Traders and operations executives won’t be the only ones affected by Standard & Poor’s downgrade of U.S. government debt and the European sovereign debt crisis.
So could plan sponsors which have lent out their securities and received either cash or fixed-income securities as collateral. The securities lending portfolios and collateral will have to be revalued and borrowers may well have to put up more securities as collateral. Also affected are collateral pools- investment vehicles used by custodian banks to park cash collateral.
Plan sponsors – the owners of assets -- typically allow their custodian banks to lend out securities in their portfolios to broker dealers to earn extra revenues. Those revenues help offset custody custody expenses..
During the 2008 and 2009 financial crisis, pools of securities used to invest cash collateral put up by broker dealers ended up experiencing liquidity issues and the loans could not be unwound. Pension plans suffered significant financial losses when they could not unwind the loans and discovered that the securities in the cash collateral pools didn’t end up being as high-quality or liquid as they thought.
Back then the culprits were mortgage-backed securities and over-the-counter derivatives. This time, it could be sovereign debt and other fixed-income instruments such as bank commercial paper that might be sensitive to the European debt crisis.
“Its time for plan sponsors to monitor closely their securities lending programs and assess the performance of their custodian banks or third party lending firms,” says Mitchell Shames, founder and managing director of Harrison Fiduciary Group in Boston, a firm providing fiduciary services to retirement plans. “Plan sponsors who don’t have the stomach or the experience to either ask the tough questions or understand the answers should either not participate in securities lending or should seek help from an external fiduciary firm or advisor”
Here are five key questions Shames recommends that plan sponsors must ask their custodian bank about the investment of collateral within their securities lending program. These questions, says Shames, should be raised before a plan sponsor implements a securities lending program and as part of its ongoing fiduciary monitoring process:
1. Can I meet with the portfolio manager and the compliance officer responsible for the securities lending collateral pool?
“Too often plan sponsors negotiate the terms of their securities lending program with asset servicing executives who have little to no investment experience,” says Shames. “Make no mistake about it. Securities lending programs include sophisticated investment and trading strategies.” According to Shames, portfolio managers and compliance professionals are best suited to answer a plan sponsor’s questions. “Simply put, if the bank refuses to provide access to those executives, the plan sponsor should not hesitate to find another securities lending program,” says Shames.
2. How often will I receive a holdings report of the collateral pool; and, during periods of extreme market volatility can I receive a holdings report on a daily basis, if I request one?
“The plan sponsor should receive a copy of the pool’s holding report on a regular basis,” says Shames. “This should be the actual report, not merely a summary, so that the plan sponsor can understand the risk characteristics of the pool. Furthermore, the bank should also provide holding reports on an in term basis, if requested by the plan sponsor.” Any refusal or hesistancy on the part of the bank to provide the information is a significant red flag.” If the bank refuses to grant the plan sponsor access to these records or reports it needs to have a pretty good reason why so the plan sponsor can ultimately determine whether the bank is fulfilling its fiduciary duty to the plan. “If the plan sponsor has any concerns that the bank is not responding in a prudent manner, then the plan sponsor should not hesitate to terminate the bank's services and seek another securities lending program." says Shames.
3. What processes are employed to assure that the collateral pool is managed in accordance with its investment guidelines?
“The plan sponsor should have a copy of the collateral pool’s investment guidelines and needs to know that the bank has processes in place to assure clients that the guidelines are being followed.,” says Shames. “If a guideline violation has taken place in the past, the plan sponsor must ask just how the violation was caught, how it affected the collateral pool and what procedures the custodian bank will take to avoid a repeat scenario.” Many custodian banks provide multiple collateral pools with different risk characteristics. Failure to adhere to investment guidelines can result in a portfolio with greater risks than the plan sponsor agreed to assume.
4. How did the collateral pools fare in prior periods of market volatility?
“The plan sponsor needs to know whether the custodian bank has ever been forced to suspend redemptions from the cash collateral pool and if so, the facts which triggered the suspension,,” says Shames. “Then the plan sponsor should also ask about the factors which the bank uses to determine whether it must suspend redemptions.
Finally, ask whether the bank has ever made any cash contributions to shore up the collateral pool. If the answer is yes, it’s time to ask lots of additional questions. “Suspending redemptions on cash collateral pools can have a significant negative impact on a retirement plan,” says Shames “For instance, if a plan is invested in an S&P 500 index fund which lends securities, a suspension of redemptions in the collateral pool can result in the plan not being able to redeem any assets from the S&P 500 fund. If a retirement plan is engaged in a regular portfolio re-balancing process, this process could be impeded by any suspension in the redemptions in the collateral pool,” says Shames.
5. What is the corporate governance structure and compliance process supporting the securities lending program?
As is the case with any investment management process, compliance professionals should have separate and distinct reporting lines from the investment professionals. “Plan sponsors should ask about the compliance processes focusing on both compliance problems as well as normal operating conditions,” says Shames. “The overriding goal for the plan fiduciary is to satisfy itself that the custodian bank has a robust compliance process. Collateral portfolios must always be managed in accordance with the relevant investment guidelines.”