The two big public pension funds, CalPERS and CalSTRS, have made relatively small but steady profits by lending stocks and bonds from their massive investment portfolios.
But even that modest sideline was hit hard by the financial system meltdown.
CalPERS this week reported a paper loss of $634 million for the year ending last March in its securities lending program, which has auctioned off an eye-popping $835 billion worth of assets in the last eight years.
CalSTRS reported in June an actual loss of $85 million last year in its securities lending program, with the possibility that additional losses might continue into the current year.
The losses in both funds came in their investments of cash received for loaning stocks and bonds to brokers, market makers, hedge funds and others. Often, the borrowers need securities to complete “short” sales, bets that the price will fall.
A primer on securities lending issued by the Council of Institutional Investors says securities lending began in the United Kingdom in the 1960s. Brokers informally loaned shares among themselves to cover failed trades and margin calls.
“Securities lending exploded internationally in the 1980s and ‘90s as a key revenue source for shareowners and a way for borrowers to obtain stocks that they had sold short or hedged,” says the primer.
It’s a win-win, as they used to say, when things go right.
The lenders get a “relatively low-risk” way for additional earnings from their securities, while also creating “well-proven benefits to market liquidity, pricing and securities settlements,” says a paper by the International Securities Lending Association.
Some of the risk comes when the borrower, as is usually the case, provides cash as collateral. The lender typically pays interest to the borrower, while trying to get a “spread” by investing the cash at a higher rate.
The California Public Employees Retirement System began lending securities in the early 1980s. In 2000, CalPERS joined with United Asset Management to develop an Internet-based auction lending program known as eSecLending.
The CalPERS securities lending program has net earnings since it began of about $1.4 billion, nearly 77 percent of which came after the launch of the auction-based system, a CalPERS report said this week.
When the auction system was launched, CalPERS separated the lending program from the cash investment management. The report said the lending program earned $220 million during the year that ended last March 31.
But the cash management pool had an “unrealized loss” of $854 million, producing a net paper loss of $634 million. The loss could be overstated if the value of some of the pool investments has increased since March.
Wilshire Consultants estimated last month that the investments in the collateral pool are likely to result “in a total eventual loss to CalPERS of between $500 million and $1 billion.”
Due to the troubled credit market, there was a “rapid drop in prices” for some of the “instruments” purchased by CalPERS. Wilshire said other securities have defaulted or are expected to default.
To prevent additional losses, all new investments are in overnight securities, a move toward safety that limits earnings. CalPERS staff is working on new investment policies that will reduce risk in the future.
Wilshire issued a separate report last month after conducting a review of the management of the CalPERS collateral investments.
“In general, we found that the team manages the portfolio in an effective, risk-controlled manner and has state-of-the-art systems to assist in monitoring and managing the portfolio,” Wilshire said.
But if the lending program continues to grow and is managed in-house, Wilshire said, additional staff is likely to be needed. The consultants said that as a government agency CalPERS faces more organizational risks than a private-sector firm.
For example, CalPERS cannot offer ownership in the firm to retain key employees. Wilshire said turnover is “high” among the staff, where some consider CalPERS as a “steppingstone” to similar jobs elsewhere with higher pay.
The consultants said one collateral pool manager left CalPERS because of a three-days-per month furlough, a pay cut of about 14 percent, imposed on agencies by Gov. Arnold Schwarzenegger to help the cash-strapped state budget.
CalPERS announced yesterday (Aug. 19) that it filed a lawsuit in San Francisco Superior Court challenging the furloughs, contending they harm CalPERS operations and produce no state general fund savings because CalPERS operates on its own money.
(A similar argument against the furloughs was made last week by Jack Ehnes, the CalSTRS chief executive officer. See Calpensions 13 Aug 09: “New CalSTRS building: bittersweet beginning.”)
Rob Feckner, the CalPERS board president, said the CalPERS board has cancelled its monthly meeting in October. The rare cancellation provides relief for the CalPERS staff, which prepares briefings and reports for monthly meetings.
A rare bright note in the CalPERS securities lending report was “zero losses” as the result of the bankruptcy of Lehman Brothers last September. A CalPERS policy of requiring excess collateral covered all positions.
On the other hand, the California State Teachers Retirement System attributed most of the $85 million loss in its securities lending program last year to the collapse of Lehman Brothers.
CalSTRS uses four outside lending agents for its securities lending program: Goldman Sachs, CS First Boston, Wachovia Global and State Street. CalSTRS staff manages the collateral investments for loans through Goldman Sachs and CS First Boston.
“Although the program was working out of its Lehman exposure at the time of the bankruptcy in September, CalSTRS and Wachovia Global Securities Lending both held Lehman Brothers unsecured debt, with the majority of maturities out three to six months,” a CalSTRS report said in June.
“State Street Bank also held the name, but in a secured manner, and was, therefore, able to avoid loss,” said the report.
Since it began in 1988, the CalSTRS securities lending program has earned about $870 million, which is roughly $1.3 billion when compounded at the growth rate of the total CalSTRS investment fund.
One thing CalPERS and CalSTRS both try to guard against is the borrowing of shares to cast shareholder votes that may be against the best interests of the company.
“Private investment firms have found a simple way to profit from the workings of public companies: Borrow their shares, and then swing the outcomes of their vote,” the Wall Street Journal reported in a story by Kara Scannell on Jan. 26, 2007.
“In some cases, the strategy has allowed speculators to gamble that a company’s stock will drop, and then vote for decisions that will ensure that it does — without their every having to own any stock themselves,” the story said.
Reporter Ed Mendel covered the Capitol in Sacramento for nearly three decades, most recently for the San Diego Union-Tribune. More stories are at https://calpensions.com/ Posted 20 Aug 09
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