Custodial banks are looking for new ways to convince wary investors to become active in securities lending again. For years pension funds and other big investors made tidy sums by lending the shares they own to hedge funds and others that employ short-selling strategies; the California Public Employees’ Retirement System, for instance, collected $1.2 billion in securities lending revenues for the eight-year period ended June 30. But in recent months investors have pulled back, chastened by an increased perception of risk and frustrated by watching assets stagnate in cash collateral pools.
“Securities lending is a crucial component of the necessary functioning of financial markets, and the revenue generated by lending can be significant in paying for administrative staff, keeping the lights on and paying consultants,” says Michael Vardas Jr., managing director of capital markets at Chicago’s Northern Trust Corp. “Clients are going to put a lot of thought into their future participation.”
Custodial banks act as lending agents, identifying borrowers and securing cash as collateral — 102 to 105 percent of the shares’ value is standard. Collateral from multiple borrowers is often pooled and can be invested in a range of short- and medium-term fixed-income securities, including mortgage-backed assets and commercial paper. Cash collateral pools operate in a similar fashion to money market funds and generally have a net asset value of $1 per unit. In theory, then, the pool should always represent at least 102 percent of the value of the collateralized shares.
However, as turmoil in the financial markets has caused asset values to plunge and the market for commercial paper to all but evaporate, cash collateral pools have been especially hard hit. Many pools had invested in the commercial paper of Lehman Brothers Holdings, which declared bankruptcy in September, and it could be years before it is determined what, if anything, that paper is worth. Three of the industry’s biggest lending agents — Bank of New York Mellon Corp., Northern Trust and Boston’s State Street Corp. — have imposed redemption restrictions to avoid having to sell securities at a loss, having seen the market value of their cash collateral pools recede in the past year.
Many investors have suffered big unrealized losses. CalPERS, for one, reported a $509 million collateral reinvestment loss in the first quarter of 2008. Unwilling to risk adding to or locking in these losses, and reluctant to be associated with short-selling of vulnerable stocks, as some observers believe that doing so exacerbated the financial crisis, some investors have reduced or even abandoned their involvement in securities lending. Although understandable, the reaction nonetheless lands them in a catch-22 situation.
“If you’re a big pension fund, you’re in a securities lending program and you’re also in hedge funds,” explains Rajan Chari, a partner at financial services consulting firm Deloitte & Touche in Chicago. “If you pull back from securities lending, your hedge funds can’t execute their strategies.”
Pension fund lenders are not the only potential losers. Custodial banks earn massive profits — often 7 to 10 percent of their custody revenues — by acting as intermediaries, and hedge fund borrowers have grown reliant on loaned shares. Both groups have a vested interest in minimizing investor risk and restoring confidence in the practice.
One result: Hedge funds are paying more for the privilege of borrowing. “Investors should get paid for whatever risks they take,” says Brian Lamb, CEO of EquiLend Holdings, a New York–based securities lending platform. How much they get paid depends on the availability of the desired shares, Lamb notes; scarcer shares command a higher price.
Higher fees, in turn, are prompting hedge funds to pay closer attention to their strategies, explains Wai Lee, head of quantitative investing for Neuberger Berman, a money management firm based in New York: “As the cost of borrowing securities has gone up, you clearly have to have more conviction about your shorts.”
Some borrowers are offering noncash collateral, such as U.S. Treasuries, eliminating the need for reinvestment, says Lisa Laird, a senior custody consultant at Watson Wyatt Investment Consulting in Los Angeles. That approach, though commonplace in the U.K., is rare in the U.S. Should it become popular, it could cause a depletion of Treasuries in circulation, she notes.
Her firm’s advice? Abandon the practice altogether. “Securities lending is an investment decision,” Laird notes. “It’s not an administrative decision to offset custody fees.”
