By Bryan Richardson
Determining the state of securities lending for US MNCs depends on whom you ask.
The securities lending practice of most custodian banks certainly took its lumps during the financial crisis.
Unfortunately it continues to plague certain institutions. Witness State Street Bank’s recent Q2 financial results. The company missed expectations due primarily to a $251 million after-tax charge emanating from its securities lending business; this on top of its need last year to curb redemptions from the program, which will be eased this month. The overall product category has seen a dramatic drop-off in activity since the crisis.
According to a recent report from Bernstein Research, lending volumes at the three large US custodian banks in late 2009 were down by 40-60 percent compared with the previous three years. The reason for the business run-off comes down to the risks involved. Like so many other securities or practices that were assumed to be safe, the financial crisis exposed weaknesses that many knew were there but never imagined would materialize.
The two big risks in securities lending are borrower default and collateral investment risk. If the borrower of your securities fails to return your securities by the agreed upon time, you may liquidate their collateral to make yourself whole. Collateral is commonly in the form of cash, which gets invested for the benefit of the lender. However, if the collateral was invested in something that has lost value or become illiquid you now have a problem. It is these risks that have been an obstacle for many institutional investors to utilize this service and sent many others to the exits.
what the timpg says
In recent discussion among The NeuGroup’s Treasury Investment Managers’ Peer Group (TIMPG), representing highly cash-rich firms, one member asked the group, “Who is doing securities lending and what types of investments do you permit for the collateral?” Out of 13 responses, only one was participating in a securities lending program. Two had participated formerly but discontinued sometime in the past two years due to risk concerns. Two others had researched the option and concluded the risk was not worth the return.
Initiating a securities lending program is like “picking up pennies in front of a steamroller.”
Scott J. Whalen, an executive vice president and senior consultant with Wurts & Associates Inc. in Los Angeles, supports this view, noting that many of his clients who participate in securities lending may well decide to withdraw, concluding that they were “picking up pennies in front of a steam roller.”
provider response
The environment has impacted the service providers, too. These entities, also known as agents, have tightened up their risk tolerances for their collateral pools where customer collateral is often co-mingled. After moving into those “safe” assets, such as MBS, to enhance returns on the collateral pools, agents have been dialing down the risk. In a BlackRock marketing brochure for Securities Lending dated January 2010, the following “frequently asked question” and answer is included:
Question: How has BlackRock’s cash management changed as a result of the credit crisis?
Answer: During the credit crisis, our strategy has been to reduce risk in the cash collateral portfolios by reducing exposures to sectors most impacted by the dislocation, shortening the maturity profile and maintaining increased levels of liquidity.
So agents, with the help of regulators and investors, have been reviewing how to best restructure their programs in order to reignite the product. Among the options reported as being considered are replacing commingled collateral funds with separate accounts, establishing a greater reliance on non-cash collateral which would eliminate the need for reinvestment, separating the functions of matching lenders and borrowers, and investing collateral by assigning them to different specialized providers and simply implementing more conservative investment policies. There is also talk of establishing a central clearinghouse regulated by the SEC.
All of this will no doubt have a negative impact on returns from the product and revenue for agents. Goldman Sachs, in its recent Q2 results reported, “Securities Services net revenues were $397 million, 35 percent lower than the second quarter of 2009. The decrease in net revenues primarily reflected tighter securities lending spreads, principally due to the impact of changes in the composition of securities lending customer balances, partially offset by the impact of higher average customer balances.”
the optimists
In spite of the blight on securities lending, many firms are seeing clients regaining confidence in the product. Northern Trust recently recruited two senior managers from JPMorgan to support “renewed interest for securities lending among its clients,” according to Andy Clayton, global head of securities lending at Northern Trust. Eight executives and senior managers at State Street have enough confidence in the product and market that they left State Street in June to join a securities lending startup.
The same Bernstein Research report cited earlier predictions of 6 percent volume growth for US securities lending in 2010, followed by 18 percent growth. However, this increase is driven mostly by growth in M&A activity and hedge fund assets. But for now, those with any doubts are perhaps best suited for the sidelines.