Enhancing portfolio yield through securities lending.

In the current interest rate environment, competition is fierce and pension fund managers are finding it more important than ever before to develop creative solutions to produce higher yields. In identifying new strategies, previously untapped markets are being examined, and one area in which many are finding success is securities lending.

Securities lending allows lenders to generate extra earnings from otherwise idle securities, enabling investors to make their portfolios work even harder, thus increasing their overall yield. Given today's challenging investment environment, every basis point helps. An additional 10 to 25 basis points, for example, is considerable when viewed against current overall investment returns of 4% or 5%.

Many pension consultants are counseling their clients to consider securities lending as an investment management service, since both the risk and rewards are driven by the reinvestment of cash collateral. Under this assumption, securities lending must warrant the same professional attention given to other investment activities.

The following examples demonstrate just how significant securities lending is in today's financial marketplace:

It's 5:01 a.m. At a securities lending trading room, a primary dealer in government securities has just called to request $50 million of the current five-year treasury note. The dealer needs to borrow the notes to cover a short position created by its fixed income desk. The "govies" are needed fast, before the Federal Reserve closes at 2:30 p.m.

A broker/dealer specializing in equity trading needs 2,000 shares of a new technology stock. Traders on the street are saying the stock is "hot," and could go up $5 today. The original lender has called the stock back, creating the need to borrow more - or buy shares in the open market at a higher price. It's a "hard stock," meaning dealers can't get enough, and too many people have shorted the stock.

As these situations illustrate, the practice of securities lending is vitally important in preserving market liquidity because it prevents millions of trades from failing. And, securities lending actually makes short selling - a leveling factor in the market - possible. As an example of the dramatic numbers involved, $200 billion in debt and equity securities are placed on loan world-wide everyday.

HOW SECURITIES LENDING WORKS

Securities loans are typically arranged by an agent, usually a commercial bank, on behalf of pension or ERISA investment portfolios. Loanable securities include U.S. treasuries and agencies, actively traded stocks, new issue corporate bonds and non-U.S. securities. The agent negotiates the terms of the loan and receives collateral in the form of cash, government securities or bank letters of credit. Loans are fully collateralized at 102%, plus accrued interest of the market value of the securities loaned. When cash is provided as collateral, the agency invests it on behalf of the lenders, usually in short-term, high-quality money market instruments. Through a process called "marking to market," the amount of collateral is recalculated each day to ensure that it is maintained at a level higher than the value of the securities borrowed.

THE RISK AND RETURN TRADE-OFF

Given the minimal risks of a well-structured and professionally managed program, securities lending is a worthwhile and profitable activity.

The primary risk of securities lending is borrower default - the borrower may go out of business and be unable to return the security to the lender. Therefore, creditworthiness of the borrower is critical. Brokerage firms with low credit ratings are more likely to default than those with high ratings; thus, lenders can work to minimize the risk of their loans by dealing exclusively with highly rated brokerage firms.

An additional cushion against the risk of broker default is provided by the daily "marking to market" of securities. This process sets the market value of the collateral each day at 102% of the market value of the loaned securities.

Broker/dealer credit risk also can be viewed as equivalent to the risk created when buying or selling securities. When purchasing a security, an investor owns it at an established price, but if the broker/dealer from whom it was purchased becomes insolvent before settlement of the trade, the investor still expects to receive the security at the original price (unless it can now be purchased for less). The risk involved is the marginal difference between these two prices.

When lending securities, the exposure is the same - to maintain book cost, lenders expect that the security will be returned at the same price. Unlike a purchase, however, a loan provides some margin (2%) for extra protection. This 2% should provide adequate coverage of market risk until the securities can be repurchased.

When securities loans are collateralized with cash, the lender also bears the risk of investing the cash collateral over the period of the loan. This risk can be mitigated by utilizing the lender's own short-term cash investment policy and guidelines. The key to being comfortable with the reinvestment risk is to understand how the cash collateral will be invested and to be assured that the lending agent adheres to customer-approved guidelines (not necessarily their own).

On the positive side of the equation, treasuries and non-U.S. securities are presently the most profitable loanable securities. However, earnings vary considerably depending on the size and composition of the loanable assets and other restrictions placed on the lending agent.

While most lenders view securities lending as a method of offsetting custody fees, many large pension funds generate millions in incremental revenue each year through securities lending. Because the fees generated are split between the fund manager lending the securities and the agency coordinating the service, both parties come out ahead. For example, if a fund manager lends 90% of a $100 million treasury portfolio, earns an average return of 35 basis points and receives 60% of the return (with the remainder going to the agent), the manager would earn $189,000. The best way to gauge prospective earnings is to have the portfolio evaluated by a securities lending agent.

CUSTOMIZATION AND CONTROL: THE KEYS TO SUCCESSFUL LENDING

Today's lenders have many choices of how to lend their portfolios. Many choose the traditional custodian lending route. However, demand for unbundling of various service components from custody packages has created a small group of "third party" lending specialists, who provide services similar to those of an investment manager and can act as a lender even if the bank does not have custody of the securities. Lending specialists are exerting considerable influence on how leaders perceive performance and risk.

Lenders must insist on a customized program, tailored to their needs and operating parameters. By examining the benefits offered by securities lending and developing a customized program, pension fund managers can move forward in increasing their overall return.