Monday, December 12, 2011

Securities Lending – Share Hypothecation

For the last several months, Efinity Finanical has quietly grown in the Dallas Fort Worth market. Those clients already presently working with our advisors are well aware of the weekly commentary we publish. Last week's was so good we felt it should repost here on the Efinity Report. Enjoy.

Securities Lending – Share Hypothecation
One of the main issues facing the financial world today is the difficulty investors have estimating the effect that a specific financial issue, such as a 50% haircut on Greek bonds, may have on the global or domestic financial and banking system.

So why can’t the people who run the European Central bank, the U.S. Central Banks Federal Reserve and Wall Street estimate the probability and effect of a bank going out of business? It looks like the reason some banks are classed as “too big to fail” is the fact that no one knows what will happen if they DO fail!

The reason is the financial system is based on everyone lending and making promissory contracts with each other. The system has evolved to a highly leveraged point where very little real cash or collateral exists. Looking at ‘cash in the bank’ has been replaced by credit ratings and rates as means to judge the fiscal security of a loan to a counterparty.

Unfortunately, these ratings and loan rates can change quickly; confidence is especially ephemeral these days. Take Italy, for example, whose cost of borrowing has nearly doubled in a period of weeks. This means the capital held by banks in the form of Italian bonds has shrunk by nearly 50%.

European banks are currently levered by approximately 30 to 1 – for every $1 they have in actual capital, they have $30 in borrowings. U.S. banks are current around half that level.

Shorting the System
Another reason for high volatility is the increasing ability of financial firms to profit from betting against markets - Shorting. Probably the most infamous example was Goldman Sach’s $550 million fine relating to fraud charges over the shorting of (seeking to profit from betting against) mortgage securities they had previously profited from by advising clients to buy. The fund was called Abacus.

Securities Lending
Securities Lending, a.k.a. Share Hypothecation, is a little known method for large financial firms to leverage the financial system - proponents call it the lubrication of securities markets. It certainly facilitates increased short selling activity. It is estimated that $1.9 trillion of securities are out on loan every day.

Securities Lending allows a Wall Street firm to loan shares to another firm in return for both a transaction fee and collateral to cover the loan. Although this may sound ‘normal’ among large companies, many Wall Street investor custody agreements include securities lending clauses allowing the firm to lend out shares owned by retail investors.

Yes, investment banks and the like regularly take their investors’ shares and loan them to companies looking to short the market.

For any financial relationship you have, check to see if the company participates in Securities Lending. If they do and the lender goes bankrupt, you will lose your shares!

Why Lend Securities?
Financial companies often “Lend” securities to facilitate short selling. Selling a stock “Short” means borrowing stock from a Lender for a period then selling the stock to a Buyer. At the end of the borrowing period, the Borrower has to give the stock back to the Lender.

If the price of the stock goes down during the lending period, at the end of the period the Borrower buys the stock in the market at the current reduced market price and gives it to the Lender. The Borrower therefore pockets the difference between the price they had originally sold to the Buyer at the start of the lending period and the price they had just paid for it at the end of the lending period.

If the stock rises in value during the borrowing period, the Borrower loses the difference in the original sale price and the price they have to buy it back to satisfy the loan. This practice avoids the short company for being accused of “Naked Shorting”, the practice of selling a stock short without owning the underlying stock.

Take a moment to think how frightening this concept is…in order to make a big negative bet against a company or country, all a Wall Street company has to do it find a counterparty who is willing to loan the representative securities for a nominal fee.

Even worse, the collateral to cover the trade is rarely “tangible”; it’s often other financial contracts. It is therefore very easy to see how confidence can rapidly evaporate in financial markets.

Company versus Country
One interesting result of the above is the changing risk/credit perception between many large corporations and a number of countries, chiefly those in Europe. Sovereign fixed income investments that were previously thought to be low volatility are now behaving like Tech stocks! At the same time, high yield corporate bonds are relatively stable.

Countries have been able to run whatever fiscal policy they wanted because their credit rating always allowed them to borrow and borrow at low interest rates. Companies generally had to maintain pristine balance sheets to enjoy anything like similar access to debt. Moreover, everyone assumed sovereign debtors were highly creditworthy whereas companies have to prove their creditworthiness on a quarterly basis.

Now that the confidence in the finances of many countries has disappeared, we are seeing massive swings in the prices of sovereign bonds; those securities that we all previously thought were very stable. Hedge Funds and short sellers are able to use leverage to bet against the debt of countries in the same way they contributed to the decline of Lehman Brothers.

In our opinion, large multinationals have managed their finances exceptionally well in recent years and their debt (Bonds) deserve the stability currently being shown. We have long stated that the world continues to grow in new areas and different ways. Companies and not countries seem to be doing much better at managing this change.