Public pension funds and other big investors have long squeezed out a few extra bucks by lending stock held in their portfolios -- for a fee -- to short-sellers. Now those funds are starting to feel a squeeze of their own.
The collapse of Lehman Brothers Holdings Inc. and Washington Mutual Inc. have set off new troubles in the securities-lending business, and the recent freeze in short-term debt markets has only compounded the problem.
That has left a number of big financial firms -- from the California State Teachers' pension fund to giant mutual funds -- with at least temporary losses. They could become permanent if conditions don't improve soon.
The business of securities lending can seem yet another obscure corner of Wall Street. But it is big business for funds with huge portfolios of stocks. The profits earned from securities lending are one reason why index fund companies like Vanguard can charge clients such small fees. They can also boost overall pension-fund returns.
Under a typical agreement, a pension fund lends out securities and receives cash as collateral, plus another 2%. That cash is then handed over to a broker, who invests the money so that the pension fund can get an additional return on that collateral of as much as 1% per transaction.
The pressure on securities-lending programs comes at a time when pension funds and mutual funds around the world are voluntarily restricting their lending of shares of financial companies to hedge funds. The funds use borrowed shares for short-selling, though most say that this is to prevent speculators from shorting the stocks. In a short sale, a trader borrows a security and hopes it will fall in price before the trader has to buy it back and return it.
The California Public Employees' Retirement System, for instance, earned $118 million in net income for a $38 billion securities-lending program for the year ended in June. Over the past eight years, the program had cumulative net earnings of nearly $1.2 billion.
That has worked reliably for years. But the decline in Lehman and Washington Mutual have set off an unsettling chain of events: first causing the value of their own securities to plummet, then contributing to a freeze in the credit markets that hurt most short-term debt securities.
After that happened, investors were forced to make up the difference when they returned the collateral to the borrower of the securities. Christopher Ailman
"Our earnings in this program will be affected," said Christopher Ailman, chief investment officer for the California State Teachers' Retirement System, the nation's second-largest pension fund that lends securities valued around $29 billion.
Mr. Ailman said the fund "will not get face value" for collateral invested in medium-term notes issued by Lehman Brothers and Washington Mutual. The amount of losses is unclear because the pension fund expects to hold the paper for a long time and wait for a price rebound.
They aren't alone. Northern Trust Corp. on Monday said it is taking a pretax charge of $150 million in the third quarter to pay back investors who lost money on collateral from securities lending that was invested by the Chicago-based investment firm.
Bank of New York Mellon Corp. took similar action last week, saying it will "provide support" to clients impacted by the Lehman bankruptcy filing, including those in a fund used for "reinvestment of cash collateral within the company's securities lending business."