Securities lending put on front burner again

Large pension funds have come back to securities lending with lessons learned from the 2008-"09 financial crisis and a greater focus on risk than ever before.

That's because rather than viewing securities lending as a means to get incremental returns, possibly to pay for other services such as custody, it's now seen more as part of an overall risk-based investment strategy. And while smaller pension funds have stayed on the sidelines since the Lehman Brothers Holdings Inc. default in 2009 hit securities lending hard, larger pension funds are back in the game, albeit more cautiously and with increased scrutiny.

“We're back in to take advantage of the economic opportunities of lending these securities with as close to no risk as possible,” said Gary McGuire, chief investment officer at Dow Chemical Co., Midland, Mich., which has a $13.5 billion U.S. defined benefit plan.

“The main thing to consider is that in the overall global DB universe, some smaller plans are no longer interested, but larger plans are still consistently engaged in securities lending,” said Josh Galper, managing principal at securities lending consultant Finadium LLC, Concord, Mass.

“In 2012, 89% of the largest public and private pension funds and sovereign wealth funds we surveyed globally had a securities-lending program. The smallest plans generally don't have as sizable an amount or diverse assets to make (securities lending) worth their while.” The firm defined “largest” as plans with more than $1 billion in total assets.

“There's a new appreciation (by clients) that securities lending is a risk, but there are ways to do risk management,” said Nicholas J. Bonn, executive vice president and head of transition management and portfolio solutions at State Street Corp., Boston.

As for the pre-crisis view of “set it and forget it” when selecting a securities lending agent, “those days are gone,” Mr. Bonn said. Pension funds “all supervise us now. ... Gone are the days when someone says, "What's the difference between securities lenders?' The crisis showed they're not the same.”

(Mr. Bonn was also interim head of the firm's securities lending business for three years until Lou Maiuri took over the position last week.)

“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.

Mr. Smollen said consultant involvement is a sign that public pension funds are looking for “more transparency and professionalism” from securities lending agents. “If there's no consultant (assisting on the RFP), we think long and hard about whether we'll participant in that RFP,” Mr. Smollen said.

That consultant involvement is a recognition by public plan executives that they need to take a closer look at their securities lending agent, added Joseph Santoro, Deutsche Bank director and head of origination for agency securities lending, also in New York.

“Most clients aren't that close to securities lending,” Mr. Santoro said. “It's not easy for them to decipher how to select an agent. It's the same as hiring or firing a money manager, and that's where the consultant can help.”

Ultimately, securities lending still remains the search for excess returns apart from regular investment portfolios, said Finadium's Mr. Galper. And the ability to do that increases with the size of the pension fund.

“Specifically in the DB market, we find divergence between the largest plans, in what they want in terms of risk and returns, and smaller plans who have less diverse asset pools and can't allocate as much attention to these programs. It's accurate among smaller DB plans that their securities-lending returns are less. There's no evidence to suggest that revenues for smaller DB plans will grow significantly at this time.” n