Although it is becoming clearer that there is something rotten in the state of securities lending, the root of the problem never seems to get fully articulated. The problem is that much of what is called securities lending is not actually securities lending but portfolio leverage.
The difference between securities lending - a fully collateralized, fee-generating activity relying upon operations prowess - and leveraging a portfolio - the act of generating return by compounding systematic risk - is subtle but critical. Securities lenders obfuscate this difference and thereby bamboozle plan sponsors into ludicrously unfavorable investment terms.
Theoretically, plan sponsors can earn a small fee with minimal risk by lending securities, such as stocks, to short sellers and others who are temporarily in need of a security. Such lending is usually done through an intermediary broker.
To indemnify the plan sponsor against the failure of the broker to return the security, the agent (a party acting on behalf of the plan sponsor to lend securities) receives collateral. The plan is exposed only to settlement risks because the agent receives Treasury bills as collateral. At the end of the transaction, the T-bills are returned to the borrower of the stock (along with any accumulated interest), and the plan receives its stock and a fee.
In reality, however, the agent often does not receive T-bills as collateral - and this is where the problem begins. Instead, the agent receives cash as collateral. And rather than receiving a fee, the agent must pay the broker a "rebate rate" (which is about equal to the federal funds rate) for the use of the cash collateral. In essence, the agent is no longer lending the securities, but repo-ing them. The agent is not providing scarce securities to those willing to pay up to get a hold of them; it is forcing securities out onto the market and thereby competing with brokerages and other financial institutions to raise short-term working capital.
The expected rate of return on these activities is quite different as evidenced by the fact that if the agent were to invest the cash collateral in T-bills, it would lose money (the spread between T-bills and the rebate rate). So in order to achieve a positive expected rate of return on securities lending, the agent must invest in a vehicle with a higher expected return than the fed funds rate. Typically this means the agent will invest in lower-grade credits or will extend duration; but it also can include creative investments such as inverse floaters or equity.
Because the plan sponsor is the ultimate owner of the collateral investments, it means the whole nature of the securities lending proposition has changed. The plan sponsor must bear not just settlement risk, but investment risk. And because the fund presumably already is invested in risky assets, investing the collateral in any vehicle other than T-bills (the risk-free asset), adds financial leverage to the fund. That is, if the plan sponsor holds 100% of investible face value in equity exposure plus 10% of the face value in other risky assets (such as bonds and equities), the portfolio has been leveraged. Such leverage creates more risk, or volatility of returns. Moreover, this risk is systematic and thus can't be diversified.
At bottom, the one irrefutable problem with securities lending is that the cost of borrowing cash by way of securities lending is unnecessarily high. Even if it were decided that it was prudent and desirable to add a modest degree of leverage to a fund, the cost of borrowing through securities lending (in order to add leverage) is well in excess of the ready alternative.
An alternative to an Standard & Poor's 500 stock index fund using securities lending is to invest, for instance, 5% of the fund in T-bills (and 95% in the S&P 500 index) and use the T-bills to secure a 7% investment in S&P 500 futures. This combination would equal a 102% exposure to the S&P 500 including a 2% borrowing position. Using futures is a cheaper way to take on systematic risk because the interest rate on the 2% borrowed by the fund would be about midway between T-bills and fed funds (the implied borrowing rate of an S&P 500 futures contract).
But the cost of borrowing through securities lending is higher still, because the fee structure, whereby the agent typically receives 30% to 50% of marginal income earned through security lending, adds significantly to the cost of borrowing. The plan sponsor must bear all the downside risks in return for only a fraction of the upside. This forfeiture of the upside return to the agent is like giving the agent a call option on proceeds of the investments in excess of fed funds. Thus, the cost of borrowing by way of securities lending (fed funds plus the call option) exceeds the cost of adding leverage through the alternative (closer to T-bills).
Because option values rise with increased volatility, the incentive fee structure may -if it does not have a safeguard such as a high-water mark - create a moral hazard by encouraging the agent to take excessive risks in order to increase his expected return. This generous "upside only" incentive compensation scheme may be appropriate in a low-risk environment, where marginal returns are generated by administrative energy. But it is entirely inappropriate in an environment in which the manager is earning marginal returns by making plan participants assume financial risk.
In the end, the agent is earning a fee by foisting unacceptable risks or risk-return trade-offs onto the plan sponsor. Old-fashioned securities lending apparently just didn't seem to be worth it, so some agents changed the rules of the game. Under the old rules, agents could lend out maybe 10% of the portfolio while earning a fee of perhaps 20 basis points; this would earn about two basis points for the portfolio, of which about one basis point would be kept by the agent.
But by getting cash and juicing up investment returns, even at highly unfavorable terms to the plan sponsor, the possibility of earning meaningful fees presented itself. Some agents couldn't resist the opportunity to dupe the plan sponsor into paying them for taking systematic risks. But paying an investment adviser an incentive fee to produce return from bearing systematic risk is like paying an S&P 500 index fund manager an incentive fee for any returns above T-bills. Even if the agent claims to be earning an excess return over fed funds through pure skill, say by trading T-bills, the fee is too high. Taking a fee of 30% to 50% of the upside is a compensation scheme that might even make a hedge fund manager blush. And chances are, the plan sponsor did not even really consider the investment prowess of the agent when considering who to hire. After all, they probably were under the mistaken belief they were hiring a securities lender rather than a hedge fund manager.12
Todd A. Tibbetts is manager-trust investments and foreign exchange at Sandoz Corp., New York.