Sec Lending Sees Challenges, Opportunities in Credit Crunch
June 2, 2008
Global custodian Northern Trust Corp. in March said that a $13.5 billion collective short-term extendable portfolio, or Step, cash collateral pool was hit with an unrealized loss of 1.35 percent for the month. Northern Trust is far from the only institution experiencing such losses.
In a report issued last month, Boston-based research firm Vodia Group says that 38 percent of the 32 executives it surveyed at leading global asset management firms lost money in their cash collateral pools over the past year.
The disclosures highlight the potential risks confronting stock lenders in the wake of the credit crunch. The Northern Trust pool represented 75 percent of the cash collateral for the lending activities of one of the bank's index funds and 5 percent of the firm's total $267 billion for such activities. Northern Trust downplayed the setback, telling its clients in a letter that "historic volatility" caused the loss and "unrealized losses should reverse over the next 18 to 24 months and the tracking error for these funds will revert to long-term averages during that period." The firm declined to comment for this article.
Industry consultants and stock lending agents also see reason for optimism. "As credit spreads widened with the crisis, securities lenders could earn significantly greater returns," said Ed Oliver, senior business consultant at London-based securities lending consultancy Spitalfields Advisors and former securities lending product manager for Europe at Northern Trust Global Investments. A report released by Spitalfields in January showed that lenders who reinvested cash collateral had the opportunity to buy the same assets as before, but with a reward that was two to three times higher.
Unlike their European counterparts, U.S. stock lenders have traditionally preferred cash collateral--valued at about 102 percent of the lent securities--because it poses a lower investment risk and provides the opportunity to reinvest the monies in a separate pool to increase potential yield.
"Cash collateral reinvestment pools that may have generated five to ten basis points prior to the credit crunch have been generating in excess of 20, 30 or 40 basis points of net spread in recent quarters due to the declining interest rate environment and widening credit spreads," said Chris Jaynes, president of eSecLending, a Boston-based electronic securities borrowing and lending agent. "Record earnings are continuing for beneficial owners in the first half of 2008."
But some observers are less enthusiastic. "While new lenders would indeed receive more return than previously, the fact that many large lenders experienced losses means that fewer credit committees will be eager to get involved in the market again," said Vodia Group managing director Josh Galper.
Lending at a Loss
Maintaining cash balances in reinvestment programs during the credit downturn became so critical that lenders sometimes effectively lent securities for no revenue, or even at a loss. But such a strategy--used only occasionally--can backfire if the cash has to be returned to the borrower. Lenders would need to liquidate positions, which, depending on the type of financial instrument, could result in a loss.
While the lack of liquidity is giving lenders a premium on their cash reinvestment pools, it is also imposing tighter balance-sheet constraints on borrowers. As a result, they are seeking to offer non-cash instruments as collateral. "The industry is seeing the desire from the broker-dealers to use less cash and more non-cash collateral, particularly fixed income," explained Jaynes. "Because of the increased focus and cost of use for balance sheets, many borrowers will offer premiums to those clients who can accommodate different collateral types such as U.S. dollar cash, euro cash and non-cash collateral."
