The jolting realization that hundreds of millions of dollars can be lost as well as earned in securities lending is pushing some institutional investors and securities lenders into re-thinking their lending strategies.
For example, the $16.5 billion Los Angeles County Employees' Retirement Association's pension staff no longer invests collateral from its securities lending program in derivatives, non-traditional and structured fixed-income investments.
The $80 billion California Public Employees' Retirement System, Sacramento, has found potential problems in securities lending as it is commonly practiced by pension funds today and ordered a review of its securities lending program. One problem is security lending agents possibly trying to increase their share of lending fees.
After being lulled by a long, low interest rate market, pension funds are starting to do more than just ask for dollar estimates on how much they can earn in securities lending fees.
"I think that the sea change .*.*. is that fund sponsors are really looking behind the rock and are saying: 'What is behind the (dollar) estimate and what are the risk parameters for those estimates,'*" said Kip Condron, vice chairman of Mellon Bank Corp., Pittsburgh.
Ron Peyton, president of the consulting firm Callan Associates, San Francisco, said many pension funds have reviewed or are reviewing their lending programs.
Those non-structured, non-traditional hybrid investments that Los Angeles County eliminated commonly are used by securities lending agents to help drive up income from lending fees. But those securities have been associated with major investment losses for funds in a rising interest rate environment.
Typically, pension funds get collateral equal to 102% to 105% of the market value of the securities they lend. That collateral is invested in various securities, some of them risky because they are interest rate sensitive at a time of rising interest rates.
For example, Mellon's institutional bond asset review committee gave long-term Treasuries a total low risk rating of 1, but gave short-term leveraged collateralized mortgage obligations a risk rating of 7.8. The highest rating, 8.2, went to dual market bull notes, a short-term derivative.
One potential risk problem the California Public Employees' staff is now trying to cope with: lending agents of pension funds have an interest in increasing their income as much as possible. The pension fund's staff fears agents will step further out on the risk spectrum than fund officials expect.
Large pension funds and their lending agents typically split fees. Between 30% and 35% goes to the agent and the rest to the pension fund.
The split in fees is large enough for lending agents to derive significant income for themselves. In 1994, the California Employees' fund made $21 million in income from securities lending. The fee splitting arrangements for the fund with each of its lending agents isn't known publicly, but under typical arrangements, the agents could have earned as much as $9 million or more as their share of fees.
But an additional concern for lending agents is that pension funds have been comparing how much in securities lending income they will receive when picking an agent. The lending agent and the custodian are generally the same. The result is that a custodial contract can go to the bank offering the most income from securities lending, forcing lending agents to come up with the highest lending fee numbers they think reasonable. That, in turn, can force some to do higher-risk transactions.
"If it's down to the nuances, in a short list, yeah, it does matter," said a corporate pension officer about the importance of a securities lending agent in determining which custodian gets picked.
Securities lending contracts should be - but often aren't - separate from custodial contracts, said Philip Halpern, chief investment officer for the Washington State Investment Board, Olympia. Washington has split its securities lending duties between Mellon and Bank of New York. BONY is the fund custodian.
Meanwhile, a stronger emphasis on safety prompted the Los Angeles County fund to make changes that other pension funds might initiate. They include:
Increasing the minimum overnight portfolio liquidity level to 30% from 20%.
Reducing the maximum stated maturity for any investments - except mortgage obligations, asset-backed securities and floating-rate instruments - to 12 months from 36 months.
Reducing the maximum stated maturity for floating-rate instruments to 24 months from 60 months.
Reducing the maximum average life for CMOs and asset-backed securities to 13 months from five years.
Despite the changes, Los Angeles County's new securities lender, Mellon Trust, predicts the fund will suffer only a small reduction in incremental income, about $168,000.
The California Employees' staff, meanwhile, wants to look at the problems of monitoring its four securities lenders - Bankers Trust Co., Mellon Trust, Metropolitan West Securities and State Street Bank and Trust Co.
Staff members try to monitor the portfolio holdings of the securities lending program, but the fast growth of complicated hybrid securities and the use of derivatives has made monitoring difficult.
The problem is a serious one because securities lenders often split fees on securities lent.
Another problem is that securities lenders invest sizable amounts of the cash collateral in the commercial paper of brokers and dealers. The paper meets the retirement system's credit, maturity and liquidity standards. But the staff fears it could be in double jeopardy by lending its securities to those brokers and dealers as well.
Still another concern is failed trades because the securities needed have been lent out. It's almost impossible to get securities lent internationally in distant time zones back in time to settle a sale. Normal settlement for U.S. government securities is one day after the trade.
Not only is the California Employees' system losing income on failed trades, but its managers are suffering in performance because of the failures. Yet no penalty is being paid by the lending agent.
Pension fund concern about securities lending has become a hot topic.
When Joseph C. Carieri, senior investment officer for fixed income at the Los Angeles County fund, gave a speech earlier this month on securities lending in Arizona, "300-plus people showed up. I don't think two years ago hardly anybody was thinking about securities lending. They thought it was found money," he said.
But with rising interest rates creating losses on many interest rate sensitive securities for the first time in years, investors have had to "step back and look at the risks" associated with securities lending, said Mr. Carieri.
When a large East Coast corporation reorganized its pension fund's lending program last summer, the pension investment officer expressed surprise at the risks in structured, non-traditional securities pension funds were taking in a commingled pool of collateral for securities lending.
"We didn't want anything to do with that stuff," he said. As a result, he drew up a much stiffer, low-risk set of guidelines for a separate securities lending account.
Many pension funds, said Callan's Mr. Peyton, haven't reviewed the guidelines for investments for their securities lender as well as they have for their money managers.
What pension funds can expect in the future from securities lenders is a tiered securities program, rather than just one program, said Mr. Carieri. Pension funds will be told they can get a certain amount of income for a certain level of risk, and the lending agents will be educating pension funds about the risks.
That way, banks can avoid picking up the tab for money lost in securities lending.
Mellon Trust, for example, picked up the tab ($130 million) when it restructured and shortened the maturities of securities in some securities lending client investment portfolios in a cash collateral pool last December. Mellon swapped underperforming securities in a cash collateral pool for short-term floating rate securities.
California Employees' staffers are concerned boutique-type security lending agents might not have the capital available to absorb losses in cash collateral pools, or might not absorb losses voluntarily even if they have the capital.
