Nearly two years after the collapse of Lehman Brothers brought the global securities-lending business to its knees, State Street, regarded as the biggest lending agent worldwide, is restructuring its programme.
The firm's $1.9 trillion asset-management arm, State Street Global Advisors (SSgA), has announced it will no longer lend securities from a number of Ireland-based Ucits fixed-income funds, and that it is closing positions in its sec-lending programme.
"State Street is regarded as the biggest lender of securities and the most sophisticated participant," says a banker at a rival institution. "Securities lending makes up a huge part of its quarterly earnings. Now it's not lending from its own funds. What kind of message is that sending to the market, and how should we interpret it?"
Competitor custodian banks are wary of gloating at State Street's expense. "There's a risk that clients will see this and decide not to participate in lending programmes," says one.
More likely, the announcement is the start of State Street reshaping its lending business away from using pooled investment vehicles that sought higher returns through duration mismatches, towards a model that emphasises segregated client assets, lower-return investments for borrowed cash and securities, and tighter collateral-management practices.
A Hong Kong-based asset owner that is a client of the firm says it is business as usual with regard to State Street's equities sec-lending programme and its segregated accounts.
State Street, in emailed comments to AsianInvestor, says it remains committed to securities finance and its programme gained market share through March. The Irish Ucits funds in question as of June represent less than 1% of the assets under SSgA's management that engage in securities lending. State Street is not taking similar actions with any other funds.
The announcement is the culmination of two years of problems at State Street's sec-lending business, which was forced to impose redemption fees in late 2008 on funds involved in lending securities, which had suffered losses after liquidity froze in the wake of Lehman Brother's collapse in September 2008. These fees are now being removed.
"Once certain assets acquired with the cash collateral received from lending activities have been liquidated, the redemption fee will no longer be necessary to protect the interests of non-redeeming shareholders," says a State Street announcement.
In September 2009, the firm topped up a reserve to $443 million for legal exposures related to losses incurred by investors in certain active fixed-income strategies managed by SSgA, to absorb blows from lawsuits. It has been sued by a number of US pension funds, including the teacher's pension fund of the state of Missouri, for prohibiting it from withdrawing assets from SSgA funds involved in lending securities. State Street said the withdrawals were hurting other clients.
Earlier this month, State Street put $330 million of cash to support troubled SSgA funds involved in sec-lending programmes. The support forced the bank to announce an after-tax charge of $251 million for the second quarter of 2010.
In June, the top eight executives involved in State Street's securities-lending business at its Boston headquarters quit and, joining forces with Craig Starble, the former global head of State Street's sec-lending business, said they were establishing a new, independent business called Premier Global Securities Lending.
State Street is now suing some of these people for using "confidential information [from State Street] and trading on its customer good will, potentially resulting in loss of significant business'' to State Street.
State Street's sec-lending operations comprise two components: the SSgA lending funds; and an agency lending programme and collateral-pool programme for third-party fund managers and asset owners. The business involves short-term exchanges of securities for either cash or other securities, to meet liquidity needs of lenders (asset owners and mutual funds) and borrowers (hedge funds, securities dealers and banks). The lending agent collects a fee, which it shares with its customers.
Rivals say State Street was the most aggressive when it came to how securities were lent, and the collateral received against those loans. In particular, it invested short-term assets into long-duration securities. This duration mismatch initially allowed the firm to reap juicy returns, which attracted many pension funds, insurance companies and other clients.
As credit markets tightened in 2007, well before the Lehman bust, this business model began to show strains, because lent securities were often invested in real-estate-related assets. These assets quickly became distressed. The Lehman collapse, which also saw money-market funds lose value, saw liquidity vanish, and many of State Street's lent securities ended up in illiquid, money-losing assets.
Rivals speculate the bank may have hoped a market recovery would allow it to resume business as normal. This does not appear to have happened, as the recent steps taken by State Street suggest.
Moreover, with short-term interest rates in the US close to zero, managing the collateral for lent securities is hardly lucrative any more. Says the asset-owner client of State Street: "With a 10-basis-point management fee in a money-market fund that makes a 25bp return, what's left for investors?"
However, State Street says that, unlike other lending agents, its clients have not experienced any material defaults or impairments in the underlying collateral pool assets. "The primary issue during the financial crisis has been illiquidity in the market for asset-backed securities," the firm tells AsianInvestor. "Throughout this [crisis] period, we have provided clients with transparency into the holdings of the collateral pools and our investment approach."
Other banks were also affected by the crisis. BNY Mellon, another huge sec-lending agent, had to move the cash collateral function from its custody bank to its affiliated fixed-income fund-management arm, Standish.
The third major player in the industry is JP Morgan, which, like State Street, lends assets on behalf of its affiliated fund-management group. However, each of its sec-lending clients have segregated cash-collateral accounts, whereas State Street put many clients into pooled vehicles (including its Ireland Ucits funds) and allowed duration mismatches. BNY Mellon also uses a mix of pooled and segregated accounts, but took fewer risks with how collateral was managed.
State Street now says it will separate agency lending collateral pools, with total net assets of $51.6 billion (as of June 30), into two different pools. Shorter-dated securities will go into one pool, from which clients may freely exit, while longer-dated securities go into another, with continued restrictions on redemptions.
Rivals say the series of recent events -- the legal reserve fund, the $330 million to prop up SSgA bond funds, and even the defection of the previous management team -- now clear the way for State Street to allow its clients to exit from some of its sec-lending programmes.
State Street says it undertook these actions for the interests of its clients, and these only apply to a narrow part of its securities-finance business. The separation of collateral pools will give clients choice regarding the risks and potential returns they take from sec-lending programmes.
Bankers speculate that State Street did so under pressure from these clients, who, after having their money stuck in loss-making programmes for two years, presumably threatened lawsuits or to move their business to other bond-fund houses.
State Street says it has been sued by two "small participants in the SSgA Lending Funds, who purport to bring a claim on behalf of other investors. No significant client in the Lending Funds has commenced any legal proceeding."
Market participants expect State Street will restructure its programmes to emphasise less risk and lower returns, and segregated collateral accounts. But to manage separate accounts for hundreds of clients entails a huge upfront cost that State Street will have to incorporate into its business model.
"State Street is finally facing its demons," says one banker. He expects State Street is going to try to announce as much of the bad news as possible now, pinning the blame on the departed team.
Meanwhile, for asset owners, the affair shows the need to pay attention to the type of collateral best suited to lending mandates, and in what kinds of vehicles it is invested. Clients must also weigh the risks that go with higher returns in such programmes.
Says the asset owner: "In the past, everyone believed there was no risk in securities lending." He says his fund uses sec lending not for enhanced returns, but to defray the cost of asset-management fees.
The Ireland-domiciled Ucits portfolios that are now closed to lending include: the SSgA World Broad Investment Grade Index; World Government Bond Index; EMU Government Bond Index; UK Government Bond Index; US Corporate Bond Index; US Government Bond Index; Euro Corporate Bond Index; Euro Broad Investment Grade Bond Index; and EMU Government Long Bond II funds.
