How to raise cash when liquidity runs like glue – why securities lending is at the fulcrum of the new finance

Another red letter day,
So the pound has dropped and the children are creating,
The other half ran away,
Taking all the cash and leaving you with the lumber,
Got a pain in the chest,
Doctors on strike what you need is a rest

‘Friends will be friends’: Queen, Kind of Magic, 1986

Bank liquidity is big news these days (FT this week - European banks innovate with bonds to fill funding gap), because it is challenging. At the urging of an eagle-eyed asset manager, we are shining the light on how cheap it is for banks to use the government bond lending market to upgrade their collateral (15-20bps). This is especially the case when contrasted with the overnight Repo market (50bps). We will also look at the type of pick-up a lender gets from doing fixed duration government bond lending (something that regulators are pushing them towards) and gauge the march of this term financing. Plus, we observe that asset managers and insurance companies are themselves important sources of cash at this moment in time.

Background
Challenge: an investment bank tends to sit long in equities, corporates and convertible bonds in much greater proportion than anything else. This is a by-product of their equity trading and (increasingly popular) ETF/Delta One activity, as well as their prime brokerage arm. This is an issue because none of these instruments win any popularity contests with central banks or other banks when it comes to using them as collateral to secure badly needed cash or to borrow other instruments. Some banks with large capital markets arms have easier access to cash than others. For every JP Morgan, Bank of America Merrill Lynch (BAML) and Deutsche Bank who are “universal banks” you have non-commercial banks like Goldman Sachs and Morgan Stanley who have massive trading divisions but less internal access to cash. This situation is especially sensitive at times like this when banks draw in their horns and people get very selective about which counterparts to trade with and what form of collateral to accept. For example, some Custodians will only accept G7 debt as collateral on behalf of their more prudish beneficial owners.

Opportunity: investment banks are incredibly adept at swapping assets they can’t make use of for those they can. As someone once put it to me, they are “giant re-cycling machines.” If they weren’t it would be impossible to have a big equity trading arm without being a commercial bank. If a bank wants to borrow cash from a central bank they need “eligible collateral,” and this tends to be G7 government bonds. Also, Basle III and the FSA are pressing banks to match their assets with their liabilities by getting guaranteed or so called ‘term’ or ‘evergreen’ funding in place, which translates into borrowing G7 debt under a quasi lock-up. The people who will help a bank swap equities and corporate bonds for government bonds are the big asset managers and the mechanism is the securities lending market and tri-party collateral management services.

Government Bond lending on the march
Asset managers are seeing greater demand to borrow their European government bonds. If we exclude bond repo (bond loans where cash is the collateral) we see USD 330 bn on loan against non cash collateral. This is just off a three year high. The income from lending is at a two year high at 4bps and this is double the normal rate if you exclude the non-normal period in Q4 2008. The bps fee is also rising and at a two year high at an annualized 16bps.

Focus on German Government Bonds
As the strongest European economy, German sovereign bonds are useful assets to own to lend to banks in search of improved collateral. However, 16bps is the annualized fee for these loans against non-cash. If you were to indulge in some bond repo (lending bonds and receiving cash) you make much more as my spy tells me at the direct lending firm: “Basically the spread versus Eonia in German underlying TN is 49 bps. So even when the spread reaches 30, it's off my 15-20 bps range! It's getting worse: the financing of equity collateral versus Eonia main index trades at +10 bps over Eonia, so, 59bps.”

Many Custodians perceive the risk/reward pay off to be all wrong and do not even undertake these “collateral downgrade” trades with fees as low as they are.

Why is there such a divergence? The repo market’s premium could well be closer to the “true” market perception of risk. The securities lending market, being one step removed from liquidity/treasury management could be under pricing the value of safe assets. (Is this way securities lending desks are merging with Treasury is various firms?) That said, the oversupply (see Long Short Ratio) makes it easy for the borrowers to set a low fee.

Is there a pick up and premium for ‘term’ lending?
The liquidity rulings put forward by Basle III and the FSA encourage banks to fund themselves for fixed durations to prevent them being drained of assets if all of their cash and collateral can be pulled at the blink of an eye. This time last year we received non cash Euro government bond term lending to the tune of USD 24bn. This year it is up 25% to 30bn. This represents 9% of the total non cash European (inc. UK) ‘govie’ lending. To me this is not a rampant increase and still represents a small portion of the cake; beneficial owners are clearly not that keen on term lending.

The average annualized fee rises to 25bps when you filter for just term trades. This is a great improvement on the 16bps when looking at both open and term trades but still falls short of the income from the repo market as outlined above. The highest fees are for 12 month term trades where some lenders are able to earn over 80bps. This could even be said to be cheap if the bank can classify this type of funding as “tier 2 capital” in their capital adequacy calculations.

Interestingly, most of these loans have a very long duration even if they are not booked as “term” with an end date – UK Government bonds on loan versus non cash are currently showing an average tenure of 339 days. It seems odd to be offering, in effect, annual access to G7 government debt for 15-20bps (and some essential tier 2 capital funding) when adding an end date gets you much more than this. Let us not forget that term trades are not legally binding and a recall (ideally with a substitution) is still possible in an emergency.

Solvency II
The story, at this point, turns on its head. It is clear that investment banks can use the long government bond positions held at asset managers, via the securities lending market, to manage their liquidity. But, there is an even easier path to cash when fund managers hold lots of it. In bull markets, the massive asset managers, pension funds and insurance companies each have billions of cash on deposit. During this market when many fund managers have heavily reduced their net long positions, cash is even more abundant. Add the inducement to hold cash under the insurance industry’s Solvency II directive and you see a massive amount of available cash lying at the institutions.

In days gone by, spare cash might be placed on deposit overnight to earn a small amount of interest, but one imagines that reverse repo is more attractive at present. With banks hungry for cash and central banks running out of it, they seem a good port in this storm. It enables the securities lending desk (who are good at this type of collateralized trading) to lend cash on a secured basis (unlike before) and earn more money, making them the darlings of the fund’s trustees.

Role of securities lending in shadow banking
Securities lending is going back to where it came from in the early 2000s as a primary provider of short term funding. In this “new economy” life is upside down – asset managers have cash and banks don’t. “Treasury” departments are busier than ever and exist in any company that handles large amounts of cash. This includes corporates such as Siemens. The German engineer set up a bank function in 2008 and recently used it to deposit EUR 500m with the ECB, but thanks to the skills of securities lending and some long established relationships (hence the Queen lyrics below), assets can be securely moved to where they are needed most. The Financial Stability Board are quite right, securities lending is a key component of shadow banking.

It's not easy love, but you've got friends you can trust,
Friends will be friends,
When you're in need of love (cash) they give you care and attention,
Friends will be friends,
When you're through with life and all hope is lost,
Hold out your hand cos friends will be friends right till the end