Should the board of Star reinstate securities lending? If so, which of Wendy Jefferson’s options would you recommend? Explain your reasoning.
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________________________________________________________________________________________________________________ Senior Lecturer Robert C. Pozen and Gayle Hameister (MBA 2011) prepared this case. The company, characters and events mentioned in t his case are fictional. Any resemblance to actual persons or entities is coincidental. HBS cases are developed solely as the basi s for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2011, 2014 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545- 7685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
R O B E R T C . P O Z E N
G A Y L E H A M E I S T E R
Securities Lending After the Financial Crisis
In April 2009, Wendy Jefferson had just returned to her office following a whirlwind day of meetings with her newest client, Star Advisor. Jefferson, a financial services consultant, was eager to dig into the information provided to her and her team about the Star mutual funds and the income the funds earned from securities lending. Securities lending involved temporarily transferring securities from mutual funds managed by Star Advisor to short sellers and other investors. Income from these loans had been a small but secure component of Star mutual fund returns for decades.
Jefferson had been hired by the board of directors of the Star mutual funds (the “Star Board”), which oversaw the entire array of Star mutual funds. In December 2008, the Star Board had suspended participation in securities lending across all of its funds, after one Star mutual fund had been unable to recover its loaned securities before a merger vote and another had experienced a significant loss on its collateral investments. The Star Board had asked Jefferson to take a closer look at its participation in securities lending in order to determine whether the Star mutual funds should consider reinstating a lending program and how the program should be structured.
Company Overview Star was the thirteenth-largest fund complex in the United States, founded in 1984 and growing
through a series of acquisitions in the 1990’s. Based in Philadelphia and privately-owned, Star Advisor provided its investment management services to large institutions, private clients, and to retail investors through an assortment of mutual fund products. While founded originally as a manager of public equities, Star Advisor had developed considerable expertise across all major asset classes; it was currently managing an array of mutual funds including equities, fixed income, commodities, real estate and fixed income investments. Exhibit 1 outlines Star Advisor’s current fund products.
The Star Board was elected by fund shareholders to promote shareholder interests, in much the same way as corporate directors were elected to supervise operating companies. As required by the Securities and Exchange Commission (SEC), the majority of the Star Board was composed of independent directors. The Star Board negotiated the annual advisory contract between each Star mutual fund and Star Advisor, the management company responsible for research and management
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of the assets held in each fund portfolio. The Star Board also supervised other service providers to the Star mutual funds, such as the distributor, the transfer agent, and the external auditor.
Each Star mutual fund also utilized an independent fund custodian to protect the portfolio securities from potential mismanagement. This custodian held the fund assets in a segregated account, as required by the Investment Company Act of 1940. The custodian was responsible for maintaining the security inventory as well as monitoring cash balances and trade activities. The Star Board selected its custodian from a short list of qualified candidates on the basis of price, service capabilities, and perceived stability; all Star mutual funds were currently utilizing Northern Trust as primary custodian.
Overview of Securities Lending The securities lending process involved securities owners such as mutual funds and pension
funds, intermediary lending agents, and securities borrowers. The securities owners were generally institutional asset managers such as pension funds, mutual funds, insurance funds, endowments, or foundations. These types of institutions tended to have large inventories of securities held for long periods in their asset portfolios.
A typical transaction began when a borrower (a hedge fund, for example), decided to engage in short selling—betting that the prices of securities would decline in the future. In order to execute a short sale, the short seller usually had to acquire shares of the relevant security and hold them for the trade’s duration. Through the fund’s prime broker, and using an intermediary lending agent such as Northern Trust, the hedge fund located an asset manager which owned the shares in its portfolio. In exchange for receiving the shares, the hedge fund had to post cash collateral to the lending agent; this cash was invested in relatively high-quality, short-term debt securities, on behalf of the institutional investor that had lent the shares.1 The lending agent remitted a portion of the interest from the securities as a “rebate” to the hedge fund. Thus, the revenue (“spread”) from securities lending depended on two factors—the yield on the collateral and the rebate to (or from) the hedge fund.
The rebate rates varied according to the level of demand for a given security in the marketplace. The securities lender wanted to lend its shares at the lowest rebate possible, in order to maximize income. The borrower wanted to borrow its shares at the highest rebate possible, for the same reason. For stocks that were readily available from multiple lenders, such those from large companies with high liquidity and low short interest, the rebate rate was close to the collateral investment rate. Conversely, for stocks that were difficult to borrow, the rebate rate would be lower or even negative, effectively representing a fee paid by the borrower for the privilege of borrowing shares.
For example, if the collateral was invested in an account earning 50 basis points per annum and the rebate rate was 30 basis points, the securities owner would collect a net 20 basis points of spread as compensation for loaning its shares. However, if the rebate rate was negative 200 basis points, the spread would be 250 basis points—200 basis points of fee from the hedge fund, plus 50 basis points of collateral earnings. This calculation is depicted graphically in Figure A.
1 While cash was the most common collateral, non-cash collateral was also acceptable under certain arrangements. The most common non-cash collateral was government bonds, but corporate bonds, convertible bonds, equities, letters of credit, certificates of deposit, and other money market instruments were also utilized.
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Figure A Spread Income Calculation
Source: Casewriter.
The income remaining after the rebate was split between the lending agent and the institution lending the shares in an agreed-upon “fee-split” proportion. For example, the Star funds generally received 80% of the spread income from securities on loan, with the other 20% going to Northern Trust. The terms of the lending agreement could be either open or fixed for a specified term. An open agreement, which was the norm in the market, gave the lender the right to “recall,” or ask for the return of the shares, at any point in time. A fixed-term agreement, on the other hand, which was more expensive, guaranteed that the borrower would not have to return the shares earlier than a negotiated date. More details on the mechanics of a securities lending transaction are provided in Exhibit 2.
As a consequence of the transaction outlined above, the absolute title over the securities passed from the lender to the borrower. However, the economic benefits associated with ownership of the securities, such as dividends and coupon payments, legally remained with the lender and had to be passed back by the borrower to the lender. For example, if borrower received a dividend on a stock she held on loan, she had a legal obligation to turn around and make an equivalent dividend payment to the lender. Hence, the lender would be economically indifferent to loaning securities from a dividend perspective. On the other hand, the lender did surrender the voting rights associated with these securities to the borrower. If the lender wished to participate in a vote on such securities, she would have to recall them from the borrower.1
Custodian Banks
The lending agents played the vital role of facilitating the lending and borrowing of securities. Since there was no central clearinghouse for securities on loan, the agent’s role was to locate stock either from its own proprietary inventory, from the inventory of one of its clients. Appendix 1 provides more detail on the role of the lending agent. The dominant intermediary lending agents were large custodian banks. These banks had their own inventories of securities to lend as well as relationships with prime brokers, mutual funds and other institutional investors. Appendix 2 provides additional detail on the differences between custodian banks and commercial banks. Below is a list of the largest custodial banks in the United States.
50 50 30
-200 -250 bp
-200 bp
-150 bp
-100 bp
-50 bp
0 bp
50 bp
100 bp
Security with Low Income Potential
Security with High Income Potential
Collateral Yield Rebate Rate
Spread Income =
20bp
Spread Income = 250bp
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Figure B Largest Custody Providers, 2009
($ trillions) Total Custody Assets 1940 Act Funds Only2 BNY Mellon Asset Servicing $23.0 $2.2
J.P. Morgan 14.9 2.7
State Street Corporation 13.7 4.6
Citi 12.1 1.5
Northern Trust 3.7 0.2
Brown Brothers Harriman 2.3 0.8
U.S. Bancorp Fund Services 1.5 0.5
Source: Source Media, “The 2010 Mutual Fund Service Guide.” Via Robert Pozen and Theresa Hamacher, The Fund Industry: How Your Money is Managed. Hoboken, NJ: John Wiley, 2011, p. 377. Reprinted with permission of John Wiley & Sons, Inc.
Purposes of Securities Lending Securities borrowers were typically broker/dealers, hedge funds, investment managers, and
banks that needed to hold securities for short-term purposes. The most common motivation for these borrowers was short selling, but securities lending also facilitated hedging and other arbitrage strategies.
Short Selling
Mechanically, a short seller first instituted a short sale by contacting his broker, who acted as an intermediary between the investor and the stock lender. The lender then verified availability of the desired shares within its network of clients or on its own balance sheet. In order to receive the shares, the short seller had to post cash collateral to the lender. Once a short seller has acquired legal ownership of the securities, he immediately sold them into the market, experiencing a cash inflow from the sale. When it was time to close out the transaction, either due to the expiration of a fixed- length contract or because the original owner had requested that the shares be returned, the short seller had to “cover” his position by repurchasing the securities in the open market and returning them, via broker, to the lender. A profit accrued to the short seller if he was able to repurchase these shares at a lower price than the market price at transaction initiation. Exhibit 3 diagrams a simple short sale transaction.
Short selling was controversial. On the one hand, legitimate short selling was generally seen as providing liquidity and price efficiency to the markets. Some of the largest frauds in history were uncovered by short sellers—for example, Enron and Lehman Brothers. Indeed, short sellers were one of the groups to become concerned early on about mortgage backed securities based on subprime.2
2 The term ‘1940 Act Funds’ refers to mutual funds and closed end funds regulated by the Investment Company Act of 1940. This Act set standard by which mutual funds and other investment companies should be regulated, such as limits on fund promotion, minimum requirements for reporting and pricing, and guidelines for investment.
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Short selling is also an integral part of hedging and risk reducing strategies utilized by many financial institutions.3 For example, if an investment fund wanted to take a view that Whirlpool Corporation would outperform its peers, the fund could buy Whirlpool stock while simultaneously short selling an index of appliance manufacturers. The net effect of these two transactions would be to provide long exposure to Whirlpool’s performance while hedging out the risk of fluctuations in industry conditions as a whole.
On the other hand, management of most companies strongly disliked short sellers. Companies had been known to take both legal and regulatory actions to attack short sellers, including suing them over alleged illegal activities, hiring private investigators to probe them, and insisting on regulatory investigations. Some technical weapons employed by defensive company management included splits, coordinated loan recall, and distributions specifically designed to disrupt short selling.4 Additionally, the public media tended to portray short sellers as morally dubious and destabilizing to the economy.5 During the financial crisis, an English archbishop even likened short sellers to “bank robbers and asset strippers.”6
Historically, short selling had been implicated in connection with “bear raids,” a situation in which falling securities prices became self-fulfilling due to downward price pressure in the market. The potential for bear raids was enhanced by the growth of Credit Default Swaps (CDS). CDS were derivative instruments which provided protection to the holder in case of default in an underlying credit security. In this respect, CDS were similar to insurance—in exchange for a series of fixed payments, one could buy the right to a payoff in the supposedly rare case of a “credit event,” which included situations such as failure to pay, restructuring and bankruptcy.
One mechanism by which a bear raid could occur was through the simultaneous short sale of a security and purchase of CDSs on the company’s debt, with the CDS purchases intended to spark rumors of a default or ratings downgrade that would depress the stock price, making the short sale profitable.7 Furthermore, falling prices could trigger margin calls and force liquidation, causing more price deterioration. The use of CDS was particularly concerning because there was no limit to the size of CDS positions. Unlike insurance, buyers of CDS were not required to own the underlying security being protected.3 For example, at the peak of the market in 2007, there was at least $60 trillion in CDS outstanding, yet the insured volume of underlying securities was a small fraction of this amount.8
For many years, short selling in the United States was regulated by the uptick rule. The “uptick rule” had required that short sales take place either at a price above the most recent sale or at the same price as the most recent sale if the previous price change was an increase.9 In June 2007, however, the SEC decided to repeal the rule based on a brief pilot program during 2005, a year in which the stock market was rising and volatility was low.10
During the financial crisis, some market participants argued that the rapid price declines in firms such as Lehman Brothers would have been stymied by the uptick rule or more stringent regulation. In response, the SEC banned short selling in all financial stocks from September 19 through October 8, 2008. During the ban, liquidity in these stocks decreased and bid-ask spreads widened substantially.11 As a result, the SEC lifted the short selling ban earlier than scheduled.
Following the short selling ban in financial stocks, the SEC made a more successful attempt to regulate short selling in October 2008 with the adoption of Rule 204. This rule enhanced restrictions
3 In early March 2011, the European Parliament Economic and Monetary Affairs Committee voted to prohibit naked sovereign CDS trading, which is the purchase of CDS without ownership of the underlying sovereign debt. Representatives of European member states were working on the details of the regulation, which was expected to take effect in early 2012.
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on “naked” short selling, which was the practice of short selling a security without first having it in one’s possession. Rule 204 aimed to reduce failures to deliver securities (known as “fails to deliver”) by requiring investors to pre-arrange stock loans before entering into short sale contracts. Fails to deliver occurred if an investor engaged in a naked short sale and was unable to borrow and deliver the securities to the buyer within the settlement period.4 The SEC had noted that a loss of investor confidence from abusive naked short selling could cause prices of securities to artificially decline below the level that would have resulted from the ordinary price discovery process.12
In 2010, the SEC further enhanced short selling regulation when it adopted Rule 201—an elaborate replacement for the uptick rule, referred to colloquially as the “price rule.” In essence, the price rule established a circuit breaker mechanism which was triggered when a security’s price has fallen more than ten percent from the prior day’s close.13 The price rule reinstated a version of an uptick rule only on the day when the circuit breaker mechanism was triggered and for the following day. During this period, short sales could be done only at a price above the national best bid price, which allowed the market to reflect recent data about a stock even in the absence of a completed transaction. Exhibit 4 provides information on the level of short interest in the markets over time.
Other Reasons for Securities Lending
Besides borrowing to cover a short position, securities lending was also used to transfer ownership temporarily for tax arbitrage and dividend reinvestment arbitrage. In tax arbitrage trades, foreign investors borrowed shares to take advantage of tax treaties between governments when the actual shareholder was subject to a withholding tax on interest or dividends. If a borrower free of withholding taxes temporarily held the securities, it was able to receive the entire dividend directly from the company, while remitting slightly more than the after-tax portion to the underlying security owner, leaving both parties better off.
For example, an American holder of a German equity would normally receive 75% of the dividend after incurring a 25% German withholding tax. If a German investor borrowed the security, however, he could receive the entire dividend. The German investor could transfer 75% of the dividend back to the American holder, plus an additional fee of 20% of the dividend, while pocketing the remaining 5% of the dividend. Tax arbitrage is most prevalent in markets with significant tax credits that are not available to all investors, such as Italy, Germany and France.14 European equities generally paid dividends in the springtime and these tax arbitrage loans were held open for only the portion of the year when the dividend was paid—generally no more than one quarter. Yet, income from tax arbitrage loans was estimated to account for 35% of overall equity lending volume and an even higher proportion of earnings from such lending.15
Dividend reinvestment arbitrage was possible when issuers of securities offered a choice of either a cash dividend or discounted reinvestment in additional securities. Index-tracking funds, which cannot deviate from weighting restrictions, were prohibited from accepting the more economically attractive non-cash dividend option. However, these index funds could profit by loaning out the securities to a borrower who was permitted to accept an in-kind stock dividend at a discount. This borrower would sell the discounted shares to realize a profit between the discounted share price and the market price, and then return the shares and the cash dividend to the security owner.16
In addition, securities lending was commonly used for settlement coverage, when banks and trading desks needed to deliver securities and borrowed them as a stop-gap measure until they could
4 The settlement period was typically three days.
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purchase the securities outright. This was particularly common for less liquid securities such as corporate bonds and equities with a limited free float. Banks and trading desks also engaged in securities lending for market making on behalf of clients and as part of a financing transaction in order to lend cash.17
Rewards and Risks Several factors impacted the amount of income a lender could derive from a lending program.
First, the sheer supply and liquidity of securities owned was a driving factor behind negotiating power around contract terms. Lending agents coveted relationships with large asset managers because having more securities available for loan made it more likely that a lending agent would be able to fill a borrow request from a hedge fund. For general collateral, such as equity in large and liquid companies, lenders could earn modest spreads of 20 to 30 basis points per annum.
A larger supply of “specials”—securities in particular demand because of a corporate action or trading strategy—was an important enhancement to income potential.18 For highly sought-after securities, such as hard-to-borrow securities in troubled industries, lenders could achieve spreads of 200 to 400 basis points per annum. The tax status of a lender could also make her securities more or less desirable when dividend arbitrage opportunities were being considered; spreads of 800 to 1000 basis points per annum were possible for tax-paying non-European institutions when loaning European dividend-paying stocks.
Second, agreeing to less stringent restrictions for a loan program enhanced income potential. For example, offering fixed-term loans—thereby giving up the option to recall shares—offered higher fees, as did agreeing to accept non-cash collateral from cash-constrained borrowers. In addition, offering to loan to a broader group of counterparties, including those who may be more risky, also increased income potential. The strictest lenders loaned exclusively to borrowers approved in advance after thorough diligence.
Finally, collateral investment decisions determined the ultimate profitability of a securities lending trade. While most lenders invested collateral in liquid, short-term accounts because of the need to mark to market daily, per annum yields on these accounts depended on the level of risk assumed. In 2009, the yields ranged from 10 basis points for government securities, to 30 basis points for 2a-7 mutual funds, to 100 basis points for a Short Term Investment Funds (STIF).5,6
Yet, there were risks associated with participation in a securities lending program. The first category of risk revolved around difficulties with timing when securities were out on loan. A delay in recovering loaned securities could foreclose participation in a tender offer or merger vote. Another timing risk was a result of the collateral portion of the transaction. If collateral accounts became illiquid, it was impossible to unwind a trade and return the borrowed securities within the settlement period. Furthermore, if the custodian of the collateral entered bankruptcy, there was risk that the collateral pool could be unrecoverable for an even longer period.
The collateral investment choice was a second risk category, since there was an inherent tension between seeking a higher yield and minimizing exposure to risky securities. Many securities lenders
5 The SEC’s Rule 2a-7 sets contains requirements for funds in the areas of maturity, credit qualify, diversification and liquidity in order to ensure that holdings are high quality and have only a very short time to maturity.
6 STIF is a general term for a fund that invests in high quality investments with low risk, while aiming to beat a relevant benchmark such as a treasury index.
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became so accustomed to a certain income stream that they were reluctant to forego income by shifting their collateral to lower risk options. Collateral account type was also crucial. Lending agents invested cash collateral into either pooled or separate accounts, depending on the size of the client. While pooled accounts enabled higher levels of liquidity and economies of scale for smaller clients, sponsors had a fiduciary duty to all investors in these pooled accounts and had been know to freeze withdrawals in extreme cases when the withdrawals would harm the remaining investors in the pool.
A more qualitative risk was the perception of the security borrower as an adversary to the security lender. Some portfolio managers preferred not to lend “fuel to the fire” by loaning securities in their long portfolios to borrowers wishing to bet against them, thereby increasing the chances that the value of the underlying stocks would decrease in value. Critics charged that securities lending “helped short sellers drive down the value of the markets and the funds’ own holdings.”19
Securities owners took various steps to mitigate the risks inherent in lending securities. Some lenders limited the amount of each position out on loan at a time to a portion of the total position. This was intended to give portfolio managers the ability to begin to liquidate positions quickly even if the positions were on loan. Furthermore, some lenders adjusted the size of each loan based on the liquidity of the individual security, such as capping the loan size at no more than half of the average daily trading volume.
The indemnification agreement between the lending agent and the securities owners was an additional level of risk mitigation. Indemnification agreements were the legal documents specifying which party bore the risks of unrecoverable securities, such as due to borrower default. Lending agents typically indemnified clients against these losses, although they did not cover principal losses on collateral investments.
Star’s Recent Experience In March 2008, Simon Schulz, the manager of Star’s Global Multi-Cap Value (GMV) Fund, had
reported to the board that he had not recalled his holdings in Scottish & Newcastle in time to participate in the shareholder merger vote for a proposed takeover by Heineken and Carlsberg. Scottish & Newcastle, the largest brewer in the United Kingdom, had been the subject of a series of approaches from Heineken and Carlsberg since October 2007 and Schulz intended to vote in favor of the final offer of £8 per share on March 31. The Star funds had no codified policies for tracking upcoming votes or assessing the importance of each corporate action, leaving the onus of whether to recall shares on each portfolio manager on an ad hoc basis. While Schulz had attempted to recall the fund’s loaned securities prior to the vote date, he was too late to receive delivery within the normal settlement period of three days, ultimately returning the security on April 1. Although the merger was approved by the other Scottish & Newcastle shareholders, the issue had raised preliminary concerns about the design of Star’s securities lending program.
The issue of securities lending had become more pressing in the fall of 2008. Having selected funds it believed to be liquid and cash equivalent, the Star Board had relied upon a conservative collateral investment program with Northern Trust for years. Yet, in September 2008, Northern Trust restricted redemptions on a pooled short-term collateral account which included $450 million of mutual funds managed by Star Advisor, including its Large Cap Core Fund. Star learned that a portion of the collateral account had held Lehman Brothers fixed-income securities.20,21 As these securities decreased in value, the collateral funds were forced to take writedowns and illiquidity resulted from attempted client withdrawals.22 Since the accounts were pooled, Northern Trust, as the collective trust fiduciary, implemented redemption restrictions to avoid further impairment of value
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and harm to non-redeeming clients, who could otherwise have been left with disproportionate investments in illiquid securities.23 As a result, Star realized a principal loss on its collateral investment.
Responding to both the missed Scottish & Newcastle vote and the collateral loss, the Star Board had voted in December 2008 to suspend its participation in all securities lending pending further investigation. Other mutual funds had made similar pullbacks; the value of securities on loan at BNY Mellon and State Street had plummeted from $660 billion and $591 billion, respectively, in the first quarter of 2008, to $290 billion and $344 billion in the second quarter of 2009, respectively. 24
Simultaneously, collateral risk and general fear in the market had made it much more expensive for borrowers to hold stock loan transactions open, even as the evolving SEC regulations had significantly increased the need for securities loans before short sales. As a result, borrowers of securities faced more stringent terms, with as much as 125% collateral required and loan fees for some specials approaching 50% (5,000 basis points) in October 2008, compared to 102% collateral and 300 basis point loan fees in a normalized market environment.25
Performance Impact
The Star Board’s December 2008 moratorium on securities lending was the first since the program’s inception in the mid-1990’s. The moratorium was intended to be temporary, pending further review when the market stabilized. Because many of Star’s peers continued to engage in securities lending, at relatively high fees, forgoing securities lending was apt to have an impact on the relative performance of Star’s funds.
Fund flows in the industry as a whole were heavily influenced by rankings of historical performance. According to Morningstar, a research company which assigned star ratings to funds based on risk-adjusted historical returns, four- and five-star rated funds captured 72% of the $2 trillion in net inflows into all funds with star rankings over the decade ended December 31, 2009.26 Given this “performance-flow” relationship, portfolio managers watched their peer rankings closely.
Another important metric of fund performance was the Lipper Quartile Rating. Lipper, an investment research company, assigned each mutual fund to a category after assessing its investment objectives. Lipper then ranked the funds within each category according to their total return and assigned them a percentile and quartile ranking. These rankings were important because fund complexes calculated the percentage of their funds in the top half of their respective Lipper categories and used this percentage to distinguish themselves at an organizational level. Individual portfolio managers also placed a great deal of weight on stating that their funds were in the top half of peer performance. Exhibit 5 outlines the returns by quartile of the Lipper categories for US Large Cap Core and Global Multi-Cap Value for the one- and three-year periods ending December 31, 2008.
Star’s Options Jefferson was asked to generate different approaches to securities lending for two Star funds—the
United States Large Cap Core Fund (LCC) and the Global Multi-Cap Value Fund (GMV).
United States Large Cap Core Fund (LCC)
The United States Large Cap Core Fund (LCC), managed by 15-year Star veteran Dennis Thompson, held positions in blue-chip equities and was benchmarked to the S&P 500 Index. The
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fund’s investable universe was all companies in the S&P 500, which meant that the fund’s positions were among the largest and most liquid held by any of Star’s funds. The fund currently managed approximately $25 billion in client assets. Prior to the suspension of the lending program, the collateral for this fund was invested in a high quality short-term bond product yielding 60 basis points. Historical performance of the LCC fund is shown in Exhibit 6A and historical lending revenue for this fund is shown in Exhibit 7A.
Because of the more favorable securities lending spreads in 2009 as a result of lower market rebate rates, Star could make adjustments to its lending policies for general collateral stocks while still maintaining a comparable level of lending revenue. In 2008, the program revenue had been $7.5 million with 12% of the portfolio on loan. Jefferson’s calculations for potential revenue in the 2009 market environment are below.
Figure C LCC Lending Options—2009 Lending Market—Lower Rebate Rates
Share Volume on Loan Collateral Yield Revenue
Option 1 Same Same $13.5 million
Option 2 Lower – 6% Same $6.7 million
Option 3 Same Lower – 30 bp $6.1 million
Source: Casewriters.
Global Multi-Cap Value Fund (GMV)
Second, Jefferson studied Schulz’s Global Multi-Cap Value Fund (GMV), which sought undervalued situations to hold for a three- to five-year time horizon. Although Schulz had a flexible mandate, his fund holdings were concentrated in developed markets in Western Europe. GMV holdings also tended to be smaller than those held by the LCC and were often contentious situations scrutinized closely by other asset managers and hedge funds as long/short opportunities. Hence, the GMV held a large amount of specials, with approximately 10% of its portfolio out on loan at the specials rate. In addition, the fund experienced seasonal demand for lending its European dividend- paying securities in the spring quarter. These securities represented approximately 25% of the $5 billion of holdings in the fund as of April 2009. Like the LCC fund, GMV collateral had historically been invested in a short-term bond fund yielding approximately 60 basis points from 2006 through 2008. Historical performance of the GMV fund is shown in Exhibit 6B and historical securities lending revenue is shown in Exhibit 7B.
Due to the missed vote, Jefferson’s first goal for the GMV fund was assess the impact of ceasing to lend specials—the securities most likely to be involved in corporate action votes. Ceasing to lend specials would also quell the fears of portfolio managers who did not want to provide fuel to short sellers in the market. Jefferson’s baseline for comparison was 2008’s GMV lending revenue of $39 million, when 11% of the GMV portfolio was on loan at the specials rate for one year and 23% of the GMV portfolio was on loan for one quarter at the dividend loan rate. Like the LCC fund, the GMV Fund would also benefit from lower rebate rates in 2009 and Jefferson laid out the following three options:
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Figure D GMV Lending Options—2009 Lending Market—Lower Rebate Rates
Share Volume on Loan7 Collateral Yield Revenue
Option 1 Same* Same* $61 million
Option 2 No lending of specials Same* $35 million
Option 3 Same* Lower – 30 bp $56 million
Source: Casewriters.
*Same as 2008 baseline for GMV portfolio
Board’s Decision All of the options Jefferson had outlined were going to the Star board, which was committed to
make a decision about the lending program at the May board meeting. To make this decision, the Board would have to consider the revenues and risks associated with each option together with performance implications for each fund.
7 The same means 10% of fund assets on specials for one year and 25% of fund assets on dividend loans for one quarter only.
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Exhibit 1 Star Advisor Funds Under Management
Source: Casewriter.
Star All Cap Value Fund S tar Asian Growth Fund Star All Cap Growth Fund S tar BRIC Fund Star Biotechnology Discovery Fund S tar China Fund Star Tax-Free Income Fund S tar Core World Fund Star Technology Fund S tar Developing Markets Fund Star Equity Income Fund S tar European Growth Fund Star Federal Tax-Free Income Fund S tar European Small Cap Fund Star Global Real Estate Fund S tar European Value Fund Star Gold and Precious Metals Fund S tar Foreign Growth Fund Star Growth Fund S tar Global Bond Fund Star Growth Opportunities Fund S tar Global Income Fund Star High Income Fund S tar Global Opportunities Fund Star High Yield Tax-Free Income Fund S tar Global Small Cap Fund Star Income Fund Star Global Multi-Cap Value Fund Star Large Cap Equity Fund S tar India Growth Fund Star Large Cap Value Fund S tar International Fund Star Lar ge Cap Cor e Fund S tar International Growth Fund Star MicroCap Value Fund S tar Int'l Small Cap Growth Fund Star Natural Resources Fund S tar World Perspectives Fund Star Real Estate S ecurities Fund Star Real Return Fund Star Small Cap Growth Fund Star Small Cap Value Fund Star Small-Mid Cap Growth Fund Star 2015 Retirement Target Fund Star 2025 Retirement Target Fund Star 2035 Retirement Target Fund Star 2045 Retirement Target Fund Star Conservative Allocation Fund Star Total Return Fund Star U.S . Government S ecurities Fund Star Utilities Fund
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Exhibit 2 Securities Lending Transaction Flowchart
Assumptions
x MSFT trading price: $25
x Transaction size: 400 shares
x Trade Duration: 1 year
x Cash yield: 50bp
x Rebate rate: 30bp
x Split: 20%/80%
Source: Casewriter.
Prime Broker (representing
Hedge Fund client)
Prime Broker (representing
Hedge Fund client)
Lending Agent (i.e. Northern Trust)
Cash collateral delivered @ 102% ($10,200)
Loaned Securities (40 shares of MSFT)
Collateral Investment
Fund
$10,200 cash collateral sent to prime broker’s
designated cash investment fund
Investment of cash collateral Earnings = $51.00Rebate paid to
hedge fund via prime broker:
$30.60
Net Earnings:
$20.40
Lending Agent (i.e. Northern Trust)
Star LCC Fund (underlying owner
of MSFT shares)
20% = $4.08
80% = $16.32
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311-130 Securities Lending After the Financial Crisis
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Short seller borrows share from lender with market price of $50 at Time #1 (May 1), with
promise to return share at Time #2 (July 1).
Short seller sells borrowed share on the market at market price of $50 at Time #1 (May
1).
Short seller returns borrowed share to
lender at Time #2 (July 1) and keeps the $5
difference.
Short seller repurchases share on
the market at the market price of $45 at Time #2
(July 1).
Time #1 (May 1)
Share Price = $50
Time #2 (July 1)
Share Price = $45
Exhibit 3 Typical Short Sale
In this example, the investor makes a $5 profit by selling the borrowed share of a stock at the Time #1 price of $50, and later repurchasing a share of the same stock at the $45 Time #2 price to return the borrowed share.
Source: Robert Pozen. Too Big to Save: How to Fix the U.S. Financial System. Hoboken, NJ: Wiley, 2010, p.104. Reprinted with permission of John Wiley & Sons, Inc.
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Securities Lending After the Financial Crisis 311-130
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Exhibit 4 Short Interest Levels Historically
Source: Risk Management Association. Securities Lending Quarterly Aggregate Composite. RMA Website. http://www.rmahq.org/RMA/SecuritiesLending/DataDecisionSupportCenter/SecuritiesLendingQuarterlyAggrega teComposite/PastAggregateDataSurveys.htm, accessed March 2011.
0%
10%
20%
30%
40%
50%
60%
1999 Q1 2000 Q1 2001 Q1 2002 Q1 2003 Q1 2004 Q1 2005 Q1 2006 Q1 2007 Q1 2008 Q1 2009 Q1
US Equities on Loan German Equities on Loan European Equities on Loan
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Exhibit 5 Historical Lipper Category Annualized Returns by Quartile
Large-Cap Core Funds, Performance Through 12/31/2008
One-Year Performance Three-Year Performance
High Low High Low
Top Quartile (21.65%) (33.96%) 0.97% (6.43%)
Second Quartile (33.97%) (36.86%) (6.44%) (8.38%)
Third Quartile (36.88%) (39.07%) (8.39%) (10.20%)
Bottom Quartile (39.08%) (67.65%) (10.22%) (27.89%)
Source: Lipper.
Lipper Category: Large Cap Core Funds Funds that, by portfolio practice, invest at least 75% of their equity assets in companies with market capitalizations (on a three-year weighted basis) above Lipper’s USDE large-cap floor. Large-cap core funds have more latitude in the companies in which they invest. These funds typically have an average price-to-earnings ratio, price-to-book ratio, and three-year sales-per-share growth value, compared to the S&P 500 Index.
Global Multi-Cap Value Funds, Performance Through 12/31/2008
One-Year Performance Three-Year Performance
High Low High Low
Top Quartile (24.37%) (29.71%) (0.67%) (5.30%)
Second Quartile (32.17%) (38.78%) (6.56%) (9.11%)
Third Quartile (38.99%) (46.32%) (9.35%) (10.01%)
Bottom Quartile (46.62%) (50.50%) (10.03%) (13.66%)
Source: Lipper.
Lipper Category: Global Value Funds Funds that, by portfolio practice, invest in a variety of market capitalization ranges without concentrating 75% of their equity assets in any one market capitalization range over an extended period of time. Global multi-cap value funds typically have a below-average price-to-cash flow ratio, price-to-book ratio, and three-year sales-per-share growth value compared to the S&P/Citigroup BMI.
Source: Thomson Reuters LIPPER. “Worldwide Holdings-Based Fund Classification Methodology.” April 30, 2010. Available http://www.lipperweb.com/docs/Research/Methodology/Worldwide_HBC_Methodology_1.12.pdf, accessed April 2011.
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Securities Lending After the Financial Crisis 311-130
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Exhibit 6A Historical Performance of Star Large Cap Core (LCC) Fund vs. Benchmark
LCC Return Benchmark (S&P 500) 2008 (36.83%) (38.49%) 2007 3.21% 3.53% 2006 18.21% 13.62% 2008 – Trailing 3-Year (8.34%) (10.22%)
Source: Casewriter.
Exhibit 6B Historical Performance of Star Large Global Multi-Cap Value (GMV) Fund vs. Benchmark
GLV Return Benchmark (MSCI EAFE) 2008 (38.70%) (42.14%) 2007 11.92% 9.96% 2006 9.81% 25.80% 2008-Trailing 3-Year (8.95%) (7.15%)
Source: Casewriter.
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Exhibit 7A Historical Revenue from Securities Lending—Large Cap Core Fund (LCC)
Average Portfolio Balance ($mm)
Average % of Portfolio on Loan
Revenue ($mm)
2008 $25,000 12% $7.5 2007 $40,000 11% $9.1 2006 $38,000 9% $7.2
Source: Casewriter.
Exhibit 7B Historical Revenue from Securities Lending—Global Multi Cap Value Fund (GMV)
Average Portfolio Balance ($mm)
Average % of Portfolio on Loan -
Specials
Average % of Portfolio on Loan -
Dividend Loans
Revenue ($mm)
2008 $5,000 11% 23% $39.4 2007 $8,169 10% 25% $62.7 2006 $7,299 8% 25% $49.8
Source: Casewriter.
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Securities Lending After the Financial Crisis 311-130
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Exhibit 8 Average Securities Lending Rebate Rates
(basis points) 2009 2008 2007 2006
General Collateral 5 30 35 35
Specials (590) (310) (275) (250)
Dividend Loans (1160) (875) (850) (800)
Source: Casewriter.
Note: Income earned (Spread Income) is equal to Collateral Yield less Rebate Rate, less a fee paid to the lending agent. In the case of a negative Rebate Rate, Spread Income is the sum of the Collateral Yield and the Rebate Rate, less a fee paid to the lending agent.
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Appendix 1 Lending Agent Duties
The lending agent had several roles, beginning with matching securities owners and borrowers. Since borrowers usually used prime brokers, the lending agent interacted directly with the prime broker on behalf of the borrower. Some prime brokers were deliberately vague when borrowing securities in order to protect their underlying hedge fund customers’ trading strategy and motivation.27 The agent then received the collateral with the appropriate additional margin of two to five percent and marked-to-market on a daily basis to maintain this margin. Next, the agent invested the collateral according to the contracted investment options chosen by the security owners into either a separate account or a pooled investment vehicle. The lending agent also provided an indemnification service in case the borrower was unable or unwilling to return the security in a timely manner. Finally, the agent negotiated the rebate rate with the borrower when the loan was initiated.
The borrower’s collateral, posted to the lending agent and marked to market daily, was invested according to guidelines agreed upon prior to beginning a securities lending program. These guidelines included a minimum credit rating and usually equated to liquid, low-risk securities which were available for return to the borrower at any point. The income on this collateral was split between the asset owner and the lending agent according to the fee split arrangement, with the asset owner usually receiving between 15% and 40%. Larger asset managers were able to use bargaining power to extract arrangements on the higher end of this scale. The exact split was also determined by the level of ancillary services and risk mitigation level.28 Principal losses on any cash collateral, however, were not split according to this proportion but rather passed entirely to the asset owner.
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Appendix 2 Overview of Custodian Banks as Compared to Commercial Banks
Custodian banks, also known as processing banks or trust banks, differed from typical commercial banks in the recurring and fee-based nature of their earnings stream. While commercial banks earned money based on their deposits and lending decisions, custodian banks had a lower margin, recurring-fee based revenue model. Many large, integrated financial institutions such as J.P. Morgan provided a spectrum of both commercial and custodian services, but banks such as State Street and BNY Mellon were concentrated on the custodial side.
The core competency of a traditional commercial bank was principal lending. Though a branch network, the commercial bank gathered deposits from individual and corporate savers. Separate bank employees invested these deposits into a variety of loans and other securities. The interest rate that the bank pays depositors was specified in advance and did not depend on the performance of the bank’s loans and assets. Hence, the bank’s corporate earnings were determined by the spread between the return on the loans and interest promised to the depositors.
In contrast, custodian banks were primarily agents which earned fees on services they provided to their clients. Processing banks had strong custodian and trust functions, plus asset management pools, but smaller emphasis on traditional loans to corporations and individuals. The main function of a custodial bank was to hold and supervise the financial assets of its clients, as well as to maintain an accurate security inventory, process of activity associated with portfolio holdings, and provide information to the fund accountant for the daily NAV calculation.29
Custodian banks were logically drawn to operate in the securities lending space due to the breadth of their existing banking relationships, their highly developed information technology systems, their ability to pool assets from many separate accounts and funds, and their capabilities around indemnification and the investment of cash collateral.30
The basic organizational structures of a processing bank and commercial bank are outlined below.
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311-130 Securities Lending After the Financial Crisis
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Commercial Bank Organizational Structure
Source: Casewriter.
Trust / Processing Bank Organizational Structure
Source: Casewriter.
Shareholders
Board of Directors
Deposits
Loans to: • Corporations • Individuals • Real Estate • etc.
Various executives in principal lending roles
Trust / Custodial
Dept
Wealth Mgmt
Other Services Dept’s
Shareholders
Loans to: • Custodial
Clients • Other
Board of Directors
Various executives in principal lending roles
Custody Institutional Asset Mgmt
Personal Financial Services
Mutual Funds
Securities Lending and
Other Services
Principal Lending – Primarily
short duration
Fee-based (agent)
businesses with low capital
requirements
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Endnotes
1 Frank J. Fabozzi and Steven V. Mann, Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, N.J.: Wiley, 2005, p. 4.
2 Michael Lewis. The Big Short: Inside the Doomsday Machine. New York: Norton & Co., 2010.
3 Securities and Exchange Commission. “Amendments to Regulation SHO.” SEC Website. http://www.sec.gov/rules/final/2010/34-61595.pdf, accessed March 2011.
4 Owen A. Lamont. “Go Down Fighting: Short Sellers vs. Firms.” NBER Working Paper Series. NBER Website. http://papers.nber.org.ezp-prod1.hul.harvard.edu/papers/w10659.pdf, accessed March 2011, p. 3.
5 James Mackintosh and Deborah Brewster. “Little evidence for assault on speculation.” Financial Times, September 20, 2008.
6 John Willman, “Fear and loathing in the aftermath of the credit crisis.” Financial Times, October 4, 2008. 7 Edward D. Herlihy and Theodore A. Levine, letter to the SEC, http://blogs.law.harvard.edu/corpgov/
files/2009/06/wlrk-letter-to-sec.pdf, accessed February 2011.
8 Willem Buiter. “Should you be able to sell what you do not own?” Financial Times Maverecon Blog. March 16, 2009. Available http://blogs.ft.com/maverecon/2009/03/should-you-be-able-to-sell-what-you-do-not-own, accessed April 2011.
9 Securities and Exchange Commission. “SEC Seeks Comments on Short Sale Price Test and Circuit Breaker Restrictions,” SEC Website, http://www.sec.gov/news/press/2009/2009-76.htm, accessed February 2011.
10 Robert Pozen. Too Big to Save: How to Fix the U.S. Financial System. Hoboken, NJ: Wiley, 2010, p.109.
11 Arturo Bris, “Shorting Financial Stocks Should Resume.” Wall Street Journal, September 29, 2008, p. A25. 12 Securities and Exchange Commission, “Amendments to Regulation SHO.” SEC Website.
http://www.sec.gov/rules/final/2010/34-61595.pdf, accessed March 2011.
13 Securities and Exchange Commission, “SEC Approves Short Selling Restrictions,” SEC Website, http://www.sec.gov/news/press/2010/2010-26.htm, accessed February 2011.
14 Frank J. Fabozzi and Steven V. Mann, Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, N.J.: Wiley, 2005, p. 24-25.
15 “Tax—a Lender’s Best Friend?” Fundamentals Magazine. April 29, 2005, Available http://fundamentalsmagazine.com/news/385/tax-lender%E2%80%99s-best-friend, accessed April 2011.
16 Frank J. Fabozzi and Steven V. Mann, Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, N.J.: Wiley, 2005, p. 25.
17 Ibid, p. 22.
18 Ibid, p. 6.
19 David Parkinson, “CPP board hits brakes on lending to short sellers,” The Globe and Mail, November 10, 2008.
20 Northern Trust Corporation, September 18, 2008 Form 8-K, via CapitalIQ, accessed May 2011. 21 Craig Karmin, “Crisis on Wall Street: Pension Funds Look for Some Payback—Securities Lending By
Northern Trust Stirs Investor Anger.” Wall Street Journal, October 6, 2008, p. C2. 22 David Parkinson, “CPP board hits brakes on lending to short sellers,” The Globe and Mail, November 10,
2008.
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23 Goodwin Proctor, “New Wave of ERISA-Related Litigation: Securities Lending,” June 25, 2009. 24 Dominic Hobson. “Is the downturn in securities lending cyclical or secular?” November 4, 2010. Available
http://www.thomasmurray.com/component/idoblog/viewpost/154, accessed April 2011.
25 David Parkinson, “CPP board hits brakes on lending to short sellers,” The Globe and Mail, November 10, 2008.
26 Sam Mamudi. “Five-star mutual funds don’t live up to their past.” WSJ:Marketwatch. May 28, 2010. Available http://www.marketwatch.com/story/five-star-mutual-funds-dont-live-up-to-their-past-2010-05-28, accessed April 2011.
27 Frank J. Fabozzi and Steven V. Mann, Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, N.J.: Wiley, 2005, p. 21.
28 Ibid, p. 12.
29 Robert Pozen and Theresa Hamacher. The Fund Industry: How Your Money is Managed. Hoboken, NJ: John Wiley, 2011, p. 376.
30 Frank J. Fabozzi and Steven V. Mann, Securities Finance: Securities Lending and Repurchase Agreements. Hoboken, N.J.: Wiley, 2005, p. 15.
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