SECURITIES LENDING

1

• SECURITIES LENDING
• IS IT RIGHT FOR YOUR FUND?
• Lynn H. Thompson
• Metropolitan West/Wachovia Bank

2
Securities Lending101
3
What is Securities Lending?

• A transaction in which the owner of securities
  (client), agrees to lend its securities, to a
  borrower, in exchange for collateral consisting
  of cash or government securities.
• Borrowers of securities are typically large
  broker/dealers who use the securities to
  facilitate day-to-day business such as providing
  liquidity to the markets, facilitating trade
  settlement, as well as for arbitrage or risk
  management strategies. Incremental income
  (spread) is generated for the owner/lender by
  investing the cash collateral, in high quality,
  short-term investments.
• The incremental income (spread) is split between
  the owner/lender (client) and the Agent .
• The objective is to generate incremental income
  (spread) from fully collateralized security loans
  while maintaining safety of principal.

Page 3
4
Why Securities Lending?

• Additional revenue opportunity to cover
  custody/administrative costs
• Provides introduction to additional corporate
  decision makers
• Value-added service which enables clients to
  increase overall yield on investment portfolio

Page 4
5
Structure and Terms

• Securities Lending Structures
• Third Party Agent Agent is appointed by client,
  to be the securities lending agent regardless of
  existing custodial relationship.
• Custodian as Agent Custodian of assets for the
  client acts as agent for securities lending.
• Principal Borrower of assets is the principal in
  the securities lending transaction.
• Useful Terms
• Rebate
• When cash collateral is received from a borrower
  of securities, it is invested (according to
  guidelines approved by client) in high quality,
  short-term interest bearing investments. For use
  of the borrowers cash collateral, part of the
  interest earned is returned to the borrower as a
  rebate.

Page 5
6
Terms continued

• Spread
• In securities lending the spread is the
  difference between the interest rate earned on
  the borrowers cash collateral, and the rebate
  rate negotiated with, and paid to the borrower
  of a security.
• Utilization Rate
• A measurement of the percentage of securities on
  loan by asset class in a portfolio. The
  utilization rate is calculated by dividing the
  value of securities on loan by the lendable
  portfolio value.
• Utilization rates can be an indication of the
  level of performance a lender is receiving from
  its Securities Lending Agent.
• Higher utilization rates typically equate to
  higher revenue for the lender.

Page 6
7
Securities Demand
Lendable Securities
Non-Lendable Securities
Page 7
8
Common Questions
Does the owner of the security retain ownership
when a security is out on loan? The owner of the
security loses ownership (title) but retains the
benefits of ownership (dividends, corporate
actions, interest income) except for voting
proxies. Does lending hamper management of the
portfolio? A well structured program should not
interfere with portfolio management
decisions. Who lends securities? Master
custodians as agents, third party security
lenders as agents, or in-house by money
managers/companies/public funds. Who are the
lenders? Natural lenders are the holders of
large pools of assets pension funds (public and
private), insurance companies, unions,
endowments, foundations, mutual funds.
Page 8
9
What are the Risks and How are they Mitigated?

• Borrower Risk
• The risk that the securities on loan will not be
  returned by the borrower due to default of the
  borrower. Default requires the Agent to go into
  the market and buy the security to replace the
  one held by the broker. Loss occurs if the price
  of the loaned security is more than the value of
  the collateral received versus the loan. Unless
  indemnified, the client absorbs the loss. Agents
  minimize risk to borrower default by conducting
  ongoing credit reviews of brokers and by marking
  to market on a daily basis.

10
Risks (continued)

• Investment Risk
• A lending agent must take on investment risk to
  earn a spread on each loan. A degree of
  investment risk can vary dramatically by lending
  agents. The client has the responsibility for
  monitoring investment risk. This is accomplished
  by establishing sound investment guidelines for
  the investment of cash collateral, which covers
  interest rate risk, credit quality, sector
  diversification, issuer/issue exposure,
  benchmark, derivatives, and disposition of assets.

11
Risks (continued)

• Interest Rate Risk
• Also referred to as Asset Liability Risk. This
  is the difference between the maturity profile of
  the liabilities (loans) and the assets (cash
  collateral portfolio). Mismatching is a method
  of earning a spread from securities lending in a
  decreasing interest rate environment. If the
  lending agent is required to sell assets to
  return borrower collateral, this could lock in
  market value losses and create losses to the
  client. Lending agents should be using models
  designed to help them profile and manage
  asset/liability risk. Clients should ask their
  lending agents for a Gap or Mismatch report
  of their loans and assets.

12
Risks (continued)

• Operational Risk
• Sell-fail risk is when an Agent lends a security
  that the investment manager subsequently sells.
  The Agent is unable to retrieve the security
  before trade settlement. The owner has an
  opportunity cost because it is unable to reinvest
  the proceeds of the trade. In all cases, the
  Agent covers any interest due to sell-fail.
  Timely communications of trade activity between
  the investment manager and agent is REQUIRED to
  manage this risk.

13
Risks (continued)

• Organizational Risk
• This risk can come from the client or the agent.
• Agent Management makes the decision to sell
  their securities lending business. Clients must
  make their decision of staying with the
  organization that bought the business OR if they
  have multiple lending agents, place additional
  assets with those agents, OR hire a new provider.
• Client An event occurs and the governing
  Board makes the decision to stop securities
  lending. The process to unwind securities
  lending programs do not occur overnight. A plan
  between the agent and the client must be put in
  place to manage the process without loss to the
  program.

14
EVALUATING YOUR ASSETS FOR SECURITIES LENDING

• - MARKET VALUE OF FUND
• - WHAT SECURITIES DOES THE FUND HOLD
• -TREASURIES
• -AGENCIES
• -SBA LGIP
• -SIZE OF INDIVIDUAL ASSETS
• -INVESTMENT POLICY/GUIDELINES

15
PROCESS FOR STARTING A LENDING PROGRAM

• -EVALUATION
• -REVENUE ESTIMATE
• -BOARD/COUNCIL APPROVAL
• -DOCUMENTS/CONTRACTS

16
CASE STUDIES

• -SARASOTA COUNTY
• -SBA LOCAL GOVT POOLED FUND
• -OTHER FUNDS