Tuesday, I collaborated in a fascinating conference that almost everyone wrapped up in the current financial crisis ignored. It was the third annual conference on securities lending, sponsored by Finadium (formerly Vodia), a small research house which specializes in lending-related issues. With almost everyone in the securities industry glued to their monitors whether they had anything to do or not, only about 50 attended, rather than the 110 of last year. Which was a pity, because, my own humble contribution aside, there were many other speakers to give the participants thoughts to mull over.
The consensus that emerged was that there would be a severe public examination of short-selling practices, and that lending would inevitably come under some scrutiny. The ‘locate,’ formerly an extremely informal process, would have to become formalized as part of the move to stamp out naked short-selling. There was also the nearly unanimous view that counterparty risk, which had been assumed to be zero with the prime brokers, would henceforth become a major part of lenders’ calculations, and that this would serve as a very significant constraint upon lending activity. Several panelists maintained that once lenders realized how little of the profit on lending they had been receiving, there would be a major rebellion, and possibly many withdrawals from traditional lending activity.
There is no doubt that lending institutions have been taken advantage of. Custodians, which used to do almost all the lending on behalf of their clients, and still have the largest share, were accustomed to taking several times the fee they passed on to client institutions. (As one former lending agent testified, custodians said of lenders, “We like ‘em big, and we like ‘em dumb.”) Custodians’ cuts paled beside the fees commanded by the prime brokers for arranging a short sale. Then there is the sensitive question how often shares may have been re-hypothecated without the lenders’ knowledge, something which comes unpleasantly to light when there is the failure of a prime broker such as Lehman. When it is discovered that lenders were receiving such thin margins for taking on what actually amounted to not-insignificant risks, and that this was associated with the widely mistrusted practice of short selling, one can expect a considerable backlash from some fund beneficiaries.
I presented the ICGN Securities Lending Code, which I had helped write, as a potential solution for the issues lending presented. It would provide a set of procedures to be enforced by institutions themselves, capable of being monitored by their client/beneficiaries. It was hoped that by adopting such a code, the ICGN could forestall the grave risk that at some point the whole of lending practice would become a public issue, and that severe and potentially harmful regulation would result. This was accepted in principle by some institutions, but implementation in many cases was inadequate. Many others, including the whole mutual fund industry, totally ignored the Code. Unfortunately, with a financial crisis now in full swing, both public outcry and the heavy hand of regulation are likely.
There are other issues raised by the practice of lending as it is currently conducted by most institutional shareholders. As another panelist at the conference noted, of the 70% of Risk Metrics clients which claimed to have a lending policy, less than half (that is, about 30% of all those institutions subscribing to Risk Metrics) made any attempt to coordinate it with their share voting policy. Such a failure to recognize the inherent conflict between lending shares and voting them may be judged severely when their own clients and beneficiaries demand to know why, if risk levels and CEO compensation were too high at certain financial companies, did institutions fail to speak out? When people have lost a lot of money, finger-pointing is never in short supply, and lawsuits often follow.
A positive outcome of the collapse of existing trading models may be the emergence of a central clearing house, and perhaps an exchange, for loans. The prime brokers had always fought this, and Congress backed them up. Now, they are in no position to protest such a long-overdue move. Along with more transparency in other derivative instruments, such as CDSs, it would be more possible under such a regime to figure out who was cheating on the system, and who was over-extended. As with previous market crises, the disinfectant of transparency usually has a salutary effect, at least until the fear of misbehavior declines. This typically takes at least 20 years, and possibly longer.
Of course, a failure of governance at a multitude of levels was necessary in order to create a crisis of this magnitude. Naked short selling was not the prime culprit, and may not have been a culprit at all. Investors demanded ever-rising profits from regulated entities, and the entities obliged by circumventing regulations, enormously expanding leverage and risk. Regulators failed to do their assigned tasks energetically enough, and put too much trust in the risk-control of those regulated. Congress denied regulators the authority to regulate new kinds of entities and new instruments. It also encouraged the banking system to lend imprudently. Ordinary citizens were more than happy to take advantage of the increased liquidity to lever themselves up. Managements trusted quantitative models they did not fully understand, and did not worry when the new instruments and the untested assumptions behind them led them to places they would never have deliberately gone, with leverage and sales mixes they would never have deliberately sanctioned. Boards failed to question the strange evolution of the businesses they were supposed to monitor, and continued to authorize increasingly absurd paychecks which absorbed more than half of net revenues. Everyone assumed that if the music ever stopped, it would be someone else left without a chair.
Of this feverish environment, lending practice was perhaps only a representative symbol. Lending didn’t bring any house down, and with luck, perhaps all the borrowed positions will eventually return to the appropriate owners, without damaging the borrowers unfairly, either. But lending was often conducted unwisely, without proper attention to the conflicts and risks it might engender. Now, the party is over. It remains to be seen what permanent damage will result from the failure to behave responsibly.