While volatile trading conditions have generated money-making opportunities for pension funds in securities lending programmes, Rachel Alembakis discovers the cash reinvestment component of these programmes could be putting funds at risk
The levels and spreads for lent securities were volatile as the subprime crisis unfolded and hedge funds and other managers had to unwind positions quickly.
Nonetheless, securities lending providers have been quick to note volatile trading conditions can often yield lending opportunities and pension funds with securities lending programmes could be in the position of seeing extra income from certain lent positions.
"In terms of securities lending, generally the dislocation in the credit market has been perversely positive from a lending perspective insofar as there has been a significantly higher demand for high-quality securities - US and European Treasuries," noted Paul Wilson, managing director and global head of client management for JPMorgan Securities Lending.
"We have seen spreads widen significantly because of the flight to quality and there being more demand than supply. The marketplace has reassessed the price of risk in respect to the returns and hence the widening of spreads."
In Australia, demand from hedge funds and from fund managers with 130/30 strategies has also kept demand high, said Patrick Liddy, director of marketing and strategy at NAB Custodian Services (NCS), the custodial arm of the National Australia Bank. NCS is Australia's largest provider of securities lending services.
"It's driven a lot by the hedge fund players out there. They're the ones that want to borrow stock," Liddy said. "Those plays are still happening. Income has held up pretty well over the last quarter. On the international side, it's also held up pretty well and in some cases we've seen increased income for our clients. But the majority of our securities lending service is on a principal basis and we're conservative with the collateral."
The flip side
However, industry professionals say neither volume and spread volatility, nor the likelihood of borrower default, are the biggest risk to a pension fund with a securities lending programme, but rather it is the manner in which collateral is reinvested that poses the greatest risk of loss. Under the terms of some collateral reinvestment deals, pension funds could inadvertently be exposed to riskier credit instruments and run the danger of being in a position of owing their lending provider for vehicles that have lost money.
"When I look at the second component - cash reinvestment - clearly this is where the bigger issues may occur. You're not going to be shocked to know that not all cash reinvestment programmes are born equal," said Wilson of JPMorgan.
"Some providers run a big commingled money market fund. That fund has a set of guidelines that dictates how the cash is invested. Others run their cash reinvestment programme to allow the clients to specify how cash collateral is reinvested. Some lenders' business model is to generate revenues by, for example, lending AAA-rated securities and reinvesting the cash, say, into A-rated securities. This is effectively a credit arbitrage trade. Other lenders' business model is to extract the intrinsic value of the security and invest the cash conservatively. At JPMorgan, we focus on extracting the intrinsic value from securities we lend and allowing clients to customise to their specific needs the way the cash is invested, thus creating the greatest level of transparency which minimises the potential for issues."
Providers report receiving calls from clients in the third and fourth quarter, but Francesco Squillacioti, State Street's senior managing director and regional business director - Asia/Pacific for securities finance, said the bank's programme was able to reassure pension fund clients - both those who used their pooled reinvestment vehicles and those who sought a bespoke reinvestment service - of its conservative investment choices, backed by "transparent" disclosure of the vehicles used for cash reinvestment.
"There have been questions," Squillacioti said. "The way we look at it is we're trying to earn incremental revenue for our customers without introducing undue risk to the process. It's difficult to say, as the information is not necessarily disclosed to us, but it seems when clients looked across the different programmes they may have been engaged in with other lending providers, they may have seen exposures to the asset classes and had concerns."
But consultants report that some clients have had greater risks than they likely expected. Stacy Scapino, director for the Mercer Sentinel® Group, a specialist business unit within Mercer's investment consulting business, said Mercer believed volatility in credit markets warranted advising clients with securities lending programmes to review the parameters of their lending and collateral guidelines, as well as the terms of their contracts, to ensure they were aware of potential risks.
Scapino explained: "Despite significant market events, I wouldn't say I've seen a general rush to concern for anyone - surprisingly so. People should be looking at their securities lending programmes and ensuring they understand how the programme generates revenue and how it is managed and controlled. In many cases, funds have had programmes in place for years and years, capital markets and standard market practices have evolved, but if not regularly assessed, contractual and policy guidelines do not keep pace with these changes.
Essentially, counterparty credit risk indemnifications and collateral guidelines should be regularly reviewed and amended to keep pace with market changes.
"For example, after securities lending losses in the mid-1990s, several funds identified securities that were not appropriate as collateral or for collateral reinvestment. Such laundry lists of forbidden investments ignore capital market dynamics. The forbidden investments are not in the portfolios, but other investments which have similar risk profiles, e.g. they have similar market risks or responses to interest rate changes, are being held as collateral or are in the reinvestment portfolio. So, essentially, the investor has the same undesired risk position, albeit in securities with different names."
Behind the times
Several Mercer Sentinel clients have reviewed their securities lending agreements. In many cases, Mercer Sentinel found outdated agreements, mainly because legal language and case law have evolved since the initial signing. For example, Mercer found no safeguards for counterparty credit risk indemnification and reinvestment guidelines badly out of date with current risk profiles and appetite for certain vehicles, Scapino said.
"In one case, we had an agreement that had been put in place in the early 1980s and the client hadn't reviewed it since then. The provider had evolved the programme over 20 years and offered better indemnifications to clients," she explained. "The programme was updated and improved regularly. The client assumed their legal documentation [had] kept pace with their programme and market developments, but they had never formally reviewed or updated it. The most significant issue was that nothing had been done to update the counterparty credit risk indemnification, which was essentially non-existent."
Another consultant said clients were contacting them with deep concerns about cash collateral reinvestment - and that such concerns were leading some to suspend their securities lending programmes.
"There are a number of clients in this part of the world [UK/Europe] who have withdrawn from securities lending entirely because of a concern over the reinvestment of cash collateral," said Ross Whitehill, COO of Thomas Murray, the specialist custodial rating, advisory and monitoring consultancy.
"They've been the lenders, they've taken the cash collateral, and they're concerned about how that cash is being reinvested. They're not taking assurances from the custodian that all's well, because there's no indemnification. These are big pension funds and they're smart - we're not talking provincial. They're saying, 'We're out of it, we're sitting it out and we know it's costing us money.'"
The US$15.9bn San Francisco Employees' Retirement System runs a securities lending programme through its custodian, Northern Trust, and while the pension fund never considered halting its programme, deputy head director of investments David Kushner did question Northern Trust as to how quickly positions in the collateral reinvestment portfolio could be unwound in the event of a liquidity crunch.
"The question I asked of Northern Trust in August or September was, if you had a major liquidity crunch tomorrow, what would happen," Kushner said. "The answer was that they could liquidate around 70% of the portfolio in three hours, another 20% within a day, and the rest within three to five days. Our reinvestment is primarily in highly liquid, high quality investments - there are some lower quality issues in there [but] if it went upside down, as long as we're not forced to sell, we will make good at maturity. Yes, we book the earnings marked to market, and the earnings look negative, but they will mature by next summer and we [will] get that back."
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