June 22, 2011

With interest rates anticipated to go back up and some distance from the credit crisis, some boards are reassessing securities lending programs with a greater focus on weighing the risk and returns. Boards should be considering the objectives of the lending program, whether they are seeking to generate earnings from spread and cash collateral investments or if they are looking for intrinsic value and if so what is the practical ability to do so, according to Robert Wittie, partner at K&L Gates.

“Boards are trying to get all of their ducks in a row so that when the switch is turned on [for the lending program] there aren’t any problems like during the economic crisis,” said Bruce Leto, partner at Stradley Ronon Stevens & Young. For example, Leto said, boards should make sure the collateral is invested in proper and conservative collateral pools, the agent has the best pricing and fee splits and look into having multiple agents so that everything doesn’t have to go through one source. He said some groups may decide to manage the collateral in-house instead of sending it outside, which the board should be asking about.

Darlene DeRemer, independent director and head of the advisory practice at Grail Partners, told FD that while some fund groups may be reinstating securities lending programs, others are still kicking around the idea and are trying to get comfortable with it in this post-crisis era of more transparency. Rose DiMartino, partner at Willkie Farr & Gallagher, agreed, saying a lot of boards she works with have concluded that there is actual risk in securities lending and that they are not making any money on it.

“My sense is that people are continuing to engage in securities lending and then people who have suspended it have resumed and then others who haven’t previously engaged are taking a look and thinking about it,” said David Sturms, partner at Vedder Price. Sturms said there is more clarity surrounding securities lending now and that it is understood that it isn’t “free money” and there are now appropriate risk mitigation steps being taken in this area. “The problem right now is that interest rates are so low that the income generated around securities lending is so small but that varies over time,” he said.

Bob Gunia, independent trustee of the Prudential insurance funds, said his board continued its securities lending program throughout the crisis and still does today due to its use of internal management and money-market funds. “Other fund groups’ boards have been rather reluctant to go back into the program largely because of the collateral problems that happened before and the low interest rates,” Gunia said. “The custodian banks are probably pressing their clients to renew their programs because they make a couple of dollars off of it but [they] need to have interest rates rise meaningfully. You have to sort of weigh the risk to the funds to the rewards.”