Stock Lending Today - An Industry Under Siege!

Securities Lending and Short Selling Round Up

I have a few things that I have picked up over the past week.

Prefer to Hedge Citigroup

Citigroup common shares remain one of the most shorted stocks in the US as measured by number of shares.  It still doesn’t represent a large number relative to its daily turnover, but that is an argument for another day.  In any case, it seems that one of the drivers of shorting this stock is an arbitrage play between the preferred shares and the common shares.  Investors and traders were shorting the common stocks as a hedge to their buying of preferred.  Citi has announced that it will stop paying dividends on virtually all preferred shares and that it would offer to exchange preferreds to common at a price of $3.25.  That represents a huge premium over the stock that fell off the cliff on Friday.

Citi also said that the redemption price for the preferreds would be at a “premium to market”.  So you could have bought the preferred and hoped to capture some the premium.  However, since your newly acquired preferred shares are still at risk to market price fluctuations, ideally you would want to short the common stock as a hedge.

So, it’s not all negative directional views on Citi, although that is probably the biggest driver.

http://money.cnn.com/news/newsfeeds/articles/djf500/200902271734DOWJONESDJONLINE000964_FORTUNE5.htm

Banned or Not Banned?

I’m a bit confused by a story I picked up from Down Under.  Macquarie Bank shares have taken a bit of a pasting recently, dropping to levels not seen for 10 years.  I’m not going to give any commentary on whether this is a good bank or a bad bank, because I’m not really qualified.  However it seems to me that any bank that is making a profit these days must be doing something right (or avoiding doing other things wrong).

The thing that grabbed my interest was in the article from The Australian highlighted “the basic flaws in the ASIC ban on short selling”.  It seems that short sellers are “finding myriad ways around the ban” including derivative trades.  Shock!  Horror!  Who would ever have thought of finding other ways to get short exposure that didn't involve selling borrowed stock?

Unsubstantiated Rumour of the Day

CNN carried a story that suggests that Bank of America will soon be having a fire sale of Merrill Lynch assets, including the Prime Brokerage business.  Note that in the header I cleverly used the word “unsubstantiated” because I have absolutely no idea whether or not this is true.   I did think it was odd that BoA originally bought Merrill last year having wanted to exit investment banking generally and had not too much earlier in 2008 sold BoA’s own prime brokerage business to BNP Paribas.

Brown Bashing

I can’t help it … for those of you still reading this rather long blog, check out the Open Letter from Steven Katirai to Gordon Brown demanding the PM’s resignation.  It has been doing the rounds recently and I feel it is my duty to pass it on to you.  Download Gordon_Brown(2)   Enjoy, I know I did. 

Regulate your way to success!

When government pundits run out of ideas on how to fix things, they inevitably turn to transparency.  That is where we are now. "Surely more transparency will save us all."  How do we get transparency – Regulations of course.

This past weekend, EU leaders agreed on draconian measures to crack down on hedge funds.  Although they haven’t provided details of their agreement, you can assume that transparency is a cornerstone of their proposals.

The Alternative Investment Management Association, the trade body for the hedge fund industry has itself launched a new transparency initiative, perhaps in an attempt to pre-empt or help shape any future disclosure requirements.  Included in their platform is increased transparency of significant positions and risk exposures as well as more short position disclosure to national regulators.

Earlier in the week, the Reserve Bank of Australia announced a new disclosure regime that will require all stock exchange transactions involving borrowed shares to be reported by stockbrokers at the end of each day.  The Stock Exchange will then publish the information in order that small investors will be fully informed.

In the UK disclosure is required whenever a short position reaches a quarter of a percent of a company’s issued share capital. 

Even emerging markets are getting into the game.  Last year Hungary required that investment firms disclose all short sales for positions that exceed .01% of a company’s listed shares.

So we’ve seen lots of regulations implemented and proposed.  What’s the impact of all of this?

The UK media picked up some short sale disclosures in one insurance company last week proclaiming the “King of Short Sellers” had driven down the stock price.  This was the headline despite the fact that the company’s share price has been on a downward trend for almost two years.  Then when the disclosure announcement came that the King had reduced his position below the reporting requirement, this coincided with a share price rise. 

The Hungarian regulations – at a very low hurdle rate resulted in exactly zero disclosures last year.  Yet the government has moved recently to enshrine this as law.

Will small investors in Australia really benefit from the disclosure of every short sale.  Given that there isn’t any context of that short sale, will it inform or mislead?

The short selling bans and restrictions have not been shown to benefit, support or protect share prices.  In fact Christopher Cox (pictured above), the former head of the SEC in the US is on record as saying that imposing the short selling restrictions was the biggest mistake of his career, but that the political pressure was overwhelming.

While the short selling ban in the US didn’t do anything to protect share prices, it had a dramatic and negative impact on beneficial owners and the securities lending industry.

Will the transparency that results from these regulations bring any value to the public or is it a political exercise playing to the media and the masses.  Regulation without justification, explanation or analysis is hardly likely to help the markets get out of their current turmoil. But the politicians are hoping it will at least distract us.

Guest Blog - Cash Re-investment: What have we learned?

I am pleased to provide a vehicle for this Guest Blogger.  I have covered Cash Reinvestment issues several times, but this article is from an agent lender practitioner who is at the heart of the challenges on a daily basis.  The writer wishes to remain anonymous.  Please send your comments to me and I will pass them on.

What have we learned:  Well it’s certainly no free lunch!!!

It’s important to understand cash reinvestment is not securities lending – however as a product associated with securities lending it cannot be disassociated as some try to do especially when things go bad!

The plan as always is to have very liquid, highly rated securities. Generally the primary objective as stated at the top of investment guidelines is to protect principal value of cash collateral received and maintain adequate liquidity.

Outlining the benefits to a client is obviously important and is generally the easy part. Making sure all the risks are communicated and understood is the critical part.

Cash collateral reinvestment is an option and not obligatory when participating in securities lending. For those clients choosing cash reinvestment, they should agree and sign the investment guidelines. There should also be a clear section on the risks and health warnings! Cash reinvestment introduces leverage to securities lending that would not be the case if non-cash collateral were taken.

Ultimately cash reinvestment is about risk and reward. A lot of money can be made from this strategy but the risk will climb accordingly! It’s down to the appetite one has for the risks.

Choice of strategy is key.
•    Duration - Short term cash no more than 30days…. Or no longer than 180 days. Do you match duration of loans 100% or only match a small amount.
•    How much GAP is the client willing to take? Loans on open vs WAM on investments of 30 days?

One big issue is separating the interest rate WAM from the duration WAM.
•    Loans may be on open or have the rebate reset monthly, whereas the investment may reset month, quarterly or longer. This is a strategy in itself and must be understood and accepted by the client.
•    However for duration you could have loans on open against a basket of investments with a WAM duration of 2 years. This is a BIG risk should the client be downgraded or a systemic risk materialise as in the current environment. Should a borrower want to close all loans and investments have an average of two years to maturity, the only option is to sell. Selling bonds into an illiquid market will most likely result in losses! Client may not have expected any losses let alone big losses! Were they making enough revenue from the strategy to digest the losses, unlikely being that yields from securities lending vs cash collateral are generally in the range of 5-10bps.

So what has happened…

Clients invested in a variety of asset types, interest rate durations, maturities and credit qualities. Credit qualities were at the high end. As per RMA Q308 survey 91% of investments were AAA/AA/A1/P1. However with a mixed asset class of CP, ABS, Corporates, etc., how easy has it been to sell any of these securities with no loss?
As clients have considered exiting lending programs, whether being for economic reasons, not wishing to be associated with short selling, or concerns over the liquidity risk, they have come to realise it has been difficult to withdraw due to the illiquid nature of the investments.

This is no different to the crisis experienced in Money Market Funds in the US - as investors look to get there money back, some MMFs have to put a freeze on withdrawals from the funds. They have a certain amount of cash but are unable to sell investments without losses!

Another major problem has been comingled collateral pools. Are they beneficial? Can a client exit easily? In good times yes but should any investor want to get out now then there are concerns about disadvantaging the remaining investors. For example when a client leaves they take some of the cash portion of the pool! Should an asset go bad after a client withdraws, the remaining clients are left with the problem. When a security is sold either at a loss or profit who is attributed the proceeds/ losses and how? How do pools deal with these situations to ensure a fair treatment for all participants? The benefits are economies of scale and improved liquidity. Again pools have performed well until the crisis but now they are a source of concern to investors.

So what should be appropriate going forward…..?
The client needs to fully understand what they are getting themselves into. Not only at the beginning but there needs to be quarterly reviews with the client to go over the performance, including the cash reinvestment. A review of the guidelines should also be undertaken and any changes made. Getting written sign-off by the client on a regular basis goes someway to ensure all parties understand where they stand.

Be aware of the asset mix, reduce duration risk, and be comfortable with the credit quality. With downgrades happening in a regular basis it is important to have a plan for when this happens. Selling a downgraded security will likely result in a loss to the client!

Which brings us to the choice of investment manager! Make sure the client has done their due diligence of the IM. This should also be reviewed on a regular basis possibly annually. Is the client getting value for money?

At the end of the day when everything is taken into account is the client earning enough to warrant the risks? For years the cash reinvestment model has produced excellent returns for the client. But illiquidity, downgrades and reductions in lending balances have increased the pressure and risk associated with cash reinvestment.

Securities Lending Weekend Update

A bit of a weekend wrap up of news.

I had a sneak preview of a new product launch from DataExplorers.  They have added some new features and functionality to the Transaction Explorer.  I am a bit of a data geek, so I have always loved it.  For some time I have believed that the real challenge for the product is to take it from being a valuable analytical product and transform it into a front-line trader’s tool.  These enhancements take it a long way down that path.  Have a look at the video and more importantly take a look at the product to get a more detailed idea of the functionality.

Men to Blame for Credit Crunch!

UNISON General Secretary, Dave Prentis, said at their Womens’ Conference yesterday.:
“The credit crunch is, without doubt, a man-made disaster.  But in the recession it is women who will suffer the most.”   Sky News carried on with a story this morning including three commentators who also blamed the macho male culture in the City of London for the current crisis.  Apparently women wouldn’t have taken the same risks and always bring a more balanced view.  What’s your view?  I can tell you that the overwhelming majority (95%+) of comments that I get as a result of this blog and through the two securities lending social networks that I run are from male readers.  A call to women:  Send me your views, comments and suggestions on securities finance topics you’d like me to cover.

Not Standard Practice

I never really comment on individuals in this column (other than Gordo Boom-Bust-Brown and his cadre of NuFooLabour) but I am going to make an exception today.   I read that Mark Harrison has rejoined the sell side of the business.  Mark has joined Citigroup in the role of Head of European Prime Finance.  Mark is an extremely knowledgeable and experienced professional and will make a great addition to Citi’s business.  I worked with Mark at Deutsche, and on top of everything else he is a nice guy.  Good news for Citi – for a change.

Hedge Funds, Short Selling and a Meltdown!

Hedge Fund Update
January was the second consecutive positive month for overall hedge fund performance.   Does two months make a trend?  Maybe not, but we can hope.  What is clear is that money continued to leave hedge funds in January, marking the fifth consecutive month where Assets Under Management (AUM) for hedge funds declined.  Eurekahedge estimates that hedge fund AUM declined but $384 by the end of 2008.  They further advise us that 505 hedge funds closed last year as opposed to only 280 new launches.  The number of closures has been amazingly consistent over recent years, but what is different is that in previous years new launches outpaced closures.  

There have been a few stories over the past couple of days that have addressed the tightening conditions for hedge funds from their prime brokers.  The talk is about “platinum lists”, “high-touch or low-touch clients”, “tail lists” … etc.  These are descriptions that are being applied to the categorisation of hedge fund clients by various prime brokerage firms.  We now live in a market where there are limited balance sheet and funding resources.  Overlooked by the articles, but no less scarce, is a resource called “staff” that is needed to service the accounts.  Virtually every firm, including those that have expanded their PB businesses over the past year, have been under pressure to reduce headcount. 

Less resources at PB = more focus on profitable or potentially profitable clients and those that are most likely to survive.  It may not be fair, but it is a fact.

http://online.wsj.com/article/SB123483417670296081.html

http://www.efinancialnews.com/archive/keyword/Eurekahedge/1/content/1053119004

Unintended Consequences
I have referred to unintended consequences on a number of occasions and I think the current furore over Legal & General shares is a perfect example.  The shares have been taking a battering in the past couple of days after the disclosure of short positions by Odey Asset Management and Lansdowne Partners.  Neither had a short position in excess of 1% of the company at the time of their most recent disclosure, however their disclosure has been identified by the media as the trigger for the shares tumbling.  Funny though, the LGEN shares peaked almost exactly two years ago and have been falling ever since.  Click on the chart for a larger version, courtesy of Bloomberg.  Is the short position disclosure really the driver of the share price fall?  You decide.

INSIDE THE MELTDOWN
I watched the PBS Frontline program:  "Inside The Meltdown" which is hour-long documentary covering the crisis from Bear Stearns last March up until the end of the Bush administration. If you enjoying the drama of the crisis (and can forget about all your friends, family and colleagues that have been hurt as a result), it is quite compelling.  56 minutes long.