BOSTON - Several pension funds are probing Mellon Trust's securities lending activities following the bank's plan to spend $130 million for interest rate swap contracts to reduce risk in highly interest rate sensitive securities lending portfolios.
The $16 billion Los Angeles County Employees' Retirement Association is re-evaluating its proposed securities lending contract with Mellon. The securities lending portfolios involved were managed primarily by an investment unit of The Boston Co., which Mellon acquired in May 1993.
The $7.4 billion Massachusetts State Teachers' & Employees' Retirement System, Boston, quit using Mellon for securities lending following the bank's revelation that it had acted to reduce the risk of the portfolios. One official said the pension fund viewed the lending operation as "aggressive."
The fund is keeping Mellon as global custodian. Its custody services have been "excellent," the fund official said.
Further questioning about Mellon's securities lending activities is coming from the $22 billion State of Wisconsin Investment Board, Madison; the $850 million Fresno County Employees' Retirement Association, Fresno, Calif.; the $1 billion Massachusetts Bay Transportation Authority Retirement Fund, Boston; the $26 billion Washington State Investment Board, Olympia; and the $11 billion Connecticut Trust Funds, Hartford.
Several Mellon Trust securities lending clients expressed thanks to the bank for its risk reduction actions, and expressed relief at escaping potential damage to lending revenues.
The $130 million would be the cost of the transaction "to enter into interest rate swap contracts that will convert the income generated by certain securities lending collateral investments to a short-term floating rate," bank officials said.
Still, pension fund officials said they are concerned about the riskiness of Mellon Trust's securities lending activities and will continue their inquiries.
Mellon's Boston-based securities lending unit had positioned the securities-lending collateral duration longer than was warranted in a climate of rising interest rates, said Stephen G. Elliott, bank chief financial officer.
Even after holding conversations with Mellon bank officials, pension fund executives said they still feel they don't have adequate answers from the bank.
"None of this is resolved yet. We want more details," said Ken Shaffer, chief investment officer at the Los Angeles County fund. That fund hired Mellon for securities lending and global custody in the summer following a fierce battle for the business against Bank of New York and Bankers Trust Co. Final contracts with Mellon still haven't been signed.
As is true at many pension funds, securities lending was a key consideration for the Los Angeles County fund in its selection of a global custodian.
Mr. Shaffer said the fund could tighten wording on securities lending before it signs the contract. The fund earlier asked for separate contracts for securities lending and global custody services.
Simon Russin, a fund trustee. said: "I want full disclosure (from Mellon). I won't vote to sign the (securities lending) contract until we do. That is our leverage. We are still negotiating."
Mr. Shaffer added fund executives are "evaluating the ramifications" of the reported departures of two key Mellon securities lending executives - Jacob Navon, a senior portfolio manager and senior vice president in the securities lending operation, and Glenn Davis, who worked for Mr. Navon at the Boston Co. Whether the men resigned or were dismissed could not be learned.
In the fund's search for a global custodian, the staff issued a report that hailed Mr. Navon as "a highly regarded trader. He and his staff had the highest returns during 1993 of all the cash reinvestment teams reviewed. They have an aggressive, but credit-controlled approach to investing money."
Gary Peterson, Fresno County fund administrator and county treasurer-tax collector, said his board expects to talk to Mellon executives about what happened.
Said Patricia Lipton, executive director of the Wisconsin board: "We have not finalized conversations with Mellon. At this point, I don't want to comment in detail. We most likely will be looking" at changes made at Mellon.
She added any investment program with an interest rate exposure "is going to be having a difficult time of it." She said it is "very important for people to maintain cool heads with what has happened in the portfolio and not act in a precipitous way until they understand" the exposure to the portfolio.
John Gallahue, executive director of the Massachusetts Bay Transportation Authority pension fund, said he didn't have "details" on how the problems at Mellon occurred. He said his fund is "keeping a close eye on the (securities lending) program."
"We haven't been thrilled with the direction in the last few months. Earnings have slowed down dramatically," he said.
The Washington State Investment Board has a separate account for securities lending with Mellon, one of the fund's two securities lenders. The other is Bank of New York. Philip Halpern, chief investment officer, said he doesn't think his fund suffered any loss. But, he said, he is still "trying to get the last few facts."
Mr. Halpern said his fund's consultant, Wilshire Associates, Santa Monica, Calif., has been chastising other pension funds about allowing their securities lender to take risks not allowed their money managers.
With custody services fees so low, some custody banks, which share in securities lending profits, have been moving further out on the risk spectrum to try to make money, said Mr. Halpern.
The Massachusetts teachers and employees system was "surprised at the aggressive nature of securities lending at Mellon," said Eric Fehrnstrom, assistant treasurer.
The pension investment committed approved State Treasurer Joe Malone's recommendation to withdraw from the Mellon securities lending operation.
Mr. Malone made the recommendation "given the restructuring that is occurring in Mellon Trust's securities lending division," Mr. Malone said.
For the year ended June 30, the Massachusetts fund earned $3 million on securities lending. Mr. Fehrnstrom said his fund and another state fund typically each make $5 million a year on securities lending.
Other securities lending operations of major custody banks don't appear to be in any significant trouble, according to Joseph Duwan, an analyst with the brokerage firm Keefe, Bruyette & Woods, New York. He said analysts have found other securities lending operations seem to be signaling their asset duration is within reasonable bounds.
A spokesman for State Street Bank and Trust, Boston, rejected speculation that State Street Bank might also have a problem in its securities lending operation. The spokesman said State Street "categorically denies" it has a securities lending problem.
Mellon's Mr. Elliott declined to be specific on a number of issues in an interview, saying he couldn't violate client confidences.
Mellon's securities lending operation had no market value loss on its portfolios, said Mr. Elliott. The $130 million was used to get the portfolio to a shorter-term floating interest rate during a period of "rapidly rising interest rates" and prospects of "even higher interest rates," he said.
He said Mellon executives decided to reposition the portfolio to protect the bank's reputation. He said Mellon did something "it was not obligated to do."
Indeed, L.A. County's Mr. Shaffer commended Mellon for "stepping up to the plate." Some institutions in the past haven't done what Mellon did to protect clients in similar situations, he said. All of the pension fund officials interviewed had similar views.
Mr. Elliott, meanwhile, declined to say whether any of the pension clients are trying to impose limitations on Mellon's use of derivatives or its degree of aggressiveness in making interest rate bets.
The securities that put the securities lending collateral portfolio in jeopardy, said Mr. Elliott, had durations that were "too long in light of current market conditions."
He said the rise in interest rates last month was "especially painful" and the probability of further interest rate rises "made these securities unacceptable in a securities lending type of operation."
As to whether Mellon's securities lending operation was more risky than similar operations, Mr. Elliott said, he couldn't comment because "I honestly don't know" about competitor operations.
Mr. Elliott declined to comment on the departures of Messrs. Navon and Davis.