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Shedding New Light on Securities Lending

By Matt Clay

Pension managers burned in the crisis are among those reshaping securities lending to avoid a repeat.

While the issues with money market funds grabbed the lion’s share of the headlines during the financial crisis, their troubles paled in comparison with the securities lending market, which suffered losses in the billions of dollars. Last month, a representative group of securities lending participants met in San Diego for the International Beneficial Owners’ Securities Lending and Repo Summit. The consensus thinking was that, although securities lending has been dealt a blow by the crisis, it can, when managed appropriately, be a valuable contributor to investor portfolios. Several trends that came out of the summit suggest a marketplace of more informed participants with a greater attention to risk management.

DBs Mostly Unaffected By Credit Storm

Corporate DB plans, unlike the corporate investors, capital markets and FX risk managers have not been as concerned about the credit market’s turmoil and liquidity squeeze. That’s because pension funds don’t look at the market daily, weekly or even quarterly. “We’re not managing performance for the month,” one manager said: “We measure increments of 1 and 2 years,” said the investment officer of one large DB plan.

Indeed, some DB plans, which have been moving toward a closer match-up of their asset and liabilities profile, have discovered their shift has become a sort of natural hedge. “Most of the ‘blow ups’ have been in the quant/equity world and not in regular fixed income markets,” noted an investment manager for a corporate fund. Over the month of July, “we were actually positive,” he said. August won’t look as good but in the aggregate, the volatility is unlikely to affect his company’s asset performance significantly. “Our large funds were only down 1 percent, and most of it was due to the one fund that has remained primarily equity based.”

What was interesting to this investment chief and others is that niche players in the pension investment market (offering unique strategies) either did very well or totally flunked. “One of our managers ended up 1500 bps below their benchmark,” one reported, “and gained 400 bps the next week.”

The Two Tales of Pensions: What the Numbers May Mask

The Pension Protection Act (PPA) was supposed to herald a substantial shift from equities into fixed-income instruments by pension fund managers. The reason: The PPA imposed progressively higher funding targets and then stiffer penalties on those that came up short.

By rebalancing their portfolios and reducing equity allocation in favor of longer-term debt, pensions could minimize or even eliminate their funding-variance risk, i.e., the chance that a move in interest rates or market decline would decrease the value of their assets vs. their liabilities, thus pushing them below the 100 percent funding target.

Hedging Funding Variance Risk

This year is a pivotal one for managers of corporate pensions: A new federal law (the Pension Protection Act, or PPA) is now in effect changing some of the critical “rules of the game” for sponsors, e.g., lifting the target funding level to 100 percent. A flat yield curve is making it hard to enhance total returns, and there’s talk that slower growth in the US will pull rates even lower. Finally, Phase One of a FASB pension accounting rule is coming into effect.

Any one of these would be a challenge. Ditto for this confluence of trends, which is hitting companies with defined benefit plans (DBs) the hardest. Some have had to freeze their plans, or worse, go bankrupt in order to restructure their obligations.

And while everyone got a bit of a break in 2006, as rising equity prices helped lift many corporate plans to fully funded status, these levels may not be sustainable. Most plan sponsors foresee having to fund further, and the majority of DBs are still taking on new participants.