Magazine

Published in April 2012

The Way Forward

By John Keefe | April 2012
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The postfinancial-crisis state of securities lending

Illustration by You Jung Byun

“What does not destroy me makes me stronger,” says a maxim in Friedrich Nietzche’s 1888 essay “Twilight of the Idols.” He did not have securities lending in mind, but the idea applies to a financial business that saw great injury—of its own making—during the financial crisis. While securities lending is smaller today than before 2008, attention from regulators, customers and providers has resulted in a sounder, if smaller and less profitable, industry. There remain, however, fundamental risks that securities owners need to keep in mind.

The securities lending business has been in a slow period for several years, due to depressed demand for borrowed stock since the downturn. Most stock loans go to fulfill short sales, made by hedge funds and brokers’ trading desks in carrying out long-short strategies and merger arbitrage. Data Explorers, researchers specializing in securities lending, reported U.S. equities available for loan at about $3 trillion at the end of third quarter 2011, their latest tally, down from a peak of about $4.5 trillion in mid-2007.

“Investors are unsure of what is happening in the regulatory and economic environment, decreasing their appetite for risk,” notes Tim Smith, senior vice president with the Astec Analytics unit of SunGard. “Until the prop desks at broker/dealers and the hedge funds have a better sense of what is going on in the markets, they will be on the sidelines.”

The supply of stock to be borrowed—that is, the shares institutions have made available—is down as well. Smith points out that beneficial owners withdrew about 15%, adjusted for market value changes, of the U.S. equities they made available for borrowing early in 2009. “But people realized they were missing the income,  came back into the market and increased availability about 10%,” he says. “[In 2010 and 2011,] there [was] a slight decline, as  beneficial owners have perceived that demand to borrow stocks may not be coming back and are asking themselves whether the income they earn is worth the hassle they go through.”

The lower supply reflects greater discretion in lending on the part of institutions, says Thomas Poppey, chief operating officer for New York-based Brown Brothers Harriman Global Securities Lending. Lenders are emphasizing the securities in their portfolios that have higher intrinsic values—so-called “specials,” commanding the highest fees for lending.

In the U.S. market, the most-special stocks can earn annualized rates of as much as 80% or 90%, and the somewhat special Russell 2000 universe 15% or so, while large-cap “general collateral” shares might earn just five to 10 basis points (0.05% to 0.10%).

Focusing on intrinsic value is 180 degrees away from the practices leading up to the financial crisis: Rather than lending fewer, scarcer securities to capture their high intrinsic loan rates, many programs put their emphasis on lending general collateral equities at high volume to maximize the cash collateral a securities lending portfolio could generate; this in turn would be reinvested in fixed-income portfolios that reached for yield with subprime mortgage securities and the like.

Investing the cash collateral is still a major component of securities lending, and owners have reacted to those wounds from the financial crisis in two ways: One is more conservative investment policies for securities lending collateral, limited in some cases to overnight investment in repurchase agreements.

Another reaction is more diligent monitoring of securities lending programs. “Five years ago, securities owners got a check at the end of the month from their lending agents, and a pat on the head,” observes Smith of SunGard. “Now, they are getting daily and weekly reports, covering what is on loan, who they are lending to and the risk profiles of how their cash collateral is being invested.”