Later today the SEC is going to hold an open roundtable hearing on the practice of securities lending, a practice which is central to short selling stocks.
Concern over securities lending has grown since last year’s meltdown exposed that some market participants were taking an huge risks that could threaten the stability of the financial system.
For instance, Calpers last month reported that its securities lending program had resulted in a loss of $634 million. Some think that number could climb to $1 billion, wiping out much of the $1.4 billion of gains the pension fund has made over the past 20 years, according to the Wall Street Journal.
The losses at Calpers and AIG took many by surprise. The business was thought to be a low margin, low risk strategy. It began as a practice by agents who held securities for customers lending those securities to short seller and pocketing a small fee that would be split between the customer and the agent. The short seller would put up collateral for the loan, which could then also be invested. The only risk here was that the customer might decide to sell the security while it was loaned out. The agent might then have to purchase the security on the market, which could create a liquidity risk if the agent lacked cash to make the purchase.
Part of the SEC’s hearing today will deal with disclosure issues around this business. The SEC is worried that customers may not be fully aware of the risks involved, including the way the collateral is invested, and the way the profits are split. There are also transparency issues and calls for securities lending to pass through a central clearing house.
But these would be small issues if not for a major change in securities lending in the past decade or so. During that period, certain very large institutional investors decided that they wanted to get into this business for themselves, pocketing the fees and profiting from investing in the collateral. Pension funds like Calpers and insurers like AIG would accumulate large quantities of long-term corporate bonds that they would lend out the securities to banks and brokers in exchange for cash collateral. They then invested that cash to squeeze out a bit more yield for themselves. The extra profits were often just hundredths of a percentage point. But when applied to tens of billions of dollars of securities, the returns can be significant.
Although the fund managers at Calpers and AIG thought this strategy didn’t present undue risks, the strategy is actually very risky.
- It creates a long position in the loaned securities market that is typically unhedged.
- Investing cash collateral from short sellers meant that the lenders were investing with borrowed money. It’s a form of leverage. When the short sellers close their positions, you can get caught having to sell your positions to raise the capital to give back their cash.
- Because the strategy of betting collateral only squeezed an additional 0.2 percentage point in yield, it’s more or less impossible to hedge the strategy. The extra yield would get eaten up by the cost of the hedge.
In the end, the strategy of betting with borrowed money–the collateral their customers had put up to borrow securities–wound up triggering huge losses. When short-sellers closed out their positions, they demanded back the collateral. But often the lenders had invested that collateral in the very same securities–often mortgage backed securities–they had lent out, essentially doubling down on their bets. If those securities had dropped in value, the lender can find itself facing a huge loss.
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