & Co., Citigroup and Credit Suisse Group AG -- disclose the size of their hedge-fund balances, leaving shareholders dependent on regulators who previously failed to rein in the risks.
"It remains a black box," said Adam Hurwich, a former member of the Financial Accounting Standards Board's Investors Technical Advisory Committee who's now a portfolio manager at New York-based investment firm Ulysses Management LLC. "They don't give you the information to be able to decipher whether they have changed anything."
Prime brokers facilitate short trades, the sale of borrowed stock in the hope of buying it back later at a lower price. They also make margin loans to finance stock purchases. In exchange, hedge funds usually keep their cash and stock in accounts at the prime-brokerage companies.
Frozen Assets
Few analysts understood how dependent the brokerages had become on such balances as a cheap source of funding, said Frank Suozzo, a former head of growth financial-services research at AllianceBernstein LP.
"Prime brokerage was presumed to be a pretty secure business, where the funding was not actually part of the liquidity of the bank," said Suozzo, now president of advisory firm FXS Capital LLC in Goldens Bridge, New York. "So if clients pulled their money out, the view was that money had not been lent out, so the cash would have been sitting there able to hand over. It turns out that that was not entirely correct."
In reality, "prime brokers were able to reuse clients' assets to raise cash for their own activities," the financial crisis commission wrote in its final report, published in January. Azarchs said that in her years covering Morgan Stanley for S&P she never heard executives discuss the risk that the funding might evaporate.
Lehman Brothers Holdings Inc.'s bankruptcy changed matters when it froze at least $65 billion of assets held by that firm's London-based prime brokerage. For hedge funds, it was a lesson not to bank with companies perceived to be at risk of failure, according to the commission report. So hedge funds moved quickly to pull their money from Morgan Stanley, viewed as the next weakest securities firm after Lehman, according to the report.
Unregulated, Unrated
Mark Lake, a spokesman for Morgan Stanley, declined to disclose the bank's current hedge-fund balances.