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Missouri fund scores big securities lending payout

$123 million settlement believed to be among largest since crisis

Michael Rosen
Michael Rosen said larger settlements typically hinged on the amount of securities on loan, the size of the investor and some breach of duty.

After a six-year legal battle, the $40.4 billion Public School and Education Employee Retirement Systems of Missouri quietly settled its securities-lending lawsuit against State Street Bank & Trust Co. for $123 million, one of the larger known settlements since the financial crisis.

Following the global financial crisis, a number of institutional investors sued custodians that provided securities, attempting to stop the custodians from drastically cutting the value of the investments in their securities-lending programs. Until now, most of the settlements have been much smaller. For example, Northern Trust Corp. stated in a recent Securities and Exchange Commission filing that it paid a total of $70 million to settle all of the securities-lending lawsuits brought against it; mostly in the second quarter of 2016.

The $21.7 billion San Francisco City & County Employees' Retirement System settled with Northern Trust in December 2016 for $11.7 million. A class-action lawsuit filed by 1,500 retirement plans settled with Northern Trust for $36 million in 2015. Another class action led by three pension plans — the $2.3 billion Investment Committee of the Manhattan and Bronx Surface Transit Operating System, the $1.9 billion AFTRA Retirement Fund and the $714 million Imperial County Employees' Retirement System — settled with J.P. Morgan Chase & Co. for $150 million in 2012.

The financial crisis was a game-changer for the securities-lending business, which had been considered a safe way for institutional investors to grab a little extra return by lending securities already in their portfolios.

“Generally, investments (in the cash collateral pools) that had been very safe turned out to be not so safe,” said Michael Rosen, principal and chief investment officer of Santa Monica, Calif.-based Angeles Investment Advisors LLC.

“Securities lending is about picking up nickels in front of a steamroller,” Mr. Rosen said. “For years and years, there was no problem … but then in the crisis there was no liquidity and the steamroller got out of control. … Now you're taking losses in this portfolio and the collateral that you have … can't be sold; there's simply no bidder for this stuff.”

In that environment, some custodians offered their pension fund clients securities in lieu of cash, he said.

While Mr. Rosen was unfamiliar with the particulars of the Missouri-State Street case, he said generally factors that lead to larger settlements include the amount of securities on loan, asset size of the investor and some sort of breach of duty.

'Many significant settlements'

Alan Emkin, managing director of Pension Consulting Alliance LLC. Portland, Ore., said in an email that while he also was not familiar with the case, the settlement amount seemed high, but “there were many significant settlements.”

Mr. Emkin noted that in some cases, the size of settlement would be boosted if there were a demonstrable showing of bad faith or a breach of duty.

State Street Bank officials declined to comment on the Missouri settlement beyond a statement issued in response to Pensions & Investments' questions.

M. Steve Yoakum, Missouri's executive directory, and Alan C. Thompson, the systems' general counsel, both declined to comment beyond court documents and a short description of the settlement in the systems' 2016 comprehensive annual financial report. The CAFR was the first indication the case had been settled.

The lawsuit was originally filed in 2009. According to legal filings, after the financial crisis, State Street revalued the pool of the cash collateral posted by the securities borrowers downward by about $96 million. The Missouri pension systems received a portion of the returns earned by this pool. State Street then offered pension officials distributions in the form of securities instead of in cash, the 2016 annual report stated.

The lawsuit alleged State Street had invested a substantial portion of the systems' cash collateral pool in risky asset-backed securities including residential mortgage-backed securities, commercial mortgage-backed securities, pools of credit card debt, collateralized debt obligations and collateralized loan obligations. These securities lost substantial value and were illiquid.

State Street's securities-lending agreement with Missouri permitted securities withdrawals under normal circumstances. But in September 2009, State Street executives demanded the pension fund move back $4.2 billion in securities it had earlier withdrawn, the suit maintained. Missouri executives alleged in their complaint that State Street's demand to return the securities violated its fiduciary duty.

State Street denied wrongdoing. “The financial crisis that began in 2007 created significant levels of volatility and market illiquidity in certain instruments, including those that were held in securities-lending cash collateral reinvestment vehicles,” State Street noted in its statement to P&I. “State Street's collateral pools did not have any material credit losses in the financial crisis.”

Concerns remain

While other banks have settled most of their securities-lending lawsuits, the issues that gave rise to the litigation have not been completely resolved.

Northern Trust stated in its SEC filing that “the global financial crisis of 2007-'08 and resultant period of economic turmoil and financial market disruption produced losses in some securities-lending programs, reduced borrower demand and led some clients to withdraw from these programs. A return of these conditions in the future could result in additional withdrawals and decreased activity, which could impact our earnings negatively.”

Missouri still has a securities-lending program but not with State Street, which was terminated as custodian on Oct. 1, 2010. The current custodian is J.P. Morgan Chase.

In light of the issues, some pension funds have discontinued their securities-lending programs. In April, the San Francisco retirement system discontinued its securities-lending program, saying the income earned did not justify the risk.

Securities-lending programs have “mostly been scrapped,” said Angeles Investment Advisors' Mr. Rosen. “It's not worth the headache. Picking up nickels was fine until it became pennies and half pennies. … There's not enough spread to make it worthwhile, and the losses in 2008 and 2009 were enough to last a lifetime.”

State Street, still offers securities lending, holding an aggregate amount of indemnified securities on loan totaling $373.5 billion as of March 31, according to its latest SEC filing.

Bank officials say it has made changes to improve its securities-lending program. “Since (the financial crisis) we have made a number of adjustments to our securities-lending program that reflect the experiences that we and others in the industry faced during the financial crisis,” according to State Street's written statement.

This article originally appeared in the May 29, 2017 print issue as, "Missouri fund scores big securities lending payout".