May 2009

SECURITIES LENDING: Collateral thinking

Nicholas Pratt talks to institutional investors to see what changes they have made to their securities lending programmes and what implications these will have for its long-term future... After the initial unrest that followed the Lehman Brothers default and the subsequent accusations levelled at short selling, it had appeared that the securities lending market was returning to some kind of normality. The influential International Securities Lending Authority (ISLA) had been hard at work producing various studies that showed no discernible link between market volatility and short selling. Meanwhile, the UK’s National Association of Pension Funds chairman Chris Hitchen had spoken out to remind pension funds that securities lending was a valuable mechanism in keeping the markets well oiled and should not be abandoned.

But then, in March, the finance director of Europe’s largest insurance group, Aviva, said that he was considering suspending its stock lending programme and the uncertainty came flooding back. The UK’s largest insurer had posted an after-tax loss of £7.7bn (€8.28bn) that month using a new European accounting standard. The company’s share price duly dropped by 33% following the announcement, despite assurances from Andrew Moss, Aviva’s chief executive, that the company still had a robust balance sheet and the losses were exaggerated by the new accounting standard, which uses the market’s view of a company’s investment risk rather than a company’s own projections.

As the Aviva share price continued to fall, Moss and the Aviva board hit out at short-sellers, including UK-based hedge fund Lansdowne Partners which revealed a £13m windfall from short selling Aviva. So it was perhaps understandable that Aviva made its suspension suggestion and sounded out a number of fellow insurers, encouraging them to follow suit. But, according to Aviva finance director Philip Scott, the responses he received suggested that most firms had already stopped taking equities as collateral and did not support the idea of exiting the securities lending market and Aviva’s threat of withdrawal was, well, withdrawn.

For many other institutional investors, concerns over securities financing had already been considered back in September and dealt with by March. The London Pension Fund Authority (LPFA) suspended its securities lending programme for six months in the wake of the Lehmans default and the subsequent concerns of many pension funds about both the potential loss of revenue that could result from another high-profile default and the associations being made between securities lending, short selling and market volatility.

Read the fine print
“A lot of pension funds were looking at the money they lost from repurchase agreements where cash collateral had been used. We did not lose any money but we thought that we had better take a closer look at the wording of our collateral agreements,” says Vanessa James, investment director at the LPFA. There was also some disquiet from trustees about the link between securities lending and high volatility in the market, says James. “Unfortunately there is no information available about how your stock will be used, whether it will be for short selling to oil the settlement process.”

During the review process, James found strong evidence, from research commissioned by the ISLA among other sources, that securities lending does not affect pricing in the market, other than in the short term. However, by going through a lending agent, JP Morgan, it is not always possible for the beneficial owners of the securities to know who the ultimate recipient and borrower of their stock is and what they plan to do with their stock. 

“We have gone back to using JP Morgan, our custodian, as our lending agent,” says James. “We have tightened our collateral arrangements, we will only accept government bonds, so we are not accepting equities or cash.” As well as being a more stable asset class than equities, hedge funds or any highly leveraged investment vehicles are not natural holders of government bonds, which, says James, should alleviate some concerns that any stock loaned out may be used to fund short selling. “We have also tightened up the process for recalling stock in order to retain voting rights, should the need arise.”

Permanent change
After existing for decades as a back-office function for oiling the settlement process, creating liquidity in the securities market and providing pension funds with a modest source of revenue, often through tax arbitrage, securities lending has suddenly become a topical and emotional issue for pension funds. Right now the focus is on risk management rather than generating opportunistic profit. But once the markets return to a more optimistic state, will these changes be forgotten?  

“I think these changes will be permanent,” says James. In addition to the focus on risk management, the cheap availability of finance that increased activity which in turn fuelled the growth of the securities lending market is no more. “There will probably be less revenue as a result of these changes,” says James. “It is a nice source of income for pension funds, but any investments that pension funds make will be primarily based on simplicity.”

Are there any changes to the market that James would like to see in order to make pension funds more assured about the securities lending market and, consequently, maintain a healthy level of activity? “It would be helpful to have more statistics available that tell us how much stock is used for short selling and how much is for oiling the settlement process,” says James, although she does recognise that such a change would not be a straightforward exercise. “The more transparency the better, but someone has to collect this information.”

Michael Lernihan, a portfolio manager with Irish Life Investments, which manages a pooled fund for pension fund clients and runs its own in-house securities lending programme, says the post-September changes have been focused on counterparty credit-rating and collateral requirements. “Previously we required borrowers to hold a single-A rating from Moody’s and Standard & Poors. We now require borrowers to hold a AA rating from both agencies. We also monitor credit default swap spreads for all borrowers as an indicator of emerging credit issues. We no longer accept cash or equities as collateral for loans, we now accept only AAA-rated OECD sovereign debt and apply a haircut of 105% for all loans.”

These revised arrangements will be more expensive for current borrowers and will inevitably result in a smaller number of participants, says Lernihan. “Without question we have seen our portfolio utilisation decrease over the past six months and we attribute this to a combination of reduced market activity, fewer borrowers and the relatively expensive collateral that we now require. But absolute return is less important to us than risk-adjusted return. We believe that we should take a conservative approach to risk issues in the current market environment and we recognise that absolute returns may be less than in previous years.

But while lending activity from pension funds is likely to decrease, the interest in what was previously a seldom seen back-office process has increased substantially to the point where discussions with trustees have, on occasion, been emotionally charged. For many seasoned pension fund and investment fund managers, it is an odd transformation, but one that is generally welcomed.

“Securities lending has become more topical for our clients and we find that many of them wish to understand, in detail, the risk inherent in the programme, our approach to risk management and the relative values of returns generated versus risk incurred,” says Lernihan. “We see this increased interest as a positive development and are committed to working with clients until they are satisfied that they fully understand the details of the programme.” 

The increased interest from pension fund trustees and managers into the mechanics is indeed welcome even if much of the inspiration has come from the mainstream media’s occasional overstatements regarding the effect of short selling on a company’s share price as opposed to the competence of that company’s management team.

Tax harmonisation
The irony, however, is that a potentially more important implication for continued securities lending has hardly been mentioned in all the discussions – the imminent introduction of tax harmonisation to Europe.  At the recent annual conference for the Irish Association of Pension Funds – a somewhat gloomy affair, particularly for any attending fund managers attempting to exhort the benefits of persisting with equity investments – when asking the delegates about their securities lending activity, the primary concern was not short selling but tax harmonisation.

The manager of one of Ireland’s largest pension funds told me that tax arbitrage was the main motivation for securities lending and if this opportunistic means of raising revenue was to be harmonised out of existence, then securities lending would have a much reduced allure regardless of the changes to collateral conditions and the concerns over counterparties’ creditworthiness. “I can see securities lending going the same way as commission recapture,” was the conclusion.

As yet there have been no major moves as regards the closing of cross-border tax loopholes, but, despite the valiant efforts of the ISLA and others to stress the role that securities lending plays in keeping the investment industry well oiled, the deeper one looks at the process with its rising costs, fewer participants, tighter regulatory and collateral requirements and the loss of tax-based revenues, the less lustre it has.

©2009 funds europe

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