A few years ago, stock lending programs made big news in the wake of the 2008 credit crunch. Stock lending occurs between a lender and a stockbroker 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 lending of these securities helps 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 you can adopt for securities lending; a volume-oriented strategy, or a lending-of-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. The aggressive investment is an attempt to offset the increased discount rate offered to borrowers. Easy-to-find securities have higher redemption rates than securities that are harder to find due to lower demand. The lending-of-value approach seeks to only lend those securities that are in greatest demand. They can negotiate a lower redemption rate and take a safer investment approach with the cash collateral.
Securities lending was affected by the credit crunch because stockbrokers were defaulting on their securities lending. When lenders tried to buy back the securities to offset these defaults, they had insufficient collateral because in many cases asset-backed securities, subprime mortgages, and other less creditworthy securities had been invested aggressively. These types of investments were hit hard during the economic downturn. The more responsible approach was taken by the Vanguard Group; one of the largest mutual fund companies in the country.
Vanguard takes the lending-of-value approach by lending many hard-to-borrow securities in an attempt to take advantage of the “scarcity premium.” Lending only scarce values allows Vanguard to see higher returns per dollar of assets lent and set repayment rates from low to negative, leading to higher loan income. 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 continually vetted 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 so they can maintain the guaranty rates of 102% to 105% 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 your cash collateral in conservative money market investments that earn consistent returns. Additionally, Vanguard adheres to strict guidelines on the total dollar amount loaned to each borrower.
What is most striking about the Vanguards stock lending program is that it operates on zero profit. Proceeds are returned to the funds held by the securities after subtracting program costs, agent fees and broker refunds. In fact, less than half of 1% of the income generated by Vanguard’s stock lending program is used to pay expenses. Other lenders withhold up to 50% of your income. Vanguard prides itself on always putting shareholder interest first. By simply covering their fixed and variable costs for the stock 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 coming out of an economic downturn defined primarily by greed.
Other lenders will have to implement more responsible lending programs if they wish to participate. The Dodd-Frank Act of 2010 required the SEC to institute new rules on securities lending by July 21, 2012. These rules are designed to allow more information to be made available to brokers, intermediaries, and investors about the Securities Lending. 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. Let’s hope our economy has learned from its past mistakes and we are all more responsible investors.
