Securities Lending Was Much Misunderstood

On the front page of yesterday’s New York Times, Louise Story unravels the complicated and profitable securities lending product offered by many banks.  Notwithstanding the slightly biased or misleading headline, Banks Shared Clients’ Profits, But Not Losses, Ms. Story does an excellent job of explaining the complex and somewhat arcane details of securities lending.

However, she misses a critical point  —  no one forced pension plans to engage in these transactions.  While she tends to focus on the missteps or questionable activities by the banks, there seems to be little attention paid to the investors — many of whom simply didn’t understand the basics of securities lending.

Without outlining the intricacies of a securities lending transaction in this space (see the above story and diagram), suffice it to say that securities lending entails leverage and a sophisticated investment management strategy.  Unfortunately, Jerry D. Davis, Chairman of the municipal employee pension fund of New Orleans,  explained that “fund officials did not consider securities lending to be risky.”  Furthermore, “It was, he said, ‘almost like free money'”.

Let’s run through this one again.  Mr. Davis and his colleagues, in their capacity as fiduciaries, agreed to implement a leveraged investment strategy by the pension plan because it was “almost like free money”.  While Ms. Story highlights various allegations against the Banks, she doesn’t point out that Mr. Davis didn’t have a clue as to what he was approving.  No doubt, in light of all of the litigation, there are scores of fiduciaries throughout the pension system who were equally ignorant of the risks posed by Securities Lending.

To truly appreciate this financial narrative, a little history, or context is needed. We’ve seen this movie before. The recent financial crisis was not the first time the Securities Lending industry hit a proverbial bump in the road.

Way back in the spring of 1994 when interest rates reversed a long decline, the uptick in rates generated havoc in the Securities Lending Collateral pools.  The culprits were not sub-prime mortgages, but instruments known as “reverse floaters”.  As the name implies, these products of financial wizardly fluctuated in the reverse direction of interest rates.  Not surprisingly, in a long-term falling interest rate environment, Securities Lending collateral pools were chock full of reverse floaters.

Surprise, surprise.  Interest rates tick up and reverse floaters plummeted.  Securities Lending collateral pools collapsed in values.  In fact, the Boston Company supported it’s collateral pools so that they did not “break a buck”.

Investors were outraged and claimed the investment risk of loss on the collateral pools lay with the banks.  Claims were made, negotiations ensued and various settlements were reached.

In light of some of the ambiguities which surfaced in the 1994 Securities Lending crisis, banks systematically clarified in their documentation that the risk of loss with respect to the investment performance of the collateral resided with the pension fund/client.

The specific allocation of investment risk to the pension fund/client is a key element of the securities lending process.  In fact, many banks offer investment pools with varying degrees of investment risk, and require the pension plan to select a collateral pool which reflects the pension plan’s risk tolerance.

The principle is very simple :  the securities belong to the plan.  If the plan chooses to lend out the securities, then the plan needs to invest the collateral in order to earn a return.  At all times, the securities remain assets of the plans and the plans retain the investment risk.  This risk is never transferred to the Banks.

Finally, the Banks are paid a fee usually a percentage of the investment return generated by the collateral pool.

Now, as Story’s article points out, the Banks run their own risks — they can breach investment guidelines or they can engage in activities which might give rise to conflicts of interest.   But these are risks separate and apart from the investment risk on the collateral.

Far from “free money”, anyone familiar with Securities Lending understands that it is a levered investment strategy with various inter-connecting components.  The documentation reflecting these transactions is dense and very technical.  However, for a fiduciary, complexity is not an excuse for ignorance.  Whether it is securities lending, investing in a hedge fund or commodity ETF’s, Fiduciaries have an obligation and a duty to understand the investments they authorize on behalf of plan participants.

In 1994 it was inverse floaters, in 2007/8 it was sub-prime mortgages, in 2013, who knows what?   But, it is safe to say that Wall Street will invent new products.  Fiduciaries must stay on top of these developments.

(Next Post will be on the relationship between Custody Services and Securities Lending)

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