The question whether securities lending is an investment or a custody function is being raised as cash collateral portfolios come under intense examination.
Once considered a reasonably riskless and routine back-office add-on to custodial services, securities lending increasingly is being viewed as an asset management service, subject to the same risks as other asset management categories.
Even before Mellon Trust announced plans to spend $130 million to reposition its securities lending portfolio to shorten the duration of its cash collateral portfolio in the wake of rising interest rates (Pensions & Investments, Dec. 12), plan sponsors and pension consultants were tightening investment guidelines for cash collateral.
Industry sources expect more custodian banks to acknowledge that aggressive investments of cash collateral investment funds have been whipsawed by the rise in short-term interest rates in 1994.
Some plan sponsors might be surprised to learn of the use of derivatives in their cash collateral pools, even though most major custodian banks claim they do not use derivatives in their pools.
"Many of these banks are going to have to step up to the table and take the hickey on this, just like Mellon," said a Bank of America executive, who wished to remain anonymous. He added that, with few exceptions, many custodian banks use derivatives in their securities lending pools unless specifically prohibited by plan sponsors. He said BofA does not invest in derivative vehicles in its collateral pool.
Ron Peyton, president of Callan Associates Inc., San Francisco, said Callan is advising its clients to tighten investment guidelines for cash collateral and to obtain confirmation regarding the use of leverage, derivatives and the investment techniques being used by fund managers.
"You should ask your managers how they use derivatives - all money managers not just securities lending - and review the cash management guidelines, since even with cash you can lose money if it is leveraged and interest rates turn against you,"he said.
Mr. Peyton declined to claim derivatives are in wide use among custodian banks in their cash collateral pools, but "these instruments are creeping in everywhere. ... They can be valuable if used properly, but in an aggressively managed cash portfolio it can get out of control. The banks we have checked so far seem to be OK, but we have tightened our investment guidelines."
Traditionally custodian banks packaged securities lending with custodial services as a way to more than offset custody fees while generating surplus cash.
According to one investment manager that uses securities lending, the rapid rise in interest rates in 1994 "pinched the spreads earned by the custodians while custodial fees remained the same. They have been trying to increase securities lending revenues by being more aggressive by lengthening the duration of the portfolio and through the use of derivative instruments. The cash collateral reinvestment risk is where the real problem is since there is no full indemnification against losses."
He said in the past plan sponsors "may not have viewed securities lending as an investment risk, and probably didn't pay much attention to investment guidelines of the custodian. And the banks perhaps haven't been as rigorous in defining what is included in those guidelines and in their portfolios."
A report from Wilshire Associates, Los Angeles, advised plans using securities lending to tighten guidelines also. Wilshire pointed out that extending maturities of securities lending collateral pools could pose problems in a rising rate environment.
"Banks have been able to further increase revenue by investing in securities with a maturity, and yield, somewhat longer than the maturity of the broker loan (in securities lending). Borrowing short and lending long, even if the difference is a matter of only a month, is very profitable in a steeply upward sloping yield curve environment. The risk of extending maturities for higher yield is a quick flattening of the yield curve, as happened this year. This caused some major trust banks to report losses from securities lending in some months of this year," according to a Wilshire report. "Management of securities lending ... focuses on how collateral is invested and it is here that a revenue split arrangement can potentially give the bank incentives that are contrary to those of the client."
Many plan sponsors started tightening securities lending cash collateral investment procedures even before rates started rising and Mellon repositioned its portfolio. Harris Trust incurred losses in its pool last year, which were invested in higher yielding derivatives that dropped in value when interest rates rose (P&I, Aug. 8).
The $38 billion Teacher Retirement System of Texas hired Bank of New York as its custodian bank earlier this year and included domestic securities lending in the package, said Mike Barron, chief financial officer.
He said the contract allows the use of third-party securities lending but the bank "has the first shot" at securities lending.
"We specified what the custodian and the lender could use in managing cash collateral," Mr. Barron said, and specifically excluded the use of derivatives.
As a result, he said, "we view it as very safe and we generate much more in securities lending than the custodial fee." He said fees amount to about $400,000 to $500,000 annually and that securities lending generates $4 million to $5 million in revenue.
He said some securities lending activities increase risk "if they start pushing for yield. But we don't push for that extra income. We don't look at it as a yield enhancement activity."
John Jones, senior vice president at the $4 billion Annuity Board of the Southern Baptist Convention, Dallas, agreed securities lending has gained a level of visibility among plan sponsors because of the heightened attention to potential risks.
"It has become obvious that plan sponsors need to understand how the income is being generated, and the type of risks the securities lender is taking and the investment approach they are taking. Like anything else in investments there is risk and reward associated with it," he said.
Mr. Jones said some securities lending institutions promote "significant income-generating capabilities, but they are usually being more aggressive in their investment practices. We sign off on the actual investment guidelines."
Mr. Jones said investment guidelines do not exclude the use of derivatives in its portfolios, "but we specify how a derivative product can be used by our managers. We allow them to be used as a tool for hedging and efficient restructuring of a portfolio, and don't allow them to be leveraged." Nor does the fund permit derivatives to be used for yield enhancement in securities lending cash collateral investments, he said.
Whether other custodian banks come forward with problems in their collateral reinvestment pools, most industry sources agree the nature of securities lending has changed and now clearly is more an asset management function than a safe and simple custodial service.
"It is like everything else, it has gotten more competitive and when that happens you have to do it better and cheaper," said Mr. Peyton. "Everyone assumed that you would make money in securities lending, but when losses began to materialize in late 1993 the marketplace began evaluating securities lending programs. There were some losses in 1993. But they made money for the last 15 years and last year they had to give a little of it back."
Terry Bilkey, principal at Yanni Bilkey Investment Consulting Co., Pittsburgh, said the benefits of securities lending are not as great as in years past because there are so many more participants.
"The point is that the benefits aren't as significant for a plan as they once were because more plans are doing it now and your number doesn't come up as often," he said. "Now the benefits for plans have decreased in a dollar sense."
Mr. Bilkey does not discourage the use of securities lending, but said many plans do not make use of it "because when you win, you win nickels; when you lose, you could lose quarters.
He said it probably is accurate to assume most custodial banks make use of derivatives in their reinvestment portfolios, but added "you could probably expand that to go a lot further.
"If you look at other plan portfolios I could probably find a derivative in almost all client portfolios somewhere. If you are a major player in any market it's almost impossible not to, particularly in the fixed-income area," he said.
Nevertheless the cash collateral investment skills of custodian banks has become just as significant as other aspects of its custodial service, said Mr. Bilkey.