Securities Lending: Cause Of The Next Financial Crisis?

By Larry Macdonald AAA

The lending of securities has quietly become a big business. The global volume of securities loans was $2.3 trillion in the fall of 2008, according to estimates from U.K-based consulting firm Data Explorers. Proponents say securities lending makes financial markets more efficient and improves returns for investors. Critics say it raises questions about the fiduciary duties of money managers and poses risks to investor's portfolios as well as the financial system.

What is Securities Lending?
Securities lending occurs when investors lend stocks, bonds and other securities in their portfolios to other market participants. By far, the biggest lenders are institutional investors such as mutual funds, exchange-traded funds (ETFs), and pension funds. They are harvesting billions of dollars in profits.

The market participants who borrow the securities are typically hedge funds. They use the borrowed securities to make short sales (ie. the securities are sold on the expectation they can be bought back at lower prices to turn a profit). Borrowers are required to put up collateral at least equal in value to the securities. (Learn more about short sales in Questioning The Virtue Of A Short Sale.)

Other aspects include:

  • Collateral is marked to market on a daily basis to ensure adequate coverage of loans.
  • Cash collateral is invested and earns interest that is split in varying degrees between lenders and borrowers.
  • Dividends and coupons from loaned securities are, in most cases, passed on to the lenders (beneficial owners).
  • Securities lending may be a self-administered program of the institutional investor or facilitated by intermediaries such as custodian banks and prime brokers.

There are several pros and cons to securities lending. Two benefits are market efficiency and lower management expense ratios (MERs). Concerns include: potentially lower investment returns, sharing of lending fees, heightened risk and opacity.

Benefits

  1. More efficient markets - By supporting short selling, security lending increases liquidity in the market by increasing the number of sellers, which results in benefits such as lower bid-ask spreads. It also allows financial markets to more fully reflect all available information, thus promoting the efficient pricing of securities.
  2. Potentially lower MERs - The fees earned from loaning out securities can be used to defray the costs of institutional investors and thus allow them to lower their management fees to investors. If lending fees become large enough, they could potentially fully offset management costs and enable, if they so wish, reductions in MERs to 0%.

Concerns

  1. Potentially lower investment returns - Security lending seems at odds with the fiduciary duties of institutional investors. There is an expectation their focus should be on optimizing the value of their clients' holdings, yet the practice has side effects that appear to go against this duty. Specifically, institutional investors are:
    • Collateral is marked to market on a daily basis to ensure adequate coverage of loans.
    • Cash collateral is invested and earns interest that is split in varying degrees between lenders and borrowers.
    • Dividends and coupons from loaned securities are, in most cases, passed on to the lenders (beneficial owners).
    • Securities lending may be a self-administered program of the institutional investor or facilitated by intermediaries such as custodian banks and prime brokers.
  2. Inequitable division of loan revenues - Not all institutional investors pass on the full amount of lending revenues (after costs) to their clients. Many keep large portions, or even all, of the fees for themselves. Yet the securities belong to their clients and it is not obvious they would consent to such a generous division of the spoils if allowed a say in the matter.

    Some observers have asserted that funds taking a large revenue share have greater incentives to maximize those revenues. And even after taking their cut they can pass on more revenues to unitholders than companies who just seek to cover costs. Two counterarguments are:

    • Making it easier for short sellers to bet against the securities owned by their clients, which may create downward pressures on their prices and contribute to the severity of market declines.
    • Limiting their capacity to actively campaign for shareholder value since voting interests in shares are relinquished when stocks are lent out.
  3. Heightened risk - Borrowers may not be able to meet margin calls on their collateral or return borrowed securities upon request. The borrower's collateral can be seized and/or sold but this may at times yield less than the value of the loaned-out securities – especially when collateral of lesser quality has been accepted and market conditions make it difficult to sell at good prices.

    Cash collateral can be invested in places where the risk of losing return and principal is high, as the financial crisis of 2008 brought to light. For example, some funds had collateral invested in mortgage-backed securities when demand for such instruments evaporated. Others lost collateral when Lehman Bros went bankrupt. (For an overview of the financial crisis beginning at the start of 2008, refer to The 2007-08 Financial Crisis In Review.)

  4. Lack of transparency - Securities lending occurs "over the counter," between financial institutions, not through a centralized exchange. Also, disclosure by institutional investors to their clients is not the greatest. Within such an opaque environment, the potential for questionable arrangements and excessive risk taking is high. Some examples:
  • Making it easier for short sellers to bet against the securities owned by their clients, which may create downward pressures on their prices and contribute to the severity of market declines.
  • Limiting their capacity to actively campaign for shareholder value since voting interests in shares are relinquished when stocks are lent out.

Conclusion
Personal-finance columnist Jason Zweig ended his May 30, 2009 Wall Street Journal article on securities lending with this:

Your fund should lend out your securities, but the proceeds should go to you. And fund managers should reinvest the collateral only in absolutely safe securities. The current system, where they keep half [or other large portion of] the gains and stick you with all the risks, has got to go.

It might be added that the mismatching of gains and risks in securities lending (plus the lack of transparency) bears watching. As security lending grows and takes on more significance, it could pose a systemic risk to the financial system - in a way similar to mortgage-backed securities ahead of the crisis of 2008.

As may be recalled, U.S. banks had incentives to loosen lending standards and ramp up mortgages because origination fees accrued to them while the risk of defaults accrued to the holders of the securitized mortgages. Could there be an analogous misalignment in rewards and risk across economic agents in the case of security lending?

For additional reading, take a look at Why Fund Managers Risk Too Much and Will A New Fund Manager Cost You?

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