Mutual funds and pension funds looking at new ways to reinvest the cash they hold as collateral when they lend out securities has become a hot issue.
But whether those beneficial owners of those securities opt for managing their own collateral reinvestments may depend as much on the current financial environment as concerns about reinvestments turning sour.
Few beneficial owners have decided to manage the reinvestment of cash collateral in recent years. But "a couple of our clients have said this is the way they're going," said Tim Smith, executive vice president for SunGard Data Systems' Astec Analytics unit, a provider of data and analytical tools to the securities lending industry.
Smith said he plans to query members of a panel he is moderating Feb. 14 at the Information Management Network's Beneficial Owners' International Securities Lending Summit about the trend. One of his panel members, Paul Wilson, J.P. Morgan's international head of client management and sales for financing and market products, said that if he's asked the question, he'll respond that his firm has seen just the opposite.
"We've seen one or two move back [to J.P. Morgan's reinvestment program], and we're talking to a number of other clients-mutual funds and pension funds-about doing the same," Wilson said.
One reason that securities' beneficial owners, mainly mutual funds and pension funds, may be considering moving at least part of their collateral reinvestment away from their agent banks is risk diversification, since some assets in the agents' reinvestment accounts plummeted in value during the financial crisis.
Pension funds appear to be especially concerned over those soured reinvestments. Lawsuits on the subject have been filed against one or more of the four major custodial agent banks: J.P. Morgan, State Street, BNY Mellon and Northern Trust. The plaintiffs generally allege that they entrusted the agent banks to reinvest their cash collateral in conservative, short-term assets, but instead they were placed-without their knowledge-in risky or long-duration assets.
Going back more than three years, Wilson said, Morgan did see a few large money-management clients take their reinvestment activities in-house, leaving the bank to handle the lending side. And some major money managers such as BlackRock and Vanguard Group have long handled most or all of the securities lending and collateral reinvestment themselves. Wilson said J.P. Morgan, which has 250 securities lending clients-about 200 with cash collateral accounts-has long supported clients' efforts to reinvest collateral elsewhere.
A Vanguard spokesperson said the firm has a team of traders that works directly with approved broker-dealers to lend its funds securities, and it reinvests the collateral in its own proprietary money market fund, which is available only to Vanguard funds. "Though there are cost savings to using this approach, the main reason we manage our own collateral is to shield our investors from unnecessary risk," the spokesperson said.
The value of many assets in reinvestment accounts-especially more esoteric ones such as complex asset-backed securities-dropped unexpectedly and often dramatically in 2007 and 2008. Leading up to those events, interest rates were low and investors in virtually every sector were scrambling for yield. So it remains to be seen whether the courts will rule in favor of the beneficial owners or determine that they conveniently or negligently overlooked fine print in their agreements with custodial agent banks regarding how they could manage the collateral.
Regardless of the legal outcome, the benefits to self-managing a reinvestment program were more obvious then than they are today. During the previous bull market, securities lending balances were at an all-time high as were rates for lending those securities. Consequently, asset managers seeking to manage cash collateral internally to better manage risk and to bolster assets under management were better able to cover related costs, such registering a fund in which to invest the collateral and setting up a dedicated trading team.
Today, however, lower yields and less demand to borrow securities have increased the incremental costs of an internally run program. "So while it made sense a number of years ago, it's less so today," Wilson said.
In addition, Smith said, unbundling lending and collateral management services could result in higher custodial fees, since the agent banks tend to take the whole relationship into account when pricing services.
Both J.P. Morgan and BNY Clearing say they have provided portals or dashboards as well as numerous reports for several years that enable beneficial owners of securities to monitor collateral accounts daily and scrutinize their holdings.
Bill Kelly, managing director for BNY Mellon asset servicing, said his firm has seen some institutional investors diversifying their cash collateral into two or more accounts, but "I wouldn't describe it as a groundswell." Instead, he said, those clients are looking more closely at the parameters they establish to direct their agents' collateral reinvestment activity. That's to ensure the risk level is consistent with the client's risk appetite.
Diversification, he added, has been more common on the securities lending side, especially among larger lenders. "Similar to when a client has multiple asset managers for a specific investment strategy, it may provide a basis for comparison or achieve a diversification strategy objective," Kelly said.
Rich Marin, a professor at Cornell University and former chairman and CEO of Bear Stearns Asset Management, said there has been a lack of visibility into how many agent-bank and other third-party securities lending and reinvestment programs function. Marin added those agents may push lenders to lend easy-to-borrow securities that garner low lending rates and then reinvest the collateral in the agents' own collateral accounts, where lenders are compensated for the same investment risk with a much lower overall return.
That tack, however, may have broken down recently. Demand for borrowing securities has plummeted, and borrowers need no longer borrow large volumes of easy-to-borrow securities for agent banks to allocate harder-to-borrow ones to them. Instead, it's become a borrower's market, with a focus on hard to borrow securities. Consequently, lenders have concentrated on the "intrinsic" value of specific transactions. They opt for those providing the highest rates, rather than simply generating cash collateral to reinvest.
"The cash reinvestment side is still important, but it can't be the end all of the program," Smith said.
