Managers of the enhanced cash collateral pools were caught by the credit crunch of the past 18 months because they held long-duration asset-backed and unsecured debt securities or paper from now-bankrupt Lehman Brothers Holdings Inc.
Market volatility in the pricing of those long-duration securities dropped the net asset value of cash collateral pools to below $1 per unit for all three of the major global custodians to pension funds that also are the nation's largest securities lending agents: Northern Trust Corp., Chicago; State Street Corp., Boston; and Bank of New York Mellon Corp., New York.
Barclays Global Investors, San Francisco, also has encountered similar valuation problems in the securities lending collateral pools for its passively managed strategies.
Three of the four firms have imposed redemption restrictions on the index funds underlying the cash collateral pools. BNY Mellon and Northern Trust backstopped client losses with cash contributions to the funds, according to statements from each firm. State Street has not made a cash contribution to its cash collateral funds, confirmed spokeswoman Arlene Roberts (Pensions & Investments, Jan. 26).
BGI, on the other hand, instituted “an early strategy to increase the liquidity of our collateral pools” that resulted in the firm having “ample liquidity in these funds. ... Clients are generally transacting normally,” Lance Berg, a BGI spokesman, said in an e-mail response to questions.
While executives at securities lenders maintain that the asset-backed securities in their enhanced cash collateral pools are not impaired and that their valuations will return to normal levels, sources estimate retirement plan executives face at least a year — longer if the recession deepens — of strict restrictions on their ability to redeem assets from the indexed accounts.
If investors want out entirely, major securities lenders will let them go, but won't give them 100% of their investment in cash. Instead, they are requiring investors take an in-kind distribution, a share of the collateral pool that will be returned in cash when the portfolios are back above $1 per unit.
“I think 100% par is unlikely for most securities lending portfolios,” Ms. Steer said.
But “there's no rush for redemption from cash collateral pools now because no one can bear the large losses they will incur. It's better to wait it out,” said Josh Galper, managing principal of financial researcher Finadium LLC, Concord, Mass.
Sam Kunz, chief investment officer of the $2.7 billion Chicago Policemen's Annuity & Benefits Fund, will not withdraw from affected index funds without full redemption.
He said Chicago police trustees will “wait until Northern Trust gets out of this” and its longer-duration assets have either matured or their valuations rise to fair values so the plan can make a change without a loss. Then, he said, he will recommend changes to the fund's board regarding equity management and securities lending that he declined to spell out.
A Northern Trust custody and index fund client, Chicago Policemen's fund staff is coping with liquidity restrictions on a $187 million Wilshire 5000 index fund and a $297 million Barclays Aggregate Bond index fund, said Mr. Kunz. Both were invested in Northern Trust commingled funds that had an enhanced cash collateral pool for securities lending.
Mr. Kunz said Northern Trust executives have been as accommodating as they can be in providing the pension fund with cash to meet benefit payments. Still, officials can't remove significant amounts from the accounts, which the plan had used to park assets that might be used to fund new manager hires.
“These went from being our most liquid accounts to the least liquid,” Mr. Kunz said.
Defined contribution plans and retail investors also got hit because a number of the largest index fund managers use the same custodians as pension plans. They rely on the custodian's money management unit to manage the enhanced cash collateral pools used to back up securities lending. These indexers have similar valuation problems and are permitting limited redemptions by defined contribution plans.
Sources said securities-lending profits led most big and many smaller pension plan executives to choose the enhanced cash pool option, when they had a choice. That's because they divide the investment returns from the cash pool with the securities lender in splits that range from 90% to the pension fund and 10% to the lender down to 70/30, sources said. Securities lending and the attendant cash collateral pool investment typically are offered as part of the bundled services custodians offer to their institutional clients.
Historically, pension plans derived incremental annual income from the enhanced cash collateral pools used in securities lending.
Michael Schlachter, managing director at Wilshire Consulting, Santa Monica, Calif., agreed that the lure of securities lending profits is powerful. “Most pension funds use the enhanced cash pool option. In a good year, a plan could make $1 million, in an average year, $500,000,” he said.
Sources said institutional investors are told during the request for proposals process of the risks of collateral pool investment losses. But, “institutions — and their consultants — weren't interested. All they focused on was the profitability of securities lending. The custodian who won often was the one who had the biggest revenue estimate from securities lending and (offered) the biggest split (to the client),” said an experienced securities lending executive who spoke on condition of anonymity.