Consultants are warning of unappreciated risk in securities lending after the huge unprecedented loss by Harris Trust & Savings Bank in what has been regarded as a "riskless" activity to enhance pension fund returns.
Harris Trust fell victim to "yield grab" to boost securities lending returns in the face of increasing pressure on custodial fees from growing competition for custody clients, contended Wilshire Associates Inc., Santa Monica, Calif., in a memorandum to its clients.
"Harris has been an aggressive bidder for master trust business and had used its past record of high securities lending revenues as a key selling point," the memorandum notes.
But the bond market having its worst returns in the last 15 years showed the vulnerability of investing securities lending collateral, according to consultants and others in the business.
The $12 billion Illinois Teachers' Retirement System, Springfield, a major Harris master trust client and one of its biggest securities lenders, responded to the loss by scheduling a special meeting with the trust department's executives, said Thomas Zimmerman, chief investment officer. The meeting is scheduled for September.
As it did for all the clients affected by the loss, Harris voluntarily reimbursed the Illinois fund fully for the loss.
Mr. Zimmerman said he wasn't able to say how much the loss and resulting reimbursement was, or how much in securities the Illinois fund has on loan in the securities lending program. "We like to have them lend out as much as they can," he added. The fund earned about $3 million last year on securities lending activity conducted by Harris, he noted.
The earnings "more than cover custodial costs" for the fund, Mr. Zimmerman. He declined to say how much the costs total.
Ameritech Corp., Chicago, another major Harris master trust client, with $12.5 billion in defined benefit assets, contributed a large part of the assets in the Harris securities lending program, according to industry sources. Ameritech executives didn't return phone calls.
Nancy B. Wolcott, executive vice president and head of the trust department's corporate and institutional trust, acknowledged Ameritech is a client, but declined to confirm if it was one of the clients Harris reimbursed for the securities lending loss.
In February, Harris without fanfare restructured its trust department. Jon S. Brightman, who was head of the trust department, moved to Harris Investment Management Inc., the bank holding company's money management unit, where he was made a managing director involved with client services. It couldn't be learned why Mr. Brightman was replaced.
Ms. Wolcott, a longtime trust department executive, was promoted to replace Mr. Brightman.
As a direct result of the losses, Harris said it suspended the head of its securities lending unit, although it declined to name who it was, according to Ms. Wolcott.
Securities lending reported to William F. Pridmore, senior vice president in trust operations, who couldn't be reached for comment.
Ms. Wolcott said Harris Investment Management, the bank holding company's money management unit, wasn't involved in investing securities lending collateral.
Executives of other pension funds that use Harris as a custodian or trustee and that may have been involved in the securities lending losses were unavailable for comment.
Ms. Wolcott said only one institutional client asked Harris to reduce its securities lending after the loss. She declined to name it.
Harris's $51 million loss in aggressively investing in mortgage-backed securities occurred as competition for clients continued to put pressure on trust departments to lower trust and custody fees and in turn to generate higher revenue, for both banks and clients, from securities lending. 'For every master trustee in the country, (securities lending) is an important source of revenue," Ms. Wolcott said.
"Securities lending allows you to lower fees," she added.
No other trust departments engaged in securities lending reported losses in securities lending. But many connected to the business conceded the potential for risk in securities lending and losses in recent months.
Joanne Ciacciarelli, worldwide securities lending business executive, Chase Manhattan Bank, New York, acknowledged the competitive pressure to reduce fees and increase securities lending revenue.
"There was pressure especially last year when (interest) rates were low" to move into derivatives to boost returns, she said.
"I actually wanted to," she added as Chase faced competitive pressure to raise its securities lending returns. "We know that from bids" for business. "You're being pressured to get higher returns."
"But after a long analysis we decided this isn't right for these portfolios," she said. "It's a hard decision when you see other competitors sweeping up returns."
"Lending goes hand in hand with custody," she added. "It's very much an investment management product to enhance yield" on the underlying assets of pension funds and other clients.
At Callan Associates Inc., San Francisco, Bo Abesamis, vice president, agreed. Securities lending is "asset management under the disguise of custody," he said.
"Securities lending is supposed to be designed to be a riskless way to make money," said Christina Danner, senior vice president, DeMarche Associates Inc., Overland Park, Kan. But it isn't necessarily, she added.
While trust departments and pension clients have tight guidelines for collateral to cover the loss of a security on loan in the event of a failure of a borrower, Ms. Danner noted, "there is nothing in place for the investment of collateral" such as the loss at Harris.
Trust departments overcollateralize at 102% securities on loan in the event of a default by a broker and typically promise to indemnify pension funds in the case of such a failure. But banks generally offer no indemnity for losses on the investment of securities lending collateral, she said, although Harris voluntarily made up the loss to its clients.
Other consultants also said the investment side of securities lending is often ignored or neglected by plan sponsors, leading them to take greater risks there than it might in its regular investment portfolio.
"Security lending has always been, in my mind, a sleeping giant," said Stephen L. Nesbitt, senior vice president and principal, Wilshire Associates Inc., Santa Monica, Calif.
The assets under management are large, and the profit margins are thin, he said. And with the advent of new types of short-term securities, it is becoming much more difficult to determine what a securities lender is investing in, Mr. Nesbitt added.
Of the $6.7 billion in Harris' securities lending program, $2.3 billion were in floating rate collateralized mortgage obligations, said Ed Lyman, a senior executive vice president at Harris. Consultants and others involved with the securities lending industry, although unfamiliar with the specifics of Harris' portfolio, said that amount in CMOs would be an unusually high proportion for that type of security.
Harris' Ms. Wolcott said the Harris losses came from its investments in "plain-vanilla mortgage-backed securities." She declined to describe the investments further or to confirm the CMO concentration in the portfolio.
She refused to describe the securities lending investments as aggressive.
"The definition of aggressive or non-aggressive is in the eyes of the client," she said.
Harris' investments in higher yielding securities dropped substantially in value as interest rates rose sharply this year.
Even though Harris reimbursed clients for the losses, Ms. Wolcott said Harris violated no internal or client guidelines in investing securities lending collateral. She said the trust department has not removed mortgage-type securities from the list of its approved securities lending investments.
Harris, jointly with its parent, Toronto-based Bank of Montreal, reported the loss June 24, noting, without providing other figures, the loss represented 28% of Harris Bankcorp Inc.'s total 1993 results. Ms. Wolcott declined to give other financial data.
Harris had been aggressively courting trust and custody business at least in part with the potential revenue its securities lending operation could provide, according to people in the industry.
Harris ranked sixth in new business among master trust and custody banks in the most recent Pensions & Investments survey, while it ranked 10th in total assets under custody. Despite Harris' $6.8 billion in new custodial assets, its total trust and custody assets fell to $87.1 billion as of June 30, 1993, compared with the $88.3 billion in the 1992 survey.
Most major trust departments have boosted their securities lending activities, coinciding with increased competition in the custody business.
State Street Bank & Trust Co., Bankers Trust Co., Mellon Bank/Boston Safe Deposit & Trust Co., Bank of New York, Bank of America, Chemical Banking Corp. and Northern Trust Co., all among the top 10 in pension fund custodians, significantly increased their securities lending in recent years, according to annual reports researched by P&I.
Northern Trust, the biggest securities lender among them, had $21.4 billion in trust securities on loan as of Dec. 31. That increased from $19.7 billion the previous year and $9.7 billion in 1989.
Bank of New York, the second largest lender, had $15 billion outstanding as of the same date, up from $13.7 billion in 1992 and $5.8 billion in 1989.
"Securities lending can be very lucrative as banks earn between 25% and 50% of total custody revenue from these programs," the Wilshire memorandum notes in general.
"Even small increases in yield can mean tremendous revenues. For example, a major trust bank with $15 billion on loan can increase profits to the bank by $6 million by increasing the yield on securities lending collateral by just 10 basis points.
"This creates tremendous incentives to maximize portfolio yield and, without careful scrutiny, potential exposure to added risk. Harris fell victim to just this type of 'yield grab.'"
The Wilshire memorandum estimates the combined securities lending revenue for the six largest master trust banks (Bank of New York, Bankers Trust, Chase Manhattan Bank, Mellon/Boston Safe, Northern Trust and State Street) at $620 million, based on a total estimated securities lending collateral pool of $155 billion, a much greater number than P&I found in annual reports, although the banks surveyed weren't identical in two cases. The seven banks P&I researched had $96.6 billion in securities on loan as of last Dec. 31.