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This was particularly true in the U.S. where agency
lending is the dominant model.
Customer asset
protection regulations limit the types of acceptable
collateral that broker-dealers can post to non-
broker dealers in respect of securities loans.
These rules for posting acceptable collateral result in
much higher exchanges of cash for securities than in
comparable European programs.
U.S.-based asset owners have insisted on a substantial
revamping of U.S. agent lending programs. In
addition to providing more oversight to lenders,
asset owners are requiring increased transparency
around their portfolios, setting strict guidelines on
their loan programs, the collateral they will accept
and on the reinvestment of their cash—going as far
as internalizing this function in many asset owner
organizations. This has resulted in a more stable, but
significantly smaller, business
.
Cash Reinvestment Programs Create Issues
During GFC
Asset owners that place their supply into agency
lending programs realize their investment returns
from two sources—the return they earn based on
demand for the security being lent and the return they
realize on the investment of the collateral received as
part of the lending transaction. This is illustrated in
Chart 6.
Pre-GFC, there was an escalating push by many asset
owners to boost the return on the cash reinvestment
portion of their portfolio by working with their agent
to invest their cash collateral into reinvestment pools
that sought out risky and often less liquid assets that
offered attractive yields. This was occurring against
a backdrop where risk-taking across the financial
services industry was on a steep upswing.
As the crisis unfolded, it became clear that secured
lending transactions where agents indemnified their
clients against borrower default risk were able to be
bought-in on an orderly basis, even in instances where
Lehman Brothers was the borrower on record. The
industry saw no significant losses on the securities
that were out on loan in these programs. Key aspects
of securities lending programs helped ensure this
orderly outcome such as over-collateralization of the
loans and daily mark-to-market of transactions.
Some clients, however, had exposure to unsecured
Lehman Brothers commercial paper via their
collateral reinvestment vehicles. Since there was
limited indemnification on the cash reinvestment
transactions, clients in those pools ended up
taking losses.
Another set of losses were realized by clients that
had moved into even riskier reinvestment pools that
focused on asset-backed securities, attracted by the
floating rate structures that offered large returns and
spreads relative to LIBOR on these investments.
Section I: Agent Lending Programs Become More
Conservative Post-GFC
Many securities lending programs prior to the Global Financial Crisis (GFC) sought to boost
returns via maximizing utilization of general collateral held in the portfolios and by aggressive
cash reinvestment selections. Losses and strains on the system related to cash reinvestments
raised concerns all the way up to the board level in many asset owner organizations—causing
them to question the risks and benefits of lending activities.
Source: Citi Business Advisory Services
Chart 6: Securities Lending Sources of Return:
Pre-GFC
Return Earned
on Collateral
Investment
(Y bps)
Fully Paid
Long Asset
Low
Low
Risk
High
High
Return
Lending Program Margin = X bps + Y bps
Substantial amount
of return earned from
shift of cash reinvestment
activity into riskier assets
Return Based
on Demand
for Security
(X bps)”