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Securities Lending: Too Risky or a Great Opportunity?

|Includes:JPMorgan Chase & Co. (JPM)
The practice of securities lending appears to be abig boysgame in which the inadequately informed or naively trusting can take a bad beating. Lest anyone forget, in 2008, this practice was linked to the financial elimination of some otherwise healthy investments and almost caused the collapse of AIG. Since the 70s and 80s, many investment banks have quietly merged with other banking institutions or vanished altogether. In fact, the remaining 4 major independent investment banks have been recently joined by commercial banks such as JP Morgan, Credit Suisse, and UBS.

How does securities lending work? The initial premise is that a big investor such as a pension fund, the US government, foreign equities, agency or US corporate bonds, or mortgage-protected securities will decide to loan out some of its institutional investment portfolio for a cash collateral and fee through a dealer bank such as JP Morgan or a stock broker/dealer. The new borrower of these shares must put up 102% -105% in cash collateral, government securities, or even a Letter of Credit. A specific repayment date is set as well, and the original owner still owns the stock.

The bank that handles the transaction will then take the cash collateral and reinvest it in some short term liquid projects, dividing the profit with the owners. JP Morgan actually takes 40% as its share. And heres where the rub comes in. In the event that the investments drop in market value, the borrower only has to return them because the cash collateral more than covered their original market value. It becomes the sole loss of the owner who receives back devalued stock and may lose huge amounts. Investment banks do not share losses in these transactions, only profits.

So, why is the risky practice of securities lending becoming so popular again? The answer may lie in the fact that thisback officepractice has received enormous attention in the last 3 years. For new investors, the opportunity to improve portfolio yield through this strategy may be more inviting because it represents another clever way to make money. For others, the lessons learned have made them more confident that one can turn a profit as long as one plays smart and stays hands-on. There is also a suspicious tendency of some investment banks to subtly pressure their pension funds to cooperate by obliquely threatening to raise theircustodialor management fees.

The most important lesson for would-be investors is to be well-informed of the potential risks and to be involved in the management of this process. Obvious areas of concern are the danger of borrower default. While rare, the chance does exist that the borrower will not return the funds on their due date or may actually fall into bankruptcy. Thorough vetting of potential borrowers by the institution handling the transaction should negate this. There are also collateral investment risks. Protecting oneself by investing in relatively safe, high credit and short term investments is the best choice. Finally, operational risk, the mismanagement of transactions because of miscommunication between parties can be a very expensive mistake. Effective administration is essential to protecting any investment in securities lending.

Knowing the risks, monitoring the collateral, and becoming much more involved in the process of deciding how to loan out parts of ones portfolio are essential for profiting in this investment game. Understand that if the wheel breaks, banks such as JP Morgan do not intend to suffer from the fall.

Check out the chart for JPM for the past 3 days:

Disclosure: No Positions
Stocks: JPM