I find it very interesting and encouraging that Morgan Stanley has decided to use their own credit default swap spreads to determine how much they are to lend to hedge funds! It might sound a bit odd at first but I think it makes perfect sense. If you believe in efficient markets, that is.
Since investment banks such as Morgan act as important counterparts to hedge funds (they serve as prime brokers) it is crucial for them (and for the US taxpayer) that they lend to creditworthy hedge funds. This is of course determined by the CDS spread of the hedge fund (if there is such a spread). The new thing here is that Morgan Stanley uses its own spread to determine how much it is to lend overall to hedge funds. In a way it uses the credit default swap market as an indicator of its own liquidity risk (funding liquidity). The more risky Morgan is considered by the market the less it lends! It’s as simple as that. The point is of course that in times when Morgan Stanley is considered risky, less investors are willing to lend to them and the more difficult it would be to fund hedge fund lending.
A nice innovative way of using the credit derivative market and a further blow to the rating agencies. The regulators should be happy though.
Maybe something banks in other countries could think of introducing in other types of lending? Many European banks, for instance, have traded credit default swaps.