What Should Participants in Securities Lending Deals Tell Each Other?

February 22, 2010
Chris Kentouris

“Transparency” is an oft-used, if not over-used, catchall term in the securities industry. Just what it means is open to interpretation from whomever you ask.

After the 2008 credit crisis, regulators and investors want to know a lot more about the market, credit, counterparty and liquidity risk involved in the multitrillions of dollars worth of transactions executed and processed each year. Clearly, investments in complex instruments that were derivatives of home and other loans were not well understood by investment banks as big as Lehman Brothers or brokerages as big as Merrill Lynch.

The same now holds true in the temporary lending of a security from an institutional investor to a broker-dealer or bank, known simply as securities lending.

This used to be a mundane matter and pretty lucrative to the lender. Transparency wasn’t all that important in a bull market when pension funds and other institutional investors simply lent their securities out to make a few extra bucks, from their brokers and banks on securities they could afford to give away for a short time. They still do but at the time investment funds, their trustees and their lending agents did not think anything could go wrong.

But even high-grade securities – the crisis proved – could see their values plummet. The lenders – the plan sponsors – lent securities and invested the cash received from the borrowers as collateral in so-called cash collateral pools and collective investment trusts.

Those investments, supposed to be designed as short-term liquid investments, were caught up in the market meltdown and Lehman Brothers’ bankruptcy. When they became illiquid, plan sponsors lost money – and lots of it.

It’s an investment risk which technology can’t solve and now plan sponsors say custodian banks are to blame for their financial losses. Over the past year, plan sponsors have sued Northern Trust, State Street, JP Morgan, Bank of New York Mellon, Wells Fargo, U.S. Bank and Wachovia – for allegedly violating their fiduciary, contractual and other legal responsibilities in losing millions of dollars for the investment funds in their securities lending contracts.

While the names of the plaintiffs and details of the cases may differ, most of the lawsuits involve the loss of cash collateral invested by the custodian banks in their securities lending programs. Among the plaintiffs are pension plans in New York, Georgia, Illinois, Missouri, California and Arizona. Each of the custodian banks has denied any wrongdoing and the cases are still pending.

Now courts are being asked to decide just who told what to whom and when. Are plan sponsors – the investment funds -- simply disgruntled customers seeking to recoup unavoidable investment losses from banks with deep pockets? Or were they intentionally misled by their custodian banks on just where their cash collateral was being invested? And just where did the fiduciary responsibility of custodian banks fall?

Michael Kozemchak, managing director for Institutional Investment Consulting in Bloomfield Hills, Michigan, says that at the very least the lawsuits show there were some poor communications between fund managers and custodian banks

“Investment fund managers and plan sponsors didn’t ask the right questions about how their cash collateral was being invested,” says Kozemchak. “And custodian banks who acted on behalf of investment fund lenders thought their customers were educated enough to understand that the cash collateral posted by borrowers was invested in collective investment pools.”

The merits of the cases aside, there are some lessons to be learned. “Trustees and investment fund clients are now very aware of the fact that securities lending is an investment product. And like any investment product, it carries risks that need to be monitored according to fiduciary obligations,” says Josh Galper, managing principle of Finadium, a Concord, Mass consultancy specializing in asset servicing.

Galper compares the scenario affecting the securities lending industry to the money market fund industry. “Investors in money market funds now understand that a fund could break the $1 per share net asset value,” if the assets the fund manager invests in drop in value, says Galper. “The same applies to securities lending. Collateral can be managed conservatively or aggressively, but either way there is a level of risk that needs to be attended to.”
Bottom line, says Kozemchak, plan sponsors need to look at their contracts and evaluate the potential risks involved with their securities lending program. Even if a custodian bank compensates a plan sponsor for losses incurred in the cash collateral fund, it might not be for the full amount of the losses.

For custodian banks, simply paying off disgruntled customers also won’t be enough. If they don’t sufficiently warn their plan sponsor customers of risks involved in securities lending transactions and investing in funds which conduct securities lending activities, they will face a lot more than just lawsuits. Investment funds could start pulling out of their securities lending programs. And some already have resulting in a reduction in revenues from securities lending activities.

“Having clients is good, but having clients who understand the products they are investing in is much better [for custodian banks],” adds Galper.

In a statement issued to Securities Industry News on Friday, John O’Connell, director of institutional public relations for Northern said, “we were clear with our clients at the time of the Lehman crisis of the impact on collateral pools.”

After September 2008, the global custodian bank produced weekly reports of the net asset values of funds. It also held webinars and made calls to clients. And in 2009, it created an online dashboard of key daily metrics for clients. It also produced an electronic newsletter and conducted Market Update webcasts

“We felt it was important to make sure that securities lending clients received information in a variety of formats and customized to their specifications as much as possible,’’ said O’Connell.

He said Northern Trust also offers clients a “range of collateral reinvestment options, from very conservative to more aggressive” and it makes certain clients understand the “risk-return spectrum in their choices. In addition, after the financial crisis hit, Northern offered a “staged withdrawal” option that allowed clients to “reduce their participation in securities lending while protecting all members of the collateral pools.”