Institutional investors are still struggling with securities-lending losses and partially frozen cash collateral pools more than a year after the credit crisis struck global markets.
About 90% of institutional investors in commingled index funds — especially fixed income — were hit with withdrawal restrictions when enhanced cash collateral pools that invested in long-duration asset-backed securities were crushed by the global credit seizure in fall 2008 (Pensions & Investments, Feb. 9, 2009). Those pools back securities-lending programs.
Liquidity has improved, so most custodians now can meet client requests for cash withdrawals for normal business activities such as rebalancing, manager hires and benefit payments.
Still, assets in the commingled index pools could remain tied up for at least two more years, and a growing number of institutional investors are tired of waiting.
Some are suing their custodians over 2008 losses incurred in cash collateral pools stemming from the bankruptcy of Lehman Brothers Holdings Inc. and Sigma Finance Inc., a structured investment vehicle sponsored by Sigma Finance Corp.
Others have filed suit against their custodians over the frozen pools.
“Are things better than they were a year ago? Yes. Are we out of the woods yet? Not really,” said consultant Virgilio A. “Bo” Abesamis III, senior vice president and head of master trust, securities lending and global custody at Callan Associates Inc., San Francisco.
“The situation with the investment of these collateral pools is much, much better, but they are not fully recovered. Between April and June this year, most of the short-term securities in the collateral pools will have reached maturity and about 80% of the pools will be liquid.
“But about 20% of those portfolios, mostly asset-backed securities and mortgage-backed securities, will remain very illiquid. It likely will take another two years — that means the end of 2012 — before the situation stabilizes and the market returns for these kinds of securities,” Mr. Abesamis predicted.
Said Kristen Hanto Doyle, associate with Ennis Knupp + Associates Inc., Chicago: “While it seems like there's a lot of liquidity in the fixed-income market, some fundamental problems still exist in the fixed-income securities that many cash collateral pools were invested in. A lot ... are invested in subprime mortgages, especially in the residential sector, and there are still a lot of defaults to come.” Ms. Hanto Doyle oversees custody, index fund and transition management.
Stacy Scapino, New York-based global director of Mercer Sentinel Group, the risk adviser for Mercer's institutional client base, said most securities-lending cash collateral pools will have achieved 60% to 90% liquidity this year.
Still, she said, “I don't have confidence about what the landscape for securities lending and collateral management will look like, who will be left standing. Things will be a lot clearer in January 2011. There's just an awful lot of noise right now.”
Officials at the three custody banks that handle the bulk of the U.S. institutional investor global custody and securities lending activity — Bank of New York Mellon Corp., Northern Trust Corp. and State Street Bank and Trust Corp. — confirmed they are able to meet client liquidity needs although clients are still subject to some restrictions.
Michael Vardas, managing director and head of capital markets at Northern Trust, Chicago, said he expects the bank later this year will be able to “substantially lift, reduce or eliminate redemption controls” on its enhanced cash collateral pools.
Clients of New York-based BNY Mellon “can exit from a liquidating trust over time, as the assets in the trust pay down, or can exit from a trust by taking a proportionate share of all of the assets in the trust,” Mike Dunn, a bank spokesman, said in an e-mail response to questions.
Boston-based State Street Bank also is allowing clients “to withdraw subject to certain restrictions,” wrote Peter Economou, executive vice president and global head of securities finance, in an e-mail response to questions. “We are compelled to continue with our prudent approach to protect the interests of all investors in the lending funds. State Street and State Street Global Advisor's collateral pool assets are performing as anticipated, have not realized any material credit losses, and continue to pay interest and principal when due.“
But until custody banks completely lift withdrawal restrictions, consultants said most clients are making the best of a bad situation by either living within the restrictions or exiting index funds with a partial cash, partial in-kind distribution of the illiquid securities in the fund.
“I'm seeing clients more willing to be creative and to leave an index fund with an in-kind slice, because they have confidence that the fixed-income market has come back enough that they can hand it over to other managers (who) ... can work through these securities,” Ms. Hanto Doyle said.
Scott Whalen, an executive vice president at Wurts & Associates Inc.'s El Segundo, Calif., office, predicted that 2010 will bring a resolution with regard to unrealized losses in securities-lending pools. “The pools will come as close to par as they can this year, but in many cases, clients will experience losses and then will need to decide what to do about them. To get out of these programs, they may have to write a check to their securities-lending agent and accept the loss. Or they may possibly go back to their securities lending agent and say 'Look, you messed up here. What are you going to do about it?'"