A few years ago, stock lending programs were big news in the wake of the 2008 credit crisis. Stock lending occurs between a lender and a broker in exchange for cash collateral that can be reinvested to generate income. for the lender. The lender will also charge a fixed fee for the loan of the securities. The loan of these securities helps to facilitate the practice of “short sales”. Short selling occurs when the stockbroker borrows securities and sells them in the belief that he will be able to buy them back at a lower price.
There are two strategies that securities lending can adopt; a volume-oriented strategy, or a lending-value strategy. The volume-oriented strategy involves lending large percentages of readily available securities and investing the collateral in aggressive investment vehicles to increase income. Aggressive investing is an attempt to offset the increased discount rate being offered to borrowers. Easier-to-find securities have higher redemption rates than securities that are more difficult to locate due to lower demand. The Lending-to-Value approach seeks to only lend those securities that are in highest demand. They can negotiate a lower repayment rate and take a safer investment approach with the cash collateral.
Stock lending was affected by the credit crunch because brokers were defaulting on their stock lending. When lenders tried to buy back the securities to offset these defaults, they did not have enough collateral because in many cases they had invested aggressively in asset-backed securities, subprime mortgages, and other less creditworthy securities. These types of investments were hit hard during the economic downturn. The most responsible approach was taken by the Vanguard Group; one of the largest mutual fund companies in the country.
Vanguard takes the value lending approach by lending many hard-to-borrow securities in an attempt to take advantage of the “scarcity premium.” Lending only scarce securities allows Vanguard to see higher returns per dollar of loaned assets and set low-to-negative repayment rates, leading to higher loan revenues. Vanguard also implements risk controls that ensure a successful securities lending program. First, they only lend to a limited number of pre-approved brokers who are continuously evaluated by an independent in-house credit team. This practice ensures that Vanguard only deals with responsible brokers. Second, Vanguard reviews the value of the securities they have lent in order to maintain the 102% to 105% guarantee rates they charge borrowers. Vanguard will charge additional collateral if the value of the securities increases to maintain the rate from 102% to 105%. Third, Vanguard invests its cash collateral in conservative money market investments that earn consistent returns. In addition, Vanguard adheres to strict guidelines on the total dollar amount loaned to each borrower.
The most remarkable thing about the Vanguards securities lending program is that it works with zero profits. The income earned is returned to the funds that held the securities after subtracting program costs, agent fees and broker rebates. In fact, less than half of 1% of the income generated by Vanguard’s securities lending program is used to pay expenses. Other lenders keep up to 50% of your income. Vanguard prides itself on always putting the interest of the shareholder first. By simply covering their fixed and variable costs for the securities lending program, they return all the profits to their shareholders in the form of higher returns. A company that puts its customer first is a hopeful thought emerging from an economic downturn basically defined by greed.
Other lenders will have to implement more responsible lending programs if they want to participate. The Dodd-Frank Act of 2010 required the SEC to institute new securities lending rules by July 21, 2012. These rules are designed to make more information available to brokers, dealers, and investors regarding securities lending. values. The Financial Industry Regulatory Authority (FINRA) is also considering rules that will better prepare participating securities lending programs for the risks associated with this type of practice. Hopefully our economy has learned from its past mistakes and we are all more responsible investors.
