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On
May 8, I wrote an entry titled *****Naked Short Selling, Treasury
Settlement Failures, And Central Bank Money Printing*****,
which consisted entirely of pictures. What I was trying to suggest through
these graphics was that:
1) Last October, a combination of factors (hedge fund redemptions, crack down
on naked short selling, and counterparty concerns on securities lending after
Lehman’s collapse) resulted in a drastic drop in short selling and
securities lending.
2) This drastic drop in short selling and securities lending in turn created
an enormous cash flow problem for Wall Street’s prime brokers.
3) To solve this cash flow shortfall, prime brokers sold 2.5 trillion treasury
IOUs to unsuspecting brokerage clients.
4) To reduce reduce these “failures to deliver” in the US
treasury market, central banks, primarily the Fed, Bank of England, and the
European Central bank, expanded their balance sheets and injected enough cash
into insolvent prime brokers for them to settle the market. In essence, they
monetized Wall Street’s 2.5 trillion cash shortfall.
Stock
IOUs
Below are two graphs of the number of stock suffering extended 'naked-short'
selling, which is a good indicator of the level of activity in the securities
lending industry.
Source: There. Was That So Hard? (it
was)
Cash from selling
treasury IOUs is used to repay stock IOUs
Treasury IOUs
(See *****Wall Street Selling Imaginary
Treasuries***** for more info)
Central banks print
money to repay Treasury IOUs
The Federal
Reserve's Balance Sheet
The Bank of
England's Balance Sheet
The European Central
Banks' Balance Sheet
Dollar index
- Notice how the dollar rallies as the treasury "failures to
deliver" decrease.
While the
graphics above are fairly self-explanatory, now that I am back in the States
I thought it was time to provide some background information on why the
securities lending would create such a cash crunch for Wall Street's prime
brokers.
With that in mind, eSecLending explains the steps that take place in a securities lending
transaction.
(emphasis mine) [my comment]
Securities Lending Frequently Asked Questions
…
Q3 Briefly summarize the steps that take place in a
securities lending transaction.
The following steps take place in a securities lending transaction in a
traditional agency lending cash collateral model:
1) A borrower (e.g., a broker-dealer or bank) locates a specific security.
2) A lending agent negotiates the terms of the loan with the borrower to
include price, rebate rate and in some cases, duration.
3) For loans of US equities, cash collateral is delivered at 102 percent
of the market value of the security; loans of US fixed income securities,
cash collateral is delivered at 102 percent of the market value of the
security to include accrued interest to the lending agent. In lending
programs involving loans of non-US securities, the margin required on
collateral is 105 percent.
4) Securities are delivered to the borrower upon receipt of collateral.
5) Cash collateral may be invested in a separately managed account, in an
investment pool managed by the agent or in an external fund typically in
short-term instruments within the investment guidelines of the lender.
6) A negotiated portion of the cash collateral interest earned on the
reinvestment is paid to the borrower as a rebate.
7) Out of the remaining portion of the cash collateral interest earned, the
lending agent is entitled to a percentage as negotiated between the lender
and the lending agent.
8) The market value of the loan outstanding is priced and marked to market
daily to ensure full collateralization
Wikipedia
explains the hypothecation of securities in capital markets.
Hypothecation
of securities in capital markets
Hypothecation and re-hypothecation, respectively, are commonly used to
describe the means by which securities brokers and dealers first extend
credit on margin to their customers using pledged securities as collateral,
and then pledge the client-owned securities held in the client's margin
account as collateral for the brokerage's bank loan. In this example,
hypothecation describes the posting of collateral to secure the customer's
obligation to the broker; rehypothecation is the pledging by the broker of
hypothecated client-owned securities in a margin account to secure a loan to
the broker from a bank. This common use of the terms hypothecation and
re-hypothecation is technically inaccurate, since the pledgee of the
securities collateral, in the case of the broker, may be deemed to have
possession of it.
While rehypothecation is not permitted in some jurisdictions, it is common
practice in the United States, generally under the terms of a written
collateral agreement that explicitly permits it. In addition to the
re-hypothecation of a securities broker-dealer's collateral by re-lending it
or posting it as collateral for one of its own obligations, another means of
re-hypothecation is the repurchase agreement (or repo). In a two-party repo
agreement, one party sells the other a security at a specified price with a
commitment to buy the security back at a later date for another specified
price. Overnight repos, the most commonly used form of this arrangement,
comprise a sale which takes place the first day and a repurchase that
reverses the transaction the next day. Term repos, less commonly used, extend
for a fixed period of time that may be as long as several months. Open-ended
term repos are also possible. A so-called reverse repo is not actually
different than a repo; it merely describes the opposite side of the
transaction. The seller of the security who later repurchases it is entering
into a repo; the purchaser who later resells the security enters into a
reverse repo. Notwithstanding its nominal form as a sale and subsequent
repurchase of a security, the economic effect of a repo is that of a secured
loan.
The Financial
Times reports about the bankruptcy of Lehman's European
operations.
There
are two basic forms of insolvency. The first and more common is cashflow
insolvency.
This is when a company finds itself unable to pay its debts as they fall due.
The second is balance-sheet insolvency, in which liabilities outweigh assets.
Lehman’s European operations fell into the first category. Like
many global corporations, the bank swept all the cash from its regional
operations back to New York each night and released the funds the next day [Wow,
another insane banking practice I was unaware of]. The Friday
sweep had taken about $8bn out of London. Without cash, the business could
not meet its financial obligations on Monday morning. A thriving business of
more than 5,000 staff and investments worth billions of dollars was suddenly
flat broke.
Lomas and his team had learned about the nightly sweep on Sunday afternoon.
After the 11pm call, they knew they were in a race to get the legal order
that would appoint them as administrators before the London markets opened.
Every day, Lehman dealt with thousands of companies, other banks and
investment funds. Opening another day’s London trading therefore ran
the risk of destabilising the world’s markets. Equally pressing, trading
without the cash on hand to meet obligations – technically, trading
when insolvent – is against the law.
There was a third reason to act fast: New York’s intention to make its
own bankruptcy filing in the US. Europe wanted its application approved
first, to protect its operations from any claims its US parent might make.
Lomas and team therefore had nine hours to come to terms with the wounded
mammoth they would soon be running. There are more than 200 legal entities in
the bank’s European operations. The PwC team needed to identify which
pieces ran the whole business, which assets needed immediate protection and
which would actually be insolvent as a result of a lack of cash. As the
night wore on, the partners gradually began to realise the true scale of what
they were taking on. Schwarzmann settled down to look at the standard group
structure. “Wow,” he said, “that’s quite complicated.”
Andrew Wright, Lehman’s European finance director, turned round and
answered: ”That’s just the summary.” [Great
quote]
…
The juddering halt caused by the bankruptcy meant that the previous three
days’ trades were not fully settled. They weren’t even fully
recorded in the bank’s systems. This wasn’t an unusual
time-lag, but one not helped by the fact that trading volumes had
simultaneously shot up because of market panic, caused in part by fears about
Lehman’s health. The unsettled trades caused chaos in the markets as
stock exchanges began to work through the deals to reach settlement. The
securities traded by Lehman were simply left hanging during some of the most
volatile days ever seen in the markets.
Then there were the cancellations, where counterparties such as banks or
hedge funds with whom Lehman had traded rushed to trigger legal clauses to
extricate themselves from some deals. Thousands of e-mail cancellations
hit the bank. Either for itself or its clients, the bank held billions in
securities such as stocks, currencies, commodities, bonds and various
derivatives. On Friday, Lehman traders went home comfortable they had
protected their risk on these holdings. Monday brought the realization that
the broken deals meant many hedges were no longer in place: the bank now had
a book of holdings at risk of being crushed by the wild market swings.
[
Hedges used by the financial world are mainly:
A) Futures/Forwards (to hedge inflation)
B) Credit default swaps (to hedge bonds).
B) Options (to hedge equities)
These hedges can all become worthless in a second, as shown by Lehman’s
collapse. Worse, most investors have NO IDEA WHO THEIR COUNTERPARTIES ARE FOR
THESE HEDGES. Despite insane counterparty risks inherit in
“hedges”, especially options, many investors continue to use them
out of greed because of (while they work) the leverage they offer.
]
…
It’s all complicated further by a process known as rehypothecation,
which affects a substantial proportion of the hedge fund assets held by the
bank [This
is the true killer]. In these cases, the funds pledged
collateral (usually stocks or other securities) in return for a loan, while
agreeing to the bank’s putting that collateral back in the market to
make extra profits [Lehman used securities in its clients
accounts to take out secured loan]. With the music
stopped, the hedge funds owed Lehman money in exchange for the collateral. To
honour that, Lehman must itself go back into the market and unwind deals in
which it reused the assets, paying out cash to get them back.
“There are so many trades that need to be closed and then
evaluations validated and reconciled before we can say, ’are you a
debtor or creditor’,” says Pearson. “You can’t form
views without all the facts. The danger is if you form a view on two or three
facts, that a fourth fact could fundamentally change your conclusion. And in
a number of the positions that we’ve been looking at, we’ve
discovered a fourth fact and we’ve gone from the situation being black
to it being white in terms of the resolution.” He adds: “We
don’t know if there’s a fifth fact, by the way, because this
diligence exercise has never been done before.” [I LOVE
this quote.]
Below is a batch
of entries from Roy Zimmerhansl’s blog, Stock
Lending Today. Reading these entries should provide a
good idea of what happened in the securities lending world after
Lehman’s collapse.
October
05, 2008
Cannibalism: The Latest Hedge Fund
Strategy? - Seeking Alpha
[Failure to delivers in the treasury market (ie: treasury IOUs) hit their
peak in early October]
…
There is no question that [hedge fund] redemptions are having an impact
and will do so increasingly. The deleveraging of the investment banks, the
Fund of Fund managers and the hedgies themselves all require selling and
closing out shorts [This closing out of short positions is what created a
massive (2.5 trillion) demand for cash.]. All forces that are
contributing to a massive shift change in the demand side of the business.
Scary stuff. Very
scary.
October
09, 2008
Trust and Fear
…
Let's look at this in the context of securities lending at the moment. Everyone
in the market is experiencing funding issues whether you are a hedge fund or
investment bank looking to borrow stock or cash, or a lender trying to find
someone to borrow your stock. If you are a lender that has found someone to
borrow stock and give you cash, then where do you invest that cash?
Measure your firm's approach over recent weeks and also look at the attitude
of your clients and counterparties.
October
12, 2008
Cash Reinvestment Remains an Issue
More reports in recent days in the media, including a story in the Wall Street Journal
describing a letter from State Street to its securities lending customers that
announced restrictions on the ability of clients to withdraw cash from its
cash reinvestment pools. In the Wall Street Manna
blog a State Street spokesperson is quoted as saying:
"Our
securities-lending program remains strong,"
a spokeswoman for the Boston company said. "We have not experienced any
losses, and there are no restrictions on normal course transactions within
the lending funds."
We have also seen recent stories about Northern Trust and Bank of New York
Mellon in the cash reinvestment area. The credit crisis of last year has
morphed into the liquidity crisis of today and is the most pressing issue
facing the financial markets. Watch closely as this storyline continues to
develop.
October
14, 2008
The New Reality is Clearly ...
.... well, unclear.
Who could have foreseen at the start of 2008 that we would be here today.
Being an overachieving Goldman alumnus, Hank Paulson clearly wanted to run
more than just Goldman, so his master plan turns out to be that he wanted to
run the entire US banking industry!
The world of Prime Brokerage is a very different one. We started the year
with Morgan, Goldman and Bear the dominant players. Bear has been
swallowed up by JP Morgan and the uncertainty amongst hedge funds caused by
the failure of Lehman has had a well-reported knock on impact on the other
prime brokers. Fitch Ratings has
recently made the following comment on Morgan Stanley's outlook:
"Customers
are migrating away from its premier prime brokerage business due to
deleveraging and concerns around the protection of client assets."
While to an extent this is MS [Morgan Stanley] specific, it is also a
comment on the concerns and issues facing the PB [Prime Brokerage] industry
as a whole.
October
15, 2008
Securities Lending Counterparty Risk:
Tipping the Scales
Everyone is thinking about how the world has changed in recent weeks and the
implications for their business. I'm a sheep, so I'm wondering about that as
well.
One of the most important and obvious issues for securities lending is
that of counterparty risk. I have always argued that this is the single most
important risk issue. I make this statement on the basis that if the borrower
is still in business, you can always get more collateral. However, if the
borrower if bust, you are burned. It doesn't matter if you have the highest
quality collateral or how much haircut you have taken. If the shop door is
open, you can deal with any issues. If the sign says "Closed", you
might be out of luck. The highest priority that everyone has had over the
past month is sorting out the aftermath of the Lehman failure. No one in the
business has wanted to go through the past month of turmoil. Even if lenders
had enough money left over after liquidating their collateral to repurchase
the securities on loan to Lehman, the stress during the period was tremendous
and people just don't want to have that happen again.
So where are we now? The big three prime brokers from January 2008 - Morgan,
Goldman and Bear - are now banks (or part of banks). These banks are now
part of a bigger group of semi-nationalised or completely nationalised banks
that are active securities lending market participants. What does this do to
the counterparty credit assessment process? I had dinner yesterday with
someone who's view is that essentially counterparty credit risk is no longer
a concern for those quasi-government entities. I don't necessarily agree with
that point (in fact I don't agree with it at all [me too]), but there is no
question that the credit department will view those firms differently today
than they did last Wednesday.
October
25, 2008
Cash Management Questions Continue
The credit-turned-liquidity crisis continues to undermine the market, with
a not-unexpected negative impact on securities lending. I’ve mentioned
cash reinvestments in previous posts, and will continue to do so. My fear is
that the fallout from losses - whether absorbed by agents or accepted by
beneficial owners [it was absorbed by central banks, mainly the Fed, Bank of
England, and the ECB] - will have a bigger influence on the securities
lending business than any other single factor.
Earlier this week the US Fed announced its Commercial Paper
Funding Facility which is designed to help relieve the
freeze in the money markets and free up liquidity. GE, the biggest issue of
commercial paper in the US has subsequently announced its intention to
participate in the program.
I noted recently that one lender had notified clients of the potential for
in-specie return of collateral to beneficial owners under certain
circumstances and I have to admit to being surprised. Looks like I
shouldn’t have been. I have been hearing all week that this practice
has become more common in recent months.
The overwhelming, vast majority of assets in the reinvestment programs
will mature and satisfy their initial investment criteria [if the dollar
collapses (it will), these assets will be worthless upon maturity]. The
problem is the wider market. Any sales from reinvestments are done in a
market that doesn’t want to buy any paper, from anybody, except at
fire-sales prices. Losses generated from such sales, as well as
defaulted paper have led to more reports over the past few days about
institutions suing agent lenders. Let me first say that I don’t know
any specifics of any of the situations other than what I read in the press.
In any case, there are a number of questions that come to mind when assessing
the merits of any claims:
*** Were the clients of the securities lending programs aware that the
investments were made at their risk?
*** Did the clients approve the reinvestment criteria?
*** Were the investments made by the agent in line with the client approved
criteria?
*** What processes and procedures were followed in disposing of any assets
that were as a result of client withdrawals or borrowers returning stocks?
*** How were any assets in default handled?
*** Did clients and agents discuss the impact of forced sales of collateral?
In the mid-90s there were some losses suffered as a result of cash
collateral reinvestments. These issues brought the subject of cash reinvestment
risk front and center in the minds of beneficial owners and lenders. That
sparked debate, discussions, program reviews and no doubt a number of
changes. This is not a new subject and the majority of clients in programs
today were probably lending back then. Then, like now, many assets that were
loss-generating on a mark-to-market basis simply needed to be funded to
maturity [The imminent dollar collapse removes “funding to
maturity” as a viable option].
Securities lending remains a low risk business [HAH, that is a good one.
Unregulated securities lending creates massive systematic risk]. The
current credit/liquidity/crisis situation we are in is a “once
in a hundred year event“, or “once
in a lifetime” or “the
greatest banking crisis in the history of mankind”. Take
your pick [This crisis was in big part CREATED BY out of control
Securities lending]. This is one of the few businesses that beneficial
owners can participate in with such a low likelihood of loss and that
generates a positive return even in falling markets.
My hope is that rational reviews and discussions will prevail over the
knee-jerk withdrawals that we have seen in covered in the press. [These
“knee-jerk withdrawals” resulted in a 2.5 trillion dollar cash
shortfall at prime brokers]
October
16, 2008
State Street Earnings Jump! (UPDATED
STORY)
…
SeekingAlpha.com Ron
Logue, State Street Chairman and CEO: "None of
our funds that support State Street Securities lending business has lost
money for our customers. Due primarily to declines in the market, but also
suspension or reductions in securities lending by some customers, we have
seen assets in our lending program decline by approximately 20%. As a result,
we have seen increased withdrawal activity from the collateral pools, but we
have been able to manage these outflows in a manner that protects our
customers from loss. The current spreads and volatility are expected to at
least partially offset the impact of lower volumes."
There is a clear conflict with the Bloomberg story quoting a Moodys report
as saying “Investors are also pulling out of securities-lending
programs because of losses by short-term debt funds their collateral is
invested in” and the statement by Ron Logue.
…
UPDATE: Thanks to the intrepid reader that spent their time reading State
Street's Form 8-K Filing. There are a number of fascinating comments in the
document, and let me point out a couple of them to you:
"For clients
that invest directly or indirectly in certain of the collateral pools and
seek to terminate participation in lending programs, we have required, in
accordance with the applicable client arrangements, that these withdrawals
from the collateral pools take the form of in-kind distributions of
securities."
"In addition to the
impact on the market value of client portfolios, the illiquidity and
volatility of both the global fixed-income and equity markets have negatively
affected the ability of SSgA to manage client inflows and outflows from other
pooled investment vehicles."
That's the kind of thing that worries me. It also adds some clarity to
the letter State Street issued to clients last week.
October
20, 2008
7 Considerations for the Future of Your
Lending Programme (UPDATED with additional Graph)
In previous blogs I have made it clear that I feel counterparty risk is the
single biggest issue for a lender to contemplate. Further, I think we are all
in agreement that every market participant needs to take a step back from
their existing securities lending business activity and re-examine their
business from the ground up. I am absolutely not advocating that anyone stops
lending in part or in whole. I believe in a free market and am against all of
this government intervention, but even so, no regulator has asked the
institutions to stop lending. The restrictions have been focused on the
borrowers, and if regulators are trying to target anyone, that is the correct
focal point.
Nevertheless, the market is in the midst of unravelling the biggest
default that we have experienced in our business and it is a seminal point in
the history of securities lending.
…
What actions have
been taken by so far? I posted a survey a little
while ago, and the results are posted below. Responses were received from
firms in Belgium, Denmark, France, Netherlands, Japan, Sweden. Switzerland,
UK and US, so a pretty wide universe of firms. (If you click on the
image, you will get a pop-up with more clarity.)
What does the survey
tell us?
*** It is no doubt a difficult time for firms at the fringe. Just about
every respondent reduced the number of counterparties they deal with.
*** The next most common change is to the range of acceptable collateral [This
explains the spike in demand for treasuries: they became the only form of
acceptable collateral]. I didn’t go into any more detail in the survey,
but presumably there was a “flight to quality”.
*** Forty percent of firms stopped lending restricted stocks – even
though there was no legal requirement to do so. This reinforces the anecdotal
evidence of a reduction in availability of these stocks and an increase in
recall activity. 40% of firms took actions that were not required by
regulators and may have had a negative impact on the liquidity of the markets
[no kidding?].
*** Collateral margins were also increased by forty percent of respondents
[This helps explains the desperate need for cash which resulted in 2.5
trillion treasury IOUs]. An obvious and interesting follow-on question is
whether firms increased the margins across the board or on a counterparty
specific basis. Also, more detail on the increased levels by collateral type
might be useful.
November
04, 2008
Securities Lending Financial Results
The whole spectrum of hedge fund/prime brokerage/securities lending industry
is about nothing other than making money. As we are in reporting season, we
can start to see the impact of the continuing liquidity crisis, market
weakness and the Lehman default.
I guess it is now a virtue to say that you aren't doing securities
lending. Unitrim, Principal Financial Group and Horace Mann Educators all
have recently reported little or no securities lending activity. You know
that this means that they USED TO HAVE EXPOSURE, but don't any more - and
how clever are they! [just because they have stop new lending
doesn’t mean that they have unwounded old lending.]
November
17, 2008
Stock Lending World Tour
…
It's not just shorting stocks that are a problem. The Loan Syndications
and Trading association has accused Goldman Sachs of engaging in naked short
selling of high yield, risky loans. [A firm as desperate for cash as Goldman
Sachs will naked short anything.]
When I was first involved in the securities lending business all those
centuries ago, I dreamed about the day where it was important enough to be
mentioned in my company's Annual Report. It now regularly does appear in
company reports but not the way I had hoped. The latest is the ANZ Annual
Report where the CEO mentions the review of their business and the actions
against 13 staff. Ummm, maybe "below the radar screen" is not such
a bad place to be.
November
28, 2008
Watson Wyatt Securities Lending Report
… I want to take a small subset of risk/reward considerations from
yesterday’s blog:
*** Securities lending is revenue generated from otherwise static assets [by
creating counterparty and collateral risk]. 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 collateralized 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 [which means there still a huge amount of
“open” stock loans (one party no longer has the stocks and the
other party no longer has the cash collateral)], 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. [However, this could/did create massive cash flow problem for
the entire financial world]
*** It is also possible to have further counterparty protection through
indemnifications issued by many of the top agent lending organizations.
…
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". [Another
great quote which accurately describes securities lending.]
December
02, 2008
An Odd Day - Corrected Version!
…
Tax Relief on Stamp
Duty in UK
I wasn't aware of this, but in the pre-budget report in the UK last week
there was a provision stuck in there for relief from stamp duty on
transactions whereby a stock lender is disposing of collateral to acquire
replacement shares as a result of a borrower default. It pains me to say
so, but this is a helpful and sensible provision from the government. What an
odd day - I'm saying something nice about Darling Darling.
December
04, 2008
Follow up on AllAboutAlpha.com Article
The Pensions & Investments article referred
to quotes a corporate pension fund executive as saying he was surprised at
how much long dated paper was held in the collateral pool for his loans [Stocks
were lent out and sold, with the proceeds being placed into long dated paper.
This process mirrors what happened with gold leasing, and explains why long
term interest rates have fallen during the last two decades]. Surely people
check their investments from time to time and cash collateral re-investment
should have been the same.
In any case, as the reader points out:
“This for many will no doubt be a contentious view point but ABS and
MBS were seen as good investments for many years and by the size of the
market issuance this view was held by others not just Securities Lenders.
Risk managers and investment professionals believed they were appropriate
investments as did rating agencies who rated them AAA [AAA = toxic].”
Time will tell just how many of these investments actually default [It
doesn’t matter if they default. A dollar collapse will wipe out their
worth, which means their real value will only go down from here]. Until
then, the real losers will be the ones who bought at previous
“normal” market prices and have been forced to crystallise losses
that are simply a result of selling distressed assets in an illiquid market. The
real winners will be those who do the buying and can fund them until
maturity. [The real winners will be those who avoid the credit markets
and sidestep the dollar collapse.]
February
09, 2009
Four Guidelines for the Future
…
You are not
prisoners
I had a number of conversations with people (including other consultants)
before going to Arizona, then at the conference and since the event. Many
people feel they are trapped in their [securities lending] programs and are
forced to carry on as before. While it may not be simple or
straightforward to make changes, and it may not be possible for most or all
your program, there are things you can do to alter your profile and risk.
Again, talk to your providers first, and think outside the box.
February
25, 2009
Guest
Blog - Cash Re-investment: What have we learned?
…
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.
…
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? [no] 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.
March
06, 2009
Securities Lending Guest Article -
Operational Risk - Under Control?
…
Minimising
Counterparty Exposure
Prior to the Lehman default in September 2008, the risk of loss as a
direct result of over/under collateralisation was generally thought to be
very small. This was because excessive exposure only has the potential for
loss if the counterparty defaults.
Now that there is a much greater level of awareness of counterparty risk,
market participants are making significantly greater efforts to ensure their
exposure is kept to a minimum. However, agreeing marks/exposure with a
counterparty without automation is particularly difficult as every loan and
collateral position has to be valued using an up-to-date market price/FX rate
and margined appropriately. Significant differences in any of these
components will cause problems in the marks/exposure process.
March
14, 2009
Pension Funds and Twitter
…
Terrific news from
the London Pension Fund Authority - they are returning to the securities
lending market. Their trustees had decided that there was no evidence that
short selling was "evil". According to the report the fund
generates income of £700,000 per annum from lending securities. A nice
positive earner, particularly in these markets.
April
18, 2009
Don't get too excited!
… you may recall from my post in February that Prime Brokers, along
with just about everyone else in the financial services industry are
suffering from a reduction in resources of all types. This includes everything
from a limitation of leverage available to funds through to staff on the
trading desk that cover their hedgie clients. So obviously what
they try to do is focus on the funds that make the money or have the best
potential to do so in the future.
At the same time as resources are being cut, PB’s costs have risen and
they have typically passed them on to their clients. Stock loan fees have
increased. Internal funding rates at PBs [Prime Brokerages] are up across the
board. Banks do everything they can to avoid giving cash as collateral, yet
at the same time, many lenders are more desperate for dollars then ever.
Further, lenders have tightened their list of securities collateral
acceptability, making it more expensive to borrow securities. An old
hedge fund client of mine recently asked me about the good old days when
convertible bonds were good collateral. Now you can see them piled up in
the corner gathering dust. Well, not really, but you get the idea.
So for the majority of end borrowers, stock borrowing fees (along with
other PB charges) have increased over the past year to eighteen months.
…
However, enough bad news … Time for a bit of humour
6 Lessons about Lehman
*** Don’t p*ss off The Man – you will lose
*** If you are an 800 pound gorilla running around wall street, chances are
that someone will lock you up in a cage eventually
*** If you are driving down Wall Street and find yourself heading towards
Sh*t Street, when someone offers you a lift in the opposite direction
it’s generally a good idea to take it, and not hold out for
“something better” to come along.
*** If you used to captain an airliner and are used to high altitudes then
you should already know :
--- It’s a long way down
--- Nothing but hot air is keeping you where you are
--- You may think you are flying the plane, but the guy in the control tower
has your balls in his hands
*** If your name is Dick, try not to act like one – it makes for great
headlines at your expense
*** Always remember there are a lot of people who work for you in countries
where gun ownership is still legal
My reaction: When
Wall
Street’s prime brokers met redemption request (from hedge funds closing
out their positions) with cash from new investors (those flocking to
treasuries out of panic), they were running a ponzi scheme in every sense of
the word. The only difference between what Bernie Madoff did and
broker-dealers selling 2.5 trillion imaginary treasuries is the
government’s response.
Authorities discovered two ponzi-scheme related cash shortfalls last October:
$50 billion in the case of Madoff and 2.5 trillion in the case of Wall
Street’s prime dealers. The result? Madoff was thrown in jail, and Wall
Street was given an ungodly amount of printed money. Madoff should complain
about his unfair treatment.
The other key points summarized in my May 8 entry
include:
1)
Investors were buying treasuries last October because they believed the
financial system was insolvent. How do you think they would react to knowing
broker-dealers took their money and never bought treasuries?
2) While Treasury fails have declined substantially since the October 2008
peak, this is because central banks printed 2.5 trillion to allow prime
brokers to settle their trades. This implies that the expansion in the
central banks' balance sheet can never be undone.
3) There is nothing preventing broker-dealers from selling more
treasury IOUs (or gold IOUs, stock IOUs, etc…) if they run into another
cash flow problem.
4) Broker-Dealers would not have sold treasury IOUs if they had any other
source of funding available. This confirms that they are truly insolvent and
have virtually cash on hand at all.
5) The US now owes over 1 trillion in foreign denominated debt, either
directly through swap lines set up by the fed or indirectly via US financial
institutions. The US can't print its way out of this debt.
6) The dollar rally was a onetime phenomenon, resulting in the inflow of
money to settle these failed treasury trades.
Finally, in my
article *****Fed Planning 15-Fold Increase In US
Monetary Base*****, I outlined nine factors which will
cause yields to move higher:
1) Massive supply of treasuries in the pipeline
2) As a reserve asset, treasury bonds will face enormous selling pressure in
2009
3) Retirement inflows into treasuries are over
4) Deleveraging in credit-default swap market will drive up risk premiums
5) Unwinding the Gold carry trade
6) The return of the 580 billion dollars circulating abroad
7) Interest rate derivates nightmare
8) The liquidation of the 8 Trillion dollar holdings of overleveraged European
banks
9) Inflation expectations
We can now add “unwinding securities lending programs” as the
tenth reason interests rates are headed higher.
Eric de Carbonnel
Market Skeptics
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