“We have seen a derisking route for a number of our clients,” added Mark Kinoshita, vice president of Callan Associates' San Francisco-based trust, custody and securities lending group. “Small to midsize plans have either substantially tapered their programs or exited in full. Large institutional plans took the derisking route and focus on proper risk/reward trade-off with a focus on intrinsic value lending as opposed to volume lending.”
The risk in securities lending concerns the cash collateral that is used in lending and the fear of “breaking the buck” among money market funds frequently used as collateral in lending arrangements, leading pension fund executives to make one of two choices available to them, said T. Andrew Smith, managing director, J.P. Morgan Investor Services, New York. “There are two camps,” he said. “Either it's, "I'm going to manage this and get smart about it,' or the pension boards say, "We don't understand, so we're getting out and moving on.' ”
“It's not just losses from "breaking the buck' (where the net asset value of a money market fund falls below $1). This is no longer an enhanced-return strategy,” Mr. Smith said. “It's really part of an investment strategy of the plan. Now they care about the credit process. The restrictions of what you're lending are what pension funds care about. Now pension funds' investment policy committees are becoming involved.”
On the face of it, particularly among large public plans, securities lending requests for proposals continue to be issued and agents continue to be hired. From Jan. 1 through Nov. 5, five public pension funds issued RFPs solely for securities lending agents, while eight others sought agents along with global or master custody services, according to Pensions & Investments data.
Those seeking securities lending agents apart from custodians were the $171.9 billion California State Teachers' Retirement System; $26.3 billion Connecticut Retirement Plans & Trust Funds; $3.5 billion Colorado Fire & Police Pension Association; $1.4 billion Chicago Laborers Annuity & Benefit Fund; and $1 billion Hartford Municipal Employees Retirement Fund. Of those, Hartford hired BNY Mellon Asset Servicing; and Connecticut, Colorado Fire & Police and Chicago Laborers hired Deutsche Bank. CalSTRS, for which proposals were due Oct. 11, has not yet made any hiring.
Scott Simon, chief investment officer of the Colorado Fire & Police pension fund, said the focus on credit risk in the securities lending program increased after the financial crisis although the size of its securities lending program has remained the same.
“After the financial crisis we maintained the size of our securities lending program, but we did reduce the credit risk being taken on the investment pool. Our program now has a greater emphasis on earning income through the lending side by focusing on specials and repos. In changing this focus, we saw more value from a third-party lender, like Deutsche Bank,” Mr. Simon said.
In the corporate pension fund market, “a large percentage suspended their (securities lending) program after the financial crisis,” said Peter Bassler, managing director and global head of business development at eSecLending, Boston. “(Corporate) plans were more surprised by the problems that followed the crisis. They expected their securities lending revenue to pay their custodial costs. They didn't expect to have to monitor them. They were surprised when they found their biggest allocation commitment was with their custodians, in their cash collateral portfolio.”
However, some large corporate plans are also making securities lending work for them. At Dow Chemical, Mr. McGuire said plan executives focus only on securities that are trading as specials — with high borrowing demand and less risk than general collateral repurchase agreements that previously drove the program's returns.
“Before the crisis, we had a lot of (general collateral), with returns on the investment of the collateral,” Mr. McGuire said. “Now we've sort of buttoned (the program) down extremely tight. ... I don't know if you'd call it a search for alpha. We said, "let's take the low-hanging fruit by trading specials and let's take the results.' That's all we're after.”
He would not say how much the pension fund lends but said it was “much smaller” than before the financial crisis, with only 10 to 25 securities now on loan at any given time.
Dow hired eSecLending as its third-party securities lending agent last January.
Tim Smollen, managing director and global head of agency securities lending at Deutsche Bank, New York, said the RFP process for securities lending has changed since the financial crisis, with much more involvement from investment consultants advising pension funds on the searches. Mr. Smollen said Callan historically has advised public plans on securities lending RFPs, but in the past five years Callan has been joined by Hewitt EnnisKnupp, NEPC and others.