Back from the dead

 

The New Orleans Municipal Employees’ Retirement System was first presented with an opportunity, some 20 years ago, to generate “free money” from the millions of dollars of assets sitting idly in its back office.

“It was a very seductive concept and it worked for a long time,” said chairman of the board of trustees Jerry Davis when he spoke at the Securities Exchange Commission’s (SEC) recent roundtable on securities lending. “Then Lehman failed. Then Sigma failed. Then all of a sudden in our securities lending programme we lost six years’ worth of revenue in a matter of weeks.”

The medium-sized New Orleans fund is not alone in having experienced the shock of seeing a long established practice, widely perceived as fairly pedestrian and effectively risk-free, actually cause very material losses. Its larger counterparts have also had their fingers burnt. The California Public Employees’ Retirement System (CalPERS), the largest pension fund in the US, recorded a US$634m loss on its securities lending programme for the 12 month period ending in March 2009, and consultancy firm Wilshire has predicted this could rise to as much as $1bn.

 

Income boost

Institutional investors engage in securities lending to provide a slice of extra income from their otherwise idle portfolios of stocks and bonds sitting aggregated at their custodial bank. Prime brokers seek to borrow such securities on behalf of their hedge fund clients and provide some form of collateral in return. In the US, this is predominantly cash collateral which then needs to be reinvested by the custodian in short-term, liquid instruments to earn additional income for the pension fund lender.

As Sonja Spinner, a senior associate in Mercer Sentinel, the consultant’s securities lending advisory arm, explained, securities lending has historically taken up a small proportion of pension fund’s time and resources, especially where trustees were concerned. As an agenda item, it certainly pales into insignificance alongside the likes of asset liability models, strategic asset allocations and pension fund deficits.

“Securities lending, generating a couple of basis points of earnings for the portfolio, shouldn’t be taking up a huge amount of your time,” she said. “But if it is, it almost means that something has gone wrong.”

Davis, who took time out to travel from New Orleans to Washington to take part in the SEC’s roundtable in September, has probably never spent as much time on the matter as he has in the past 12 months. And he would almost certainly agree that ‘something has gone wrong’.

During the roundtable he observed that when a fund manager hired by the City of New Orleans “gets in trouble”, the board of trustees always has the ability to fire them within 30 days.

He added: “But when the securities lending programme tanked and it was clear that our cash collateral situation was going to be a very bad one, and our revenues were not going to be good for some time, we said: well, let’s just quit lending for a while.

“And the bank said: well, that’s fine, but you’ll have to write us a cheque for $500,000 if you want to get out. So the idea to have to pay to exit the programme we were already losing money on was a pretty instant and nasty shock and it has left a bad taste in everyone’s mouth.”

 

Preparing for the future

So how did pension funds get to this situation and what should they be doing in the future with regard to securities lending programmes? The first point worth noting is that not all institutional investors with such programmes – or beneficial owners – experienced significant losses. Many beneficial owners in Europe were not affected in the same way, and this is chiefly down to the different forms of collateral used.

The securities lending market in the US is dominated by the use of cash as collateral, which has to be reinvested by the custodian to generate further income for the pension fund. The traditional approach in Europe is to use non-cash assets as collateral, such as fixed interest or equities. The traditional European approach of using non-cash collateral can allow pension funds to exit more quickly from securities lending programmes than they might be able to under cash programmes. It is possible to suspend cash collateralised lending programmes, but it proved very difficult to liquidate such collateral following the collapse of Lehman Brothers, as evidenced by Davis’ aforementioned remarks.

“The losses have probably been nearly all – if not completely – in the cash collateral field, which is not the fault of securities lending, it is the reinvestment risk of reinvesting the cash,” said Securities Lending Association consultant Hugh Gibson. He recently retired from HSBC with many years of experience in the field.

“I don’t think it is right to say that everybody who has been in cash collateral has had problems. But it is probably fair to say that lenders who are in non-cash programmes have had less to contend with than those in cash programmes,” concurred BNY Mellon Asset Servicing’s head of international business development, global securities lending, Mark Tidy.

 

The European approach

That is not to say that European lenders of securities did not feel any heat, as the practice of using cash as collateral has gained ground on the continent (it is still in the minority in contrast to the US). For example, Spinner said that most of Mercer Sentinel’s UK clients do not take cash collateral, but for those that do problems have mainly arisen from commingled pools, where the cash collateral of several pension fund is combined to be reinvested.

Spinner questioned whether such pools are appropriate since they offer no control to individual pension funds, and she always steers clients towards segregated accounts where possible, if they are keen to take cash collateral and understand the risks.

“Some of the biggest losses I’ve seen clients have is where there has actually been in a very aggressive pooled fund investment programme,” she said. “So a pension plan has effectively thought that it has made an allocation to maybe passive equity and then it has suddenly ended up with 5% being wiped out because of securities lending losses.”

Spinner complained that cash collateral reinvestment parameters have been too broad in commingled funds, leading to cash being reinvested in asset-backed securities and risky, high-yielding assets. “Quite a lot of people didn’t realise quite how much risk there was in those cash collateral reinvestment pools, and they have been quite surprised when they have actually found out what the cash collateral has been reinvested in,” she said.

Speaking at the SEC roundtable, Davis called for more disclosure and “a more precise commitment” from lending agents when it came to how they reinvest cash collateral. He said some aspects of the master agreement held between the New Orleans pension fund and its custodian amounted to “marvels of simplicity”, citing the part of the agreement that specified what assets were allowable to reinvestment. “It said cash, securities and letters of credit – period,” he recalled. “There was nothing about the rating of these various instruments. There was nothing at all about the monitoring of the instruments. There was nothing at all about how the bank was going to care for those instruments.”

Spinner said that when she has looked at prospectuses for cash collateral reinvestment pools, there has been very little disclosure about what assets can be reinvested in. “It is very difficult for pension funds to really understand how much risk there is in the securities lending programme. I think that is an area where the industry needs to tighten up,” she said.

Tidy said that while segregated cash collateral accounts can be desirable for large investors, smaller participants have been served very well by commingled pools. “The liquidity that is shared within the pool efficiently facilitates the daily ebb and flow of portfolio management,” he said. “This becomes more difficult to manage as the segregated account gets smaller, because of the need to invest to generate some spread while at the same time maintaining adequate daily liquidity.”

A number of pension funds around the world sought to suspend their securities lending programmes in 2008 as a result of portfolio losses and/or regulatory pressure to curb short selling – another topic of debate entirely. However, many have since resumed their programmes, albeit possibly with a more conservative risk appetite. A survey by BNY Mellon in conjunction with Finadium found that the number of institutional lenders who had stopped lending permanently was fairly low: 17.5% of all surveyed.

Tidy said that pension funds are very much returning to securities lending, and even those who have not lent in the past are considering it, because of its potential to increase income at a time when everyone is “revenue hungry”. However, demand in Europe is very much geared towards a back-to-basics style of securities lending, centred around the use of non-cash collateral. “This is very much the traditional European model anyway,” he said.

All eyes will also been on how the US cash-dominated market evolves, especially since there has been growing talk about using alternatives to cash collateral there. “Whether the US will actually restructure the market to move away from cash reinvestment towards a more European type lending against fixed interest collateral and the like, it will be interesting,” Spinner said.