Spending it Forward: Securities Lending Fiasco Finds Granholm’s Pension Fund Managers Embarassed by $2 Billion Loss

The unfunded liability for the state's four major pensions — schools, state employees, police, and judges — is pegged at $11.6 billion, and the future health care liability ranges from $45-50 billion. Even if the state started meeting its obligations today, it would take $2 billion annually for the next 30 years just to get even.

Amidst the world financial turmoil in 2008-09, Michigan's pension funds lost some $2 billion on a little known activity called 'securities lending.' This loss was different in kind from normal market fluctuations in that a large portion of the money can never be recovered.

When the State of Michigan closed its books for the fiscal year ending Sept. 30, 2008, they included a decline in the value of pension fund investments of some $12 billion, or almost 20% of the portfolio. This was hardly surprising — the world financial system was in the midst of a financial panic, and stock markets were in a decline that had begun a year earlier and would not hit bottom until the following March.

Neither was it particularly alarming: managers of large pension funds like those employed by Michigan's Dept. of Treasury realize that when one has $50-60 billion in long-term stock investments — the only proven way to preserve and grow funds set aside to cover pension liabilities extending decades into the future — the inevitable 'corrections' and bear markets will generate near-term valuation swings measured in frightfully large amounts. Such swings come with the territory, and residents of the capital city are unlikely ever to see state pension fund managers leaping from the roof of Treasury's Richard H. Austin Building because of such declines.

However, one $2 billion loss was highly embarrassing to those professional money managers. What's more, although the value of the securities in the pension funds themselves has recovered somewhat since the March, 2009, market low, this particular loss will probably never be completely erased. The hit came from the arcane activity called 'securities lending.' This practice is used by holders of large stock portfolios (such as pension funds) to generate a modest additional return on their investments.

It works like this: in return for a loan of stock shares lasting a few days, weeks, or months, the "borrower" gives the lender collateral in the form of cash equaling the market value of the borrowed shares plus 2% (or +5% for non-dollar denominated securities whose primary trading market is overseas). The lender also receives a small fee for the loans, which — given principle+interest dollar amounts measured in billions — can add up to tens of millions of additional pension fund earnings each year.

For example, the school employee pension fund (MPSERS), which is the state's largest, earned some $48 million from these loans in 2008 and $68 million in 2009, despite the financial meltdown going on around it. The Michigan Dept. of Treasury handled its securities lending practices through an agent — the Credit Suisse Bank — which promised to indemnify the state if a borrower failed to return the loaned security. For what purpose are securities "borrowed"? The shares may be used to facilitate the settlement of trades, to facilitate short sales of stock (a form of hedge or bet that the price will fall within a certain time period), or for certain other specific purposes.

Michigan incurred no losses on the actual lending of stock shares; those that were "loaned out" were all returned, and if the share price had fallen in the meantime, it would have done so even if the securities had remained "in the vault."

So far, so good, but big trouble arose as a result of what our money managers did with the cash they received as collateral for these loans. When that cash was received, the Treasury managers invested it in short-term "asset-backed obligations" — essentially, interest-bearing notes offered by various issuers. Many of those "assets" were derivatives of home mortgage loans, and one of the issuers was Lehman Brothers, Inc.

With the benefit of hindsight, readers can start to sense the impending train wreck that actually occurred beginning on Sept. 15, 2008. That was the day Lehman declared bankruptcy, and, according to highranking Treasury officials, the securities lending collateral account held $575 million of its obligations at the time. Overnight the value of those instruments went "poof" — a loss that will never be recovered.

Furthermore, the ensuing worldwide financial panic and liquidity freeze generated another $1.5 billion in losses on the remaining asset-backed securities in that account by Sept. 30, the day the books were closed on the 2007-08 state fiscal year. One year later, the state had recouped less than $300 million of that. Given the Lehman bankruptcy, it's virtually certain that a substantial portion of the value will never be regained no matter what the ultimate resolution of the mortgage mess.

So, should heads roll in the Dept. of Treasury? In their defense, Treasury officials would point out that "everybody was doing it" and that pension funds in some other states suffered even greater losses on the practice.

However, there does appear to have been some "reaching for yield" in the securities lending collateral account, which is where the losses actually occurred. Most of the asset-backed obligations there were rated AAA or AA by the "Nationally Recognized Statistical Rating Organizations" such as Moody's, which are themselves now under investigation and about whom questions had been raised before the sub-prime meltdown — but more than $1 billion was in instruments rated less-than-investment-grade, or unrated ones. True, Treasury's losses may not have been in the noninvestment- grade obligations; nevertheless, if our state investment managers had just bought U.S. Treasury notes and bills (on which the yield was virtually zero at the time), there would have been no losses.

The lesson we might take from all this applies to the entire worldwide financial system "morality play" of the past decade: Somewhere in heaven, J.P. Morgan is shaking his head as he looks down on these recent mortgage-backed obligation and real-estate bubble follies. Pension fund managers in particular are fiduciaries of a public trust. As such, they're supposed to be prudent, boring "eat your vegetables" investors who never get swept up in chasing "enhanced returns" gained through what old-school money managers would have viewed as gimmicks.

But these managers are people, too, and, in this life, their performances are benchmarked not against some heavenly ideal, but by how their funds compare with similar ones elsewhere. Michigan's pension managers are undoubtedly earnest professionals who may be no worse than their colleagues in other states, and possibly better than some. If their heads were to roll, their replacements might not be any more prescient or immune to the madness of crowds.

In fairness to the hapless Granholm and her state treasurer (Robert Kleine), they inherited the practice of 'securities lending' from their two predecessor governors and their treasurers, who for years had made money for the pensions off the stratagem.

Here’s the question now, however: Is 'securities lending' still with us over at Treasury? If so, should it be?

"This article reprinted with permission from Inside Michigan Politics, Michigan's #1 political newsletter. Subscriptions available at www.insidemichiganpolitics.com"