In June this year, Lehman Brothers trustee James Giddens issued a brief, but not insignificant, statement: hedge funds and other brokerage customers of the defunct bank would be paid back in full after having their assets frozen for nearly five years.
About $40 billion in hedge fund assets were frozen as a result of Lehman’s collapse in 2008, of which $22 billion had been re-hypothecated, according to PricewaterhouseCoopers, the administrator for Lehman Brothers International Europe (LBIE).
Re-hypothecation – wherein prime brokers provide leverage to hedge funds which pledge securities as collateral, and the primes on-lend those securities in the market for a fee – is regulated differently in the US than in Europe. Lehman had taken advantage of that fact to offer hedge funds greater leverage.
In the US, prime brokers could re-hypothecate assets to the maximum value of 140% of a client’s liability, and also were not able to use those assets to raise more money than they lent to their customers. Whereas in the UK, there were no statutory limits on the value of assets that a prime broker could re-hypothecate.
Hedge funds were told by Lehman that they could open an account with LBIE to enhance margin financing. Unbeknown to managers, any assets transferred offshore to LBIE were not protected under US law.
When LBIE, the European prime brokerage arm of Lehman, went into administration on September 15, 2008, hundreds of hedge funds had their assets frozen. Most were based in the US, although a small number of Asia-based managers were also caught in the mire. At the time, many managers did not know what percentage of their assets were held offshore by LBIE.
Securities that had been re-hypothecated via LBIE were technically no longer held by the prime brokerage and were simply obligations, making it difficult for hedge funds to reclaim their assets. They ended up lower on the list of Lehman creditors when recovering assets in the bankruptcy process.
“It was almost unthinkable that a major investment bank would default on its obligations, so the idea of re-hypothecation exacerbating the problems associated with an unlikely default were never really appreciated,” says Michael Langton, head of sales for Quality Risk Management and Operations in Hong Kong.
One fallout of the Lehman crisis was the rise of the multi-prime model, with hedge funds splitting assets between at least two prime brokers. While it was already in use among large billion-dollar funds pre-crisis, multi-prime has become much more commonplace among mid- to large-sized strategies after Lehman’s fall.
A hybrid service called prime custody also emerged post-crisis, offering differing models but generally putting hedge fund’s unencumbered long portfolio holdings held in a traditional custodian account while leveraged assets – such as short positions and derivatives – are held by brokerages.
Some hedge funds opt for assets to be held under a custody arrangement similar to that for long-only retail funds, says Glenn Kennedy, head of alternatives sector for HSBC Securities Services in Asia Pacific.
"They are held by the custodian for the benefit of the fund, and in the event there is another Lehman event, those assets will be beyond the reach of any creditor or liquidator,” says Kennedy.
Regulations surrounding re-hypothecation have not changed since the financial crisis, although the Financial Stability Board – an international body – last month issued recommendations surrounding re-hypothecation of client assets. Among them is that brokers disclose plans to re-use the securities as collateral in other transactions and also meet minimum standards in managing liquidity risks.
While there is some criticism surrounding the need for re-hypothecation – similar to debates about short-selling – Kennedy says it serves an important function in the market. “It enables prime brokers to lend stock in order to short. Shorting is an integral part of in the industry and serves a function in the wider financial markets.”
Lehman’s collapse raised awareness that re-hypothecation was “not a risk-free proposition”, Kennedy adds. “People now understand it, are wary of it and in more control of it than they were in the years leading up to the crisis.”