Stock lending – worth the candle?
Nina Röhrbein finds that the collapse of Lehman Brothers and the shorting bans in major markets have prompted some European pension funds to suspend their stocklending activities
The events of 2008 - in particular the collapse of Lehman Brothers - appear to have shattered the confidence of a pension fund industry in at least certain types of stock lending. Several market players believe that it has partly contributed to the financial crisis.
The consultancy Watson Wyatt has even recommended that pension funds suspend their securities lending activity if they are in any doubt about their lending guidelines and arrangements. It has warned that the risk/reward trade-off around this activity has changed and may no longer be worthwhile.
The firm has identified counterparty risk, collateral and indemnification as the three key areas that pension funds need to focus on when dealing with their lending agents, who are typically custodians.
Watson Wyatt advises pension funds to ensure the collateral agreed for the lending programme is of high quality and in line with the fund's risk tolerances. It recommends pension funds be aware of the potential risks, although it acknowledges that it would need an extreme chain of events that invokes indemnification and then for it to fail.
So, what stock lending policies do pension funds and asset managers have in place and what is their all-important collateral?
All of the listed assets of Dutch pension fund Vervoer, which has invested assets of €6bn, are available for lending - with the exception of financial stocks.
The pension fund stopped the lending of financials in September 2008 following the shorting ban by Dutch pension regulator and central bank DNB. But it did not recall any existing positions.
"We had some outstanding positions but we waited until they came back and then stopped lending on new requirements," says Theo Hartgring, CFO at Vervoer. "As a small player, we tend to follow the rules of the supervisor. Once the ban is lifted we will discuss with our investment advisory committee whether to lend these stocks again, with the next quarterly meeting due in February."
With the Dutch supervisor banning the lending of financial stocks, it comes to no surprise that APG Investments, the asset manager of the €195bn Dutch civil service pension scheme ABP, has also stopped lending several European and US financials.
But lending of other stocks remains important to APG. "It provides APG with compelling risk-adjusted returns," says Mark Linklater, head of securities lending at APG Investments. "Benchmarks do not lend, so all return captured throughllink lending is alpha to our performance."
Vervoer, like most other pension funds, practises securities lending for its contribution to net income, which Hartgring pegs at around €8-9m on annually.
But Hartgring is also perfectly aware of the risks. "The danger is that we will not get the stocks back that we lent out," he says. "But that is why we have collateral."
Vervoer's collateral is in government bonds and cash. "We prefer government bonds, of course, but since our collateral is being managed by our custodian bank, some cash has also been involved," says Hartgring.
Linklater believes that APG has a comprehensive enough oversight structure in place to monitor its lending programme and ensure that its guidelines are being followed.
"We involve many areas of the company in our strategic decision making and programme monitoring, including our risk and portfolio management group," he explains. "All of our loans are collateralised with the highest-rated counterparties and are either reinvested via our investment guidelines or held by a third party. We use both exclusive and discretionary routes to markets and accept multiple collateral types."
For APG this means US dollar and euro cash as well as non-cash collateral, such as government bonds.
"The recent stress in the market has provided a real-world test of our programme risk controls," Linklater says. "Through the Lehman default we learned that our collateral margin was enough to avoid any losses and our default procedures ensured a timely repurchase of any outstanding positions. To us the credit crisis has highlighted the importance of oversight vigilance and the importance of limiting reliance on the rating agencies."
The pension fund for the Members of the European Parliament (MEPs) in Belgium stopped the lending of financial stocks in early autumn, following in footsteps of many other pension funds. However, stock lending served a different purpose for the fund.
"We do most of our stock lending - around 80% - to reclaim tax on dividends rather than to short-sell," says Richard Balfe, (pictured right) chairman of the MEPs' Pension Fund, which has invested assets of €180m. "In other words, we lend stock to people who can reclaim the tax once the dividend is paid on our stock."
With Crédit Agricole accessing and guaranteeing the collateral, the stock lending fee is split between the MEPs' pension fund and the bank. In return, the bank underwrites the stock at 120%.
"And because of this underwriting we do not really see a risk in our stock lending," adds Balfe. "We are effectively hedging any potential losses by paying the bank to underwrite the stock. In short, if the stock fails to come back, the bank will replace it with up to 120% of the value on the day it was lent."
Some market players have gone further. Swiss asset manager Pictet, for instance, has stopped securities lending altogether until further notice.
It took the decision one week after the bankruptcy of Lehman Brothers was announced.
"We no longer wanted to favour the short sale of stocks, even in an indirect manner," says Pictet's spokesperson Frank Renggli. "Securities lending at Pictet has always been done for or in the name of our clients and so we performed this service purely as an agent before we decided to stop it."
During its stock lending days, Pictet always required collateral in the form of government bonds with a triple-A rating equal to 105% of the value of the lent securities. But despite these measures some problems remain for the pension funds involved.
The issues for APG's Linklater are that - due to high funding costs - loans versus the US dollar are relatively unattractive at this time. "It is much more attractive versus euros or non-cash," he says. "And so demand for loans remains high. But we also expect US dollars to become cheaper in the new year."
As tax remains an issue for the MEPs pension fund, it keeps examining the stock lending process and other opportunities because, according to Balfe, it cannot afford to lose the tax advantage.
The pension fund has even entered preliminary discussions with a US firm that specialises in tax reclamation by taking stocks into its ownership and not short-selling them, reclaiming the tax on them, charging the pension fund a fee and returning stocks and the tax to the lender.
"We are going to look at our possibilities over the next couple of months, before the start of the next dividend season," says Balfe. "The best thing would be for the OECD to negotiate a type of tax reclamation protocol because currently, for us as a Luxembourg fund, a dividend paid in Italy, for example, is tax-deducted due to the lack of a bilateral treaty with Luxembourg. We want a protocol whereby all pension fund tax is remitted back to the fund."
And so it seems that while pension funds may not be prepared to give up stock lending completely, plenty of them have taken precautions in halting the lending of financial stocks and aiming for high-quality collateral.
How long that will last though remains to be seen in the new year.