US Bailout Banks “Securities Lending”: WE Win Together – You Lose ALONE

 20 January 2011.

 20 January 2011.

If Chinese President Hu gets tired of being lectured to by President Obama and the rest of the US corporate / government elite,

he might politely look them in the eye, and softly say two words:

SECURITIES LENDING

He could then ask Obama and the rest of the “gang” about JPMorgan Chase & Company’s

proposition for the mutual funds and pension funds that oversee many Americans’ savings:

Heads, we win together. Tails, you lose — alone.        

Here is the deal:

Funds lend some of their stocks and bonds to Wall Street, in return for cash that banks like JPMorgan then invest.

If the trades do well, the bank takes a cut of the profits.

If the trades do poorly, the funds absorb all of the losses.

The strategy is called securities lending, a practice that is thriving

even though some investments linked to it were virtually wiped out during the financial panic of 2008.

These trades were supposed to be safe enough to make a little extra money at little risk.

But JPMorgan customers – including public or corporate pension funds of I.B.M., New York State and the American Federation of Television and Radio Artists –

ended up owing JPMorgan more than $500 million to cover the losses.

Morgan, though, protected itself on some of these investments and kept millions of dollars in profit – before the trades went awry.

How JPMorgan won — while its customers lost — provides a glimpse into the ways

Wall Street banks can, and often do, gain advantages over their customers.

Today’s giant banks not only create and sell investment products,

but also bet on those products, and sometimes against them,

putting the banks’ interests at odds with those of their customers.

The banks and their lobbyists also help fashion financial rules and regulations.

And banks’ traders know what their customers are buying and selling, giving them a valuable edge.

Some of JPMorgan’s customers say they are disappointed with the bank.

“They took 40 percent of our profits, and even that was O.K.,”

said Jerry D. Davis, the chairman of the municipal employee pension fund in New Orleans,

which lost about $340,000, enough to wipe out years of profits that it had earned through securities lending.

“But then we started losing money, and they didn’t lose along with us.”

The financial regulation bill that Congress just passed, despite fierce lobbying by banks,

is aimed at curtailing some of the practices that caused the financial crisis.

But much of Wall Street has mostly gone back to business as usual.

Nowhere are the potential conflicts more apparent than on the trading floors,

where executives must balance their pursuit of profits and their duty to customers.

In addition to losing money for New Orleans workers and others,

securities lending also played a central role in the near-collapse of the American International Group.

Through securities lending, pensions and mutual funds borrow money to make trades, adding to the risks within the financial system.

Lawsuits are flying against JPMorgan and others, including Northern Trust.

Clients say that they were not warned of the risks associated with this practice and that the banks breached their fiduciary duty.

Wells Fargo lost such a suit over the summer and was ordered to pay four institutions a combined $30 million.

The State Street Corporation, which took a $414 million charge in July to cover some of its customers’ losses, faces suits from other clients.        

Despite such reverses, the securities lending business has rebounded after plummeting during the crisis.

Today shares with a combined value of $2.3 trillion are out on loan,

according to SunGard, which provides technology services to financial companies.

In 2007, before the bubble burst, the total on loan was worth $2.5 trillion.

The quick revival of securities lending raises concerns about whether banks and their pension customers have learned any lessons.

“What happened was the banks got greedy and they looked at the return they were getting on the collateral and said, ‘Why don’t we go further with this?’ ”

said Steve Niss, the managing partner at the NFS Consulting Group, an executive search firm specializing in investment management.

The idea behind securities lending is simple:

it allows big investors like pension funds to make extra money on their investments, without having to sell them.

In a typical transaction, a pension fund or other institution lets a bank like JPMorgan lend some of its stocks or bonds to other investors, like hedge funds or banks.

In return, those investors put up a cash security deposit, in case they are unable to return the securities.

The pension funds and other institutions then authorize JPMorgan traders to use that cash deposit to trade.

To pension fund managers, this is an attractive proposition.

That is because eking out marginally higher returns on investments —

even just another quarter or half of a percentage point a year —

can make a difference over time.

Securities lending also fostered the rapid growth of hedge funds,

which often borrow shares from pension funds to bet against those stocks.

The practice also helped spur the creation of some of the arcane investments that eventually threatened the US financial system.

Today, institutions around the world have about seven trillion shares worth a total of $20 trillion that they are offering to lend out.

That is roughly twice the market value of every corporation included in the Standard & Poor’s 500-stock index.

Only about a tenth of those shares are out on loan at any point in time, depending on which ones hedge funds and others want to borrow, according to SunGard.

Banks often pressure pension funds to participate in securities lending, pension consultants say.

If funds refuse, banks raise so-called custodial fees, the charge for holding a fund’s securities.

“Whenever we say ‘no securities lending,’ then they say, ‘well, we need to talk about your custodial fees,’ ”

said Jay Love, a pension consultant with Mercer.

Still, Mr. Love said, he advised clients against securities lending.

Participating in such programs amounts to borrowing money to make trades in the financial markets, he said.

Ultimately, the cash has to be returned.

He said the stocks the pensions lend out can be viewed as a security deposit in exchange for cash used for other investments.

“It’s not a free lunch,” Mr. Love said.        

As Jerry Davis, the New Orleans city employee pension fund chair mentioned above, has discovered, much to his and his colleagues chagrin.

In 1986, he joined the board of the city’s pension fund and watched over the fund ever since.

Along the way, he has also become something of a shareholder activist.

He says he has led the pension fund in suing more than 30 companies or boards of directors that he believed failed in their duties to shareholders.

When Davis first heard about it, securities lending sounded like a low-risk proposition.

So New Orleans began lending out some of the securities in its portfolio, turning modest profits.

For instance, in 2007, the fund earned $70,000 by lending out its securities and letting JPMorgan reinvest the cash deposits.

To earn even such small amounts of money, pensions have to lend out substantial amounts of securities —

$20 million on average for New Orleans that year.

But there were several aspects of the program that always bothered Davis.

Not long after the New Orleans pension became a JPMorgan customer in 2004,

Davis asked why the bank could not provide him with industrywide return data for securities lending.

JPMorgan representatives said industry rankings were too difficult to come by, Davis recalled.

And regarding Mr. Davis’s other pet peeve, JPMorgan’s practice of taking a 40 percent cut of profits?

“They told me we were too small to do any better,” he said.

That was in contrast to some giant pension funds, which share only 15 percent of investment gains with the bank.

Despite these warning signs, Davis kept the New Orleans pension in the program.

Securities lending helped the fund cover its operating costs, and, unlike investing in, say, hedge funds,

the fund officials did not consider securities lending to be risky.

It was, he said, “almost like free money.”

Almost.

One of JPMorgan’s funds was called CashCo, which pooled together the cash deposits that small pensions received for lending out their securities.

One of those small pensions was the New Orleans fund for which Davis served.

Another was the American Federation of Television and Radio Artists, whose contract stated that the customer bore the “sole risk” for the investments.

It included a five-page appendix describing investments that were permitted.

Among the requirements was that the investment carry a safe credit rating, of A or better.

That turned out to be a problem in 2008, as the financial crisis began to unfold.        

A number of investments made by CashCo, while highly rated, turned out to be risky —

including I.O.U.’s from Bear Stearns and Lehman Brothers, two Wall Street banks that foundered in the collapse.        

As Bear Stearns hit trouble in March that year, the phones on the securities lending trading floor began ringing nonstop.

Pensions and other clients were demanding to know why JPMorgan had left their cash in the plunging Bear Stearns investments,

former JPMorgan employees said.

The response: the Bear investments were allowed under the clients’ guidelines.

The calls were particularly tense because JPMorgan had bought the stricken Bear Stearns on attractive terms.

Some clients believed the bank should have known trouble was coming.

In the end, investors did not lose money on the Bear notes, but the tremors were a sign of trouble.

Around that time, several Morgan traders began to focus on another troubled trade:

an investment vehicle known as Sigma.

JPMorgan had inside knowledge of Sigma, because the bank had helped finance it.

But Sigma collapsed after JPMorgan pulled out to protect itself.

“They sensed there were problems with these investments, but they didn’t tell the clients,” said one of the former employees.

“They knew all along: we’ve got the out — the losses are yours.”

When Sigma collapsed, during Black September 2008, CashCo lost $99 million

and other JPMorgan clients lost roughly $400 million more,

according to JPMorgan client presentations.

CashCo also invested in Lehman Brothers securities.

When Lehman collapsed, JPMorgan’s customers were on the hook.

JPMorgan also had insights into Lehman’s health as one of Lehman’s business partners.

A court-appointed examiner concluded this year that

JPMorgan may, in fact, have helped to push Lehman over the brink

by demanding cash from the faltering bank.

JPMorgan has said in a court filing that it actually helped Lehman stay alive,

by providing financing that others in the industry would not.

But in the carnage of the Black September 2008 collapse,

the officials in New Orleans were stunned to find they had been left high and dry by Morgan.        

In January 2009, a representative from JPMorgan, Robert Bentz, visited to discuss the situation.        

“These are not easy meetings,” Mr. Bentz began, according to a tape recording from the meeting.        

Mr. Bentz told the New Orleans officials that former workers from Citigroup created Sigma.        

“So it was like Bernie Madoff!” one city official exclaimed.        

Mr. Bentz replied: “I would like to think he was more of a crook, and these people were just smart.”        

But a deal was a deal, Mr. Bentz said, and he said JPMorgan did not plan to help the New Orleans workers cover their losses.

Despite these and other incidents, there are few signs of change in Wall Street in general, and the securities lending industry in particular.

Some pensions have begun asking banks whether they will agree to share not only potential profits but also potential losses.

The Missouri State Employees’ Retirement System, for instance, asked banks if they would promise to cover any such losses.

All of the banks that replied declined to do so, according to Christine Rackers, a spokeswoman for that fund.

In late September, JPMorgan bankers paid another visit to the New Orleans fund,

which had decided not to sue the bank,

but did stand to benefit if two class action lawsuits were successful.

When the conversation shifted to

• the Lehman and Sigma losses,
• the lawsuits against JPMorgan and 
• the pension officials’ belief that the bank had failed them,

the “men from Morgan” mumbled apologies and rushed out.

New Orleans official Davis said in an interview that the pension was considering looking for a new bank,

even though leaving would mean his fund would have to immediately pay JPMorgan for its losses.

He also said he was disappointed that regulators had not intervened on behalf of funds like his —

a sin of omission the so-called / self-styled / allegedly democratic “financial reform” is most unlikely to change.

He added that he wished his pension fund were a JPMorgan shareholder, rather than JPMorgan customer.

“If I were a shareholder, I would say,

‘I love Jamie Dimon to death because he’s going to go out there and make money every way he can, no matter what happens to his customers’.

“He’s making money off of me,” he said in this article from the New York Times.

And millions of other Americans, whose hard-earned pension money remains in the hands of Dimon and a few other TBTF bankers.

As the 60s song said, “when will they ever learn ???”

Or as the Talking Heads said in the 80s,

“Same as it ever was, same as it ever was, same as it ever WAS”.

David Caploe PhD

Editor-in-Chief

EconomyWatch.com

President / acalaha.com