Is Anyone Paying Attention?
The debt-ceiling crisis has been momentarily addressed and the financial markets are continuing to tremble. In my past few blogs, I’ve raised topics which Plan Sponsors should address with their various plan fiduciaries. It’s all about being prudent. Today, the focus is on Securities Lending.
In the 2008-2009 financial crisis, Securities Lending programs froze. Collateral pools experienced huge liquidity issues and loans could not be unwound. Pension plan portfolios suffered significant loses.
The last time around the culprits were mortgaged-backed securities and all the various related derivatives. This time, it could be sovereign debt. Today, the NYT reports Large Banks in Europe Struggle with Weak Bonds. The main thrust of the article is that sovereign prices for certain European countries are weakening dramatically thereby affecting the capitalization of some large European banks.
However, tucked deep in the article are references to repo transactions and the posting of collateral. Sovereign debt is often used in these trascations. This is where Securities Lending (the “reverse” side of a repo transaction) comes into play, and where Plan Sponsors should be focusing their questions.
Plan Sponsors should examine two separate, but very closely related, potential risk related to European debt and the European banks:
Short-Term Bank Paper Held by Collateral Pools — Remember Lehman Bros? It’s paper was held by many investors, including pension funds. As the paper became worthless, securities lending collateral pools lost values. Plan Sponsors are on the hook for the investment losses related to collateral pools. Many plan sponsors were not happy.
Collateral Posted by Broker/Dealers — When broker/dealers borrow securities to facilitate short sales by their clients, the broker/dealer must post collateral. Often, Sovereign Debt offered as collateral qualifies for better terms than other forms of collateral. Therefore, there is a huge incentive for broker/dealers to offer Sovereign Debt for these purposes. However, to the extent that debt from any of the troubled European countries was used as collateral, and as prices continue to deteriorate, the broker/dealers will have to post more collateral as the value of this debt deteriorates. Watch the capitalizations of the broker/dealers.
Don’t dismiss the role of broker/dealers in the stability of our financial system. As Lehman as entered in bankruptcy, all the others teetered on the edge of the abyss.
Few areas are more technical, “nichey”, or esoteric than Securities Lending. If Plan Sponsors want to partake of the benefits of Securities Lending, then they must really understand the risk. They must dive into the details which I outlined above.
If these questions are too “geeky” for Plan Sponsors to develop in-house expertise, then they should delegate oversight to true experts. Ignoring complicated issues can never be prudent.