What Will Happen To The Once Lucrative Business Of Securities Lending?

Recent financial events have hindered the profitability of prime brokerages and now banks must find a replacement for the once lucrative business of securities lending. Securities lending has been a very profitable activity for prime brokerages that involves swapping ownership rights (excluding voting rights) at a specified rate depending on the security’s ability to borrow.  During this time hedge funds generally short the stock. The hedge fund repurchases the shares at a lower price (hopefully) and returns them to the investment bank. Last year was the worse on record for hedge funds as they lost approximately 20% on average.  Goldman Sachs (GS), Citigroup (C), and JP Morgan Chase (JPM) won’t be able to rip their clients in the fixed income markets forever. They will need to find a way to replace the business lost on this part of the trading floor.

What was so profitable about securities lending?

When you ask the “Average Joe” on the street his/her opinion of hedge funds, it’s probably something negative. Hedge funds and investment banks alike have been demonized in the media in reaction to the foolish actions of a few “characters.” Hedge funds particularly were the culprit in the record high volatility of Q3 ‘08 when the VIX (^VIX) marched right past 40, the old threshold that signaled volatile markets, peaking around 80. They were portrayed as the fat cats with their statistical models who manipulated the market destroying the 401Ks of the common retail investor. It would probably make them feel better if they knew hedge funds were getting a bit of their own medicine.

Well that was the case when it came to equity securities lending. Highly lucrative or “profitable” in high finance terms usually means someone is getting ripped off and in this case it was most certainly the hedge funds. This broad term can be broken into numerable activities, but for the sake of this article I will focus on cash-based and securities- based lending. Cash-based lending involves posting up a block of collateral (typically Treasuries) in return for cash while making a simultaneous agreement to repurchase the collateral at a specified price.  This is commonly referred to as a repo. The repo rate (or fee) is the sale price (market + accrued interest) + an agreed interest rate. This has become a key desk among all trading floors on Wall Street as it provides comparably low risk and steady returns.

However, equity securities lending is less transparent and in turn that much more profitable. Typically investment banks would build a block of shares from custodians who purchased them directly from beneficial owners. Generally hedge funds have multiple brokers, but when it came to securities lending, pricing the market was less competitive. According to a Global custodian survey in 2003- “on average, hedge funds use 2.2 prime brokers.”  Also according to S3- “a large number of even $1B AUM funds primarily utilize only one prime broker even if they have accounts with two.” Prime brokers were able to determine the “ask” side of this market, quoting the cost of borrowing as a discount to LIBOR with little competition from other prime brokerages. “Hot” securities, or securities that were particularly difficult to borrow were priced at LIBOR-15bps while your standard equity block might be valued around LIBOR-35bps. Surprisingly, for hedge funds who feed off the 3P’s (pedigree, performance, and philosophy), bidding on these equity or cash loans wasn’t very competitive.

How has the financial crisis affected this business?

Securities lending was a common source of leverage for hedge funds as a method of boosting their returns on capital and employing, for lack of a better word, hedges on their positions in the market. Some of the most common hedge fund strategies that employed this type of leverage were your basic long/short funds, convertible arbitrage funds, and merger arbitrage funds. Unfortunately the financial crisis greatly affected the success of these strategies.

Many money managers flocked to distressed bank shares in 2008 that prompted short-sale bans on many of these securities. This impeded long/short equity funds from conducting their typical transactions for what would have been highly profitable trades. Convertible arbitrage, a bread-and-butter strategy of hedge funds, involves buying convertible bonds with embedded stock options at predetermined conversion ratios while simultaneously hedging the exposure by borrowing common shares and selling them short on the market. When the financial crisis intensified and shares plummeted, convertible bond offerings became less popular making this strategy less applicable.

Mergers and acquisitions are a shadow of what they used to be. Q1 09 global M&A activity was down 29.3% from the same quarter last year. It’s kind of hard to employ this strategy when there aren’t any deals in the market. Additionally for the hedge funds that are still around and didn’t close shop, on average leverage among hedge funds has dropped from 60%-70% pre-crisis to around 40%. This all adds up to less market players and less overall business for prime brokerage units who used to make a killing in this service.

What’s going to happen now?

Upon recently having the opportunity to speak with an executive at a major bank on recent financial events, she confirmed the earnings potential of equity securities lending might be lost for good. As a culture driven by the short term in the form of quarterly performance numbers, investments banks and hedge funds alike will be clamoring for a way to return to profitability as quickly as possible. It’s evident that many of the major investment banks took advantage of dislocated credit markets in the Q1 09, but as usual in the equity marketplace these returns were deeply discounted given the likelihood of repeating such a performance going forward. Personally I think the investment banks will want to rid themselves of the stigma associated with the TARP money as confirmed by JP Morgan and Goldman Sachs.

Time will tell how Goldman Sachs adjusts toit’s new partner in light of it’s bank holding company status and the associated regulations that come with the title. I predict that banks will utilize the PPIP plan to unload their troubled assets onto hedge funds for 20-30 cents on the dollar who, if patient, should reap supreme benefits in the next 2-4 years. Timothy Geithner will be able source a substantial amount of the capital needed in the  TALF plans from these large players. These money managers stand to gain tremendously in the medium term by buying these grossly discounted assets. In the mean time banks and bank holding companies will fight to sustain their relevance as intermediaries to both hedge funds and retailers in the capital markets. Look for some newly created sales/trader positions and an inventory of newly structured securities that offer exposure to these troubled assets to badly burned investors who don’t really understand what they are purchasing- AGAIN.

Disclosure: None

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