Stock Lending Today - An Industry Under Siege!

Watson Wyatt Securities Lending Report

Many of you may have seen in the press that a report has been released by Watson Wyatt ("WW"), investment consultants to institutional investors.   The document addresses WW views on the current securities lending market environment and makes recommendations to clients.  I’ve finished reading it and have a few comments to make. 

They make some very sensible, if simple suggestions: 

“It is our recommendation that clients suspend securities lending activity unless loan arrangements are well understood and are comfortable with the risks associated with their program.”

Great, can’t argue with that. However, if their clients were in securities lending programs that they didn’t understand, you would have expected WW to advise clients to do this without needing Lehman as a catalyst. 

In its basic description of Collateral, WW makes the assertion that:

“The quality of noncash collateral accepted can vary, with the conservative and appropriate approach being to only accept high-quality collateral, (e.g., government securities)."

Conservative and appropriate?  I am not certain how they can categorically state that  high-quality government securities are the ONLY approach.  It seems to me that any analysis would take into account the securities on loan and the correlation with the collateral held against those loans. This seems to be particularly important in the current environment where volatility is at unprecedented levels.  Conventional and uninspired might be a better description for the approach.  The only leeway that I will concede is that it is entirely possible that some clients may be restricted in terms of which collateral types they are permitted to hold.

It’s hard to argue with the following comment: 

“As with all investment decisions, clients need to be confident that the risks taken in securities lending are well compensated in terms of expected return.”

Hard to argue with, but let's first review the risk reward profile.  I wrote a guest blog yesterday on ETF lending for IndexUniverse.com, the leading website for the world of indexing.  You can go the article here, but I want to take a small subset of risk/reward considerations from yesterday’s blog: 

• Securities lending is revenue generated from otherwise static assets.  The investment decision itself has dramatically greater scope for gains and losses, whereas under normal circumstances, securities lending returns are only positive.
• Lending activity is fully collateralised and is marked to market on a daily basis. 
• Your primary risk is counterparty and participants have complete control over their selections.
• Stock loan transactions are almost all conducted on an "open" basis, meaning that either side can cancel any or all outstanding transactions without penalty with a minimal notice period of a few days at most. In a deteriorating credit environment a lender can reduce exposure or even cease trading with a counterparty in very short order.
• It is also possible to have further counterparty protection through indemnifications issued by many of the top agent lending organisations.

The WW report acknowledges that “The chain of events resulting in an indemnification being required and then to failing would be extreme (but not impossible)”.  Am I drawing the wrong conclusion here, or does this statement actually move the focus on to the area where indemnification isn’t pervasive- i.e. cash reinvestment?

“On the whole, the industry coped well with this process”  How nice, but this leaves the suggestion in people’s minds that there are parts of the industry that didn’t cope well.  If it is their intention to show where the gaps are, then make it clear which areas need further investigation.

Having read the document, I am left with a number of thoughts and questions:

Why has it taken two months since Lehman’s demise to come up with these recommendations?  The report accepts that service providers had been implementing changes to the risk profiles of their programs for some time before the default.    I did a survey mid-October to gauge the changes that market participants had already made to their programmes post-Lehman. 

How did their clients get into lending programmes in the first instance without understanding the risks involved in securities lending and do they now really need to be told the following:

"If risks are examined and deemed unacceptable, clients can:

• Suspend securities lending, where possible.
• Initiate a gradual withdrawal from the program.
• Change the lending guidelines."

Are WW recommending another wave of departures from beneficial owners that haven’t left the market?  We have seen in output from DataExplorers that there was an early exodus of beneficial owners from the business, but that has stabilized recently.  Those organizations that had the most concern have already withdrawn, and anecdotally I am aware of some re-entering the market, or making plans to do so. 

We all benefit from a more informed client base and inevitably there were people involved in securities lending that need a better understanding of the risks issues in the business.  However, I don’t believe that this represents a substantial proportion of the industry.  If it does, then we are all at fault. 

Finally, for all their words of risk/reward analysis and a balanced view of whether it is appropriate or not, what concerns me most is the comment attributed to one of the Watson Wyatt people at a recent conference in London describing securities lending as “picking up pennies in front of a steamroller, and the steamroller is gaining speed”. 

I haven’t seen anything in this report that justifies such a comment.

Have a great weekend!

The Morgan Stanley story after Lehman

Lost track of all the different bailout packages in the US? Check out the article by Kelly McParland of National Post. I was exhausted by the end of it and my calculator had blown up. We have our own massive government nationalisations and obligations running up in the UK, and I hope someone is keeping tabs over here. That way my grandchildren will have a better understanding of why they are still paying off the debts from this government.

The Wall Street Journal has published a really interesting recap on events revolving around the Morgan Stanley share price in the days following the Lehman default. You really need to read this and form your own view. Failing a smoking gun memo or taped telephone conversation, it’s surely impossible to divine peoples’ true intentions in trading. Were firms acting to hedge themselves and reduce risk which is proper and prudent and should be demanded by shareholders or was there manipulation involved? Did some hedge funds pull their prime brokerage business from MS in order to stoke the fires of their speculative short positions in MS or because they were concerned about having their assets tied up in another dealer in the event that MS did fail?

Credit Default Swaps play a big part in the MS story and there has been a huge amount of controversy surrounding the CDS market over the past year. Read this article  by Alex Trias and you can see in a little more detail how it all links together.

Another person mentioned in the MS article is Jim Chanos, head of Kynikos Associates.  I’m not going into his comments in the MS saga, but rather I have attached a really interesting Download GRANTS-Jim_Chanos_10_2008_Presentation_FINAL he gave just over a month ago which is a review of short ideas that he has credited to the Grant Interest Rate Observer. 

Global Short Selling Task Force Formed

Yesterday the International Organization of Securities Commissions (IOSCO) Technical Committee had a global teleconference that was convened by SEC Chairman Christopher Cox. 

The outcome of the call is that three Technical Committee Task Forces will be formed and investigate three different issues:

The Short Selling Task Force will examine gaps in the regulatory approaches to naked short selling. 

The Task Force on Unregulated Financial Markets and Products will look at ways to introduce greater transparency and oversight to unregulated market segments.

The third group is the Unregulated Financial Entities Task Force.  IT will examine issues surrounding unregulated entities such as hedge funds.

The Task Forces will present their reports at the next Technical Committee meeting in February 2009 and to the next G-20 summit in spring 2009.

As regular readers will know, I have been opposed to the huge intrusions on the markets that governments around the world have made into the financial communities.  In my opinion these have typically been hastily implemented and ill-considered. 

However, I understand the need and desire for governments to act quickly and be seen to take action.  I have contrasted the actions of the SEC which implemented short selling restrictions for a relatively short period of time as a cushion for markets to normalize against the actions of the FSA that started off with a ban that went well into 2009. 

We subsequently had an announcement from Gordo Boom-Boom-No-Bust-Well-Maybe-There-Will-Be-But-Nothing-To-Do-With-ME Brown that new short selling rules would come into effect before the short selling restrictions expired.  That was before there was any analysis of the impact of the restrictions.  It is shocking, but not surprising that our politicos act before thinking. 

It seems to me that this new initiative is a sensible and reasoned approach to some very important issues that face the financial community.  In the SEC statement they added the comment introducing the Short Selling Task Force:  “In this connection, the Task Force will also examine how to minimize adverse impacts on legitimate securities lending, hedging and other types of transactions that are critical to capital formation and to reducing market volatility.”  The Short Selling Task Force will be under the leadership of the Securities and Futures Commission of Hong Kong.

Regulators have a responsibility to take reasoned and necessary actions to protect markets, investors and societies as a whole.  They are ill-equipped and ill-advised to act spontaneously and without investigation, discussion, debate and analysis.   Yesterday’s announcements herald the right approach, and bode well for a sensible outcome.  Crucially it is also globally coordinated.

Regulators conference call on short selling

Apparently Christopher Cox, chairman of the SEC has convened a conference call today for global regulators to discuss short selling.  Apparently they are going to examine the effectiveness of the restrictions / bans / controls that have been announced, implemented and in some cases removed this year.

It will be interesting to see what the outcome will be. I have yet to see any evidence that shows the restrictions have had a positive impact on markets and at least a couple of pieces of research that indicate a negative impact.  If you see any news on the conference, feel free to send it through and I'll include it tomorrow.

Portfolio Exclusives

One of the most common points of discussion in all my meetings over the past few weeks has been the area of Exclusives.  Are exclusive arrangements doomed to extinction or do they still play an important role in the industry? 

First, to make certain we are all on the same page, let’s define “Exclusive”.  For the purposes of this article, Exclusives are an arrangement whereby a Beneficial Owner agrees to give exclusive access to a pre-defined group of assets to a borrowing entity for a fixed period of time.  In return for the exclusivity, the borrower pays a specified fee and in some cases makes additional commitments in terms of minimum cash collateral balances.  The assets may be an entire portfolio, or subsets thereof and is unique to each situation. 

"Exclusive arrangements are dead"

Hardly

There is no question that the securities lending business as a whole has contracted substantially from where it was earlier in the year.  There are several reasons for this reduction – limited trading opportunities for proprietary trading firms and hedge funds, hedge fund redemptions, and the increased financing costs and impact on firms’ balance sheets and capital.

However, trading hasn’t disappeared, and many are expecting increased demand once we get into the New Year.  Tax efficient trading will always be in demand, although the savings/earnings opportunities may fluctuate dramatically.  As some beneficial owners have stopped lending, there has been an overall reduction in supply across the board so exclusives remain a valid alternative.

A high quality portfolio will always have demand for exclusive arrangements

Borrowers don’t want to pay for exclusives

Kind of …

Exclusives are a bet on the future for dealers.  They want to identify portfolios that will generate better value than their cost outlay.  The Beneficial Owner gets certainty of income from the fixed fees.  They are protected from a fall in borrowing demand – that risk is bourne by the exclusive buyer.  They lose out if the demand for their stocks goes through the roof and this valid argument is often made by agents looking to dissuade Ben Owners from going exclusive.

Given the falling market over the past year, you know that the dealers have been sucking up these costs while the demand side of their business has also fallen off.  So there is no question that the desire to “pay up” has been impacted.  For the past year the Ben Owners' (and actively involved agents) income has been protected by the exclusive borrowers.

Further, the cash re-investment side of the business for agent lenders has had an indirect impact on exclusives.  In order to attract and keep cash in their pools, agent lenders have been offering stocks to borrowers at unprecedented levels.  Give stocks away and the dealers will be attracted. 

The bottom line is that many dealers are still willing to pay, but not necessarily at the same levels as before.

Beneficial Owners don’t want exposure to exclusive borrowers

Maybe …

There is no doubt that everyone is more concerned about counterparty exposure than ever before. That applies to all sides of the market – Beneficial Owners, Agent Lenders and Borrowers. 

One of the negatives levied against exclusives is that it concentrates counterparty exposure into a single entity.  Most exclusives don’t result in an entire portfolio being awarded to a single counterparty.  If that were the case, it should indeed bring up the question about counterparty concentration.  The overwhelming majority of exclusives are parceled out to multiple counterparties and they typically have maximum borrowing limits imposed on the dealers.

Whether a beneficial owner lends to 5 dealers in a conventional lending programme with maximum exposure limits, or whether they are lending exclusives to the same 5 firms, the counterparty risks remain the same.  (Of course, this doesn’t take into account the impact of indemnifications which I will look at in the future.)

If a beneficial owner doesn’t want counterparty exposure they shouldn’t be lending their portfolios.  And that’s one of the reasons why some have pulled out of the market.

Summary

Exclusives are an important part of the business and will remain so.  Quality portfolios will always be in demand.  I think there was a time not too long ago where just about any portfolio could get a bid on it.  That’s no longer the case.

You also need to remember that not all firms are experiencing the market in the same way.  The flight of business from some dealers and prime brokers to others has meant that while exclusive demand is shrinking at many firms, it is surely rising at others.