Crisis Puts Sec Lending Risk Practices to the Test
March 2, 2009
A decade ago the securities lending business was more of a profitable hobby than a super-sized, critical component of the capital markets. The dramatic rise of hedge funds in recent years, combined with investment banks' growing appetite for proprietary trading, helped drive stock lending to the heady heights reached at its peak last year. The figures are staggering: Securities on loan have at times surged past the $3 trillion level, according to estimates.
Securities lending is sold to investors as a low-risk addition to their traditional investment activity. Be clear about the words "low risk" as opposed to "no risk." Last year made it clear to all market participants that there are tangible exposures in this business--a realization that was a shock to some.
For many, 2008 will be remembered as the year that the conceptual acceptance of counterparty default became real for everyone. Once a stock loan is settled, it carries ongoing credit exposure, so counterparty default is the core concern. In addition to detailed credit analysis and monitoring of borrowers, lenders are further protected by their requirement for over-collateralization of loans.
However, the default of Lehman Brothers crystallized the issues that arise from a major market participant's disappearance. Most lenders reevaluated the structure of their lending programs, scrutinizing their list of counterparties, approved collateral types and margin levels.
Less obviously, hedge funds became starkly aware of their exposure to prime brokerages. The investors that have suffered the most as a result of Lehman's failure are their prime broker clients. Dealers have always carried direct exposure to lenders in the form of the excess collateral they provide, but they have consoled themselves that lenders were typically asset-rich institutions and unlikely to pose default risk. The rescue of American International Group just days after Lehman put paid to that notion.
In a worst-case scenario, default closeout procedures are implemented. The preparedness of firms to deal with terminations was challenged in September. Legal agreements were tested and older documentation was found wanting. The ability of lenders to execute large-scale repurchases of stocks on loan has proven to be a critical factor in protecting beneficial owners. Lessons have been learned by market participants on many different levels.
While counterparty default is the most apparent hazard, the primary source of securities lending-related losses is cash collateral reinvestment. In a typical stock loan the lender receives cash collateral and reinvests it in the money markets. These additional returns add a small degree of leverage to a lender's portfolio but more importantly expose beneficial owners to investment risk.
Securities lending cash pools share the liquidity issues of money market funds generally; however risk is skewed more toward a funding crunch than credit-quality problems. The forced sales of assets in the current liquidity-constrained markets has precipitated losses that otherwise would not have occurred. This funding-until-maturity entanglement remains the key determinant as to the final extent of losses that might arise.
The risks of stock lending today are the same as in the past and form the core of future risks. Yet, this truism may have engendered complacency in an industry used to ever-increasing annual revenues. In 2008, the cash reinvestments that caused concern were structured investment vehicles and asset-backed commercial paper rather than the inverse floaters that caused problems for lenders in the mid-1990s. Last year it was the dissolution of Lehman rather than Drexel Burnham Lambert or Barings Bank.
