Some mutual fund companies are deciding that the cash their funds earn from lending stocks doesn't justify the risk in light of unpredictable markets and the Securities and Exchange Commission's crackdown on short sales of selected financial stocks.
It's why Columbia Management Group LLC, a Boston-based unit of Bank of America Corp. of Charlotte, N.C., temporarily ended the practice entirely Sept. 19.
"Columbia believes it is in the best interest of investors not to lend out certain securities given the downward pressure some are putting on the market," said Jon Goldstein, a spokesman for Columbia. "This has the potential to be more detrimental than helpful."
The Vanguard Group Inc. also temporarily ended the practice, said John Worth, a spokes-man for the Malvern, Pa., fund giant.
He declined to comment further, but industry experts said the timing of Vanguard's actions shows that, like Columbia, it's worried that stock lending could harm investors.
MORE BANS TO COME
Other fund companies likely will follow with temporary bans of their own, industry experts believe.
"It wouldn't surprise me a bit," said Jeff Keil, president of Keil Fiduciary Strategies LLC, a Littleton, Colo.-based industry consultant.
"Experts agree that worldwide economic conditions, a lack of confidence in the market throughout 2008 and dropping asset values due to the subprime fiasco are responsible for the sudden illiquidity of major financial institutions," said Mitchell Ames, a New York-based partner specializing in corporate and securities law at Pepper Hamilton LLP of Philadelphia. "The U.S. and other governments clearly believe that a major contributor to [the recent] market turmoil was the lack of regulation over short sales."
And when a fund lends out stocks, many times, those stocks fall into the hands of short-sellers.
It's why the SEC issued a Sept. 18 emergency order temporarily prohibiting short sales of certain financial stocks.
The SEC approved "technical amendments" to its short-selling ban last week, allowing those engaged in bona fide market making and hedging activity, including derivatives contracts, to continue to short.
Companies that are U.S. or foreign banks, brokers, money managers or parent companies of such financial institutions qualify.
Columbia's ban on stock lending, however, will remain in place, Mr. Goldstein said.
Securities lending will likely continue to be viewed with caution by other fund companies, said a Washington-based fund attorney, who asked not to be identified.
Fund companies "don't want to be perceived as being on the wrong side of the SEC," the lawyer said.
It's more than regulatory scrutiny, however, that is making mutual fund companies examine their lending practices.
The collapse of Lehman Brothers Holdings Inc. of New York highlighted the counterparty risk that comes with securities lending, said Andrew Gogerty, a mutual fund analyst with Morningstar Inc. of Chicago.
Generally, a brokerage firm such as Lehman will borrow securities from funds, providing those funds with cash used for collateral, he said.
While the funds will have the cash on hand if a brokerage firm goes bankrupt, in a volatile market, there's no telling if that cash will be enough to make the funds whole, Mr. Gogerty said.
It would be highly unlikely, however, for a fund not to be made whole, said an executive with a securities lending firm, who asked not to be identified.
"In our program, clients had exposure to Lehman," the executive said. "We were able to make the clients' account whole without any loss."
That may be true, but since securities lending doesn't bring in a huge amount of cash, fund companies may still view it as being too risky at this time.
For example, the net income from securities loaned by the Northern Institutional Equity Income Portfolio (BEIAX) was $81,000 on securities valued at $79.75 million as of Nov. 30, according to the most recent annual report from Northern Trust Corp. of Chicago.
Net income from securities loaned by the Northern Institutional Small Company Index Portfolio (BSCAX) was $160,000 on securities valued at $41.71 million, according to the report.
And net income from securities loaned by the Northern Institutional Global Tactical Asset Allocation Portfolio (BBAIX) was $24,000 on securities valued at $11.54 million, according to the report.
Such numbers are typical, said Mr. Gogerty, a former Northern Trust employee.
"This wasn't cash that was going to make or break a fund's return," he said, "but it would offset expenses and lower the hurdle for the investment manager."
The interest income generated by securities lending, however, is "free money," said Dushyant Shahrawat, a senior research director with the investment management team at The Tower Group Inc., a Needham, Mass., industry consultant.
PLENTY OF INTEREST
It's why some industry experts doubt that many fund companies will follow the lead of Vanguard and Columbia.
Vanguard and Columbia "are in the minority," the securities-lending executive said.
There is still plenty of interest in securities-lending programs, the executive said.
It's understandable why fund companies don't want to give up the practice, said Geoff Bobroff, an East Greenwich, R.I.-based mutual fund industry consultant.
"Stock lending is a lucrative program, especially if you have the right stocks," he said.
And while it's in vogue to vilify short-sellers who benefit from securities lending, that will change when the markets find their footing, Mr. Shahrawat said.
While short-sellers may be a destabilizing force in roller coaster markets, in normal markets, they serve to bring greater liquidity, which in turn leads to more-accurate pricing, he said.
E-mail David Hoffman at [email protected].
