SACRAMENTO, Calif. -- Executives at the $82 billion California State Teachers' Retirement System are poised to begin using a ground-breaking securities lending risk management system.
The SL Performance Analyzer was introduced last week by State Street Bank & Trust Co., Boston, CalSTRS' custodian, and the securities lending agent for $14 billion, about 70% of the fund's securities on loan.
CalSTRS will be using the system, believed to be the first of its kind, as soon as late April.
A primary feature of State Street's system is it gives advanced notice on risk changes. It does so by calculating a securities lending program's net return and value at risk, then charting them over time.
"We really think it's a breakthrough," said Patrick Mitchell, CalSTRS' chief investment officer.
The teachers' fund will use the system as an early warning device to track underlying changes in the riskiness of its securities lending portfolios, particularly risks that might not be readily apparent, Mr. Mitchell said.
"It will be like a smoke alarm," he said.
There were no big surprises during CalSTRS' beta testing, which served primarily as a means to confirm State Street was doing what it said it was, he said.
The system also is helpful when pension funds have multiple securities lending vendors.
"We really need some basis of comparison," he said.
Currently, comparisons of securities lending agents are made using qualitative evaluations and intuition about which provide the best risk and return tradeoff, he said.
In past requests for proposals, CalSTRS received as many as 20 responses, making evaluation difficult, given the differences in investment styles at lending agents, he said.
The State Street system will allow CalSTRS to quantify much of that process and make more apples-to-apples comparisons, he said.
The idea to track risk in securities lending followed big unexpected investment losses taken by lenders and others, a few years ago. Securities lending managers Harris Trust & Savings Bank, Chicago, and Mellon Trust, Boston, were among those hit.
Since then, there have been efforts in the industry to create a benchmark.
Ralph Vitale, executive vice president in securities lending for State Street, doesn't think a benchmark is the answer.
Because lending agents' investment styles and the underlying portfolios being lent vary widely, creating a benchmark from securities lending agents' actual data will not be useful, he said.
Value at risk and other risk-adjusted analyses are a better method, he said.
State Street's new system will identify the net returns from securities lending and compare them with the accompanying risk, using value at risk. Value at risk is a statistical attempt to identify the most a portfolio can lose over a time period, and within a given degree of confidence. Outside of that confidence level, however, the losses will be greater than the VAR number.
The need for such a risk system derives from the complicated nature of securities lending, Mr. Vitale said. In securities lending, an agent will lend securities held for long-term investment to a borrower, receiving collateral on which the lender must pay interest.
For securities lending to be profitable, the lender must earn more on its investment than it is paying in interest.
If the lender owns securities that are in demand -- because of short positions -- the borrower will charge a below-market interest rate on the collateral being invested. The lender can invest in standard overnight rates and make a profit.
But the other major source of securities lending revenue involves taking market risk with the investment collateral, either through a longer duration than the overnight rate being charged, or through lower credit quality.
The returns and risks from both of those investment activities are identified by State Street's system, giving pension executives more information about the types of risks their lending agent is taking, Mr. Vitale said.
CalSTRS will begin using the system in late April for State Street's lending portfolios, with the $6 billion of lending portfolios at the fund's other three vendors being added later in the year. CalSTRS' other three lending agents are: Metropolitan West Securities Inc., Los Angeles; Boston Global Advisors, Boston; and Bear Stearns Asset Management, New York.
Initially, the basic version of the system will be available to all of State Street's custody clients in a hard copy report form or online through State Street's InSight System.
Down the road, more advanced computations will become available, such as stress testing, simulations and credit risk analysis, for an extra fee, Mr. Vitale said.
The system will allow for analysis of multiple portfolios and vendors, looking at them separately or as a whole.
And multiple calculations for value at risk will be added, Mr. Vitale said. The current version uses only what is called the variance-covariance method, he said.
