DAVID PARKINSON

00:00 EST Monday, November 10, 2008

As the controversy continues to simmer over the role of short selling in the stock market swoon, Canada's single biggest pension fund has quietly stopped providing short sellers with critical ammunition.

Canada Pension Plan Investment Board has revealed that in the midst of September's furor over short sellers and crumbling financial stocks, it shut down indefinitely its entire securities-lending program - a profitable sideline for many large pension and mutual funds. At the time, the program had outstanding loans valued at $1.6-billion.

Under securities-lending programs, funds lend stock from their portfolios to short sellers, who sell the shares into the market. While funds collect fees and interest income from their lending programs, critics have charged that the practice has helped short sellers drive down the value of the markets and the funds' own holdings.

However, CPPIB's decision was motivated by problems not in the stock market, but the credit market. The board, headed by chief executive officer David Denison, had grown increasingly worried about the reliability of borrowers and the collateral they were pledging for share loans. "There was a concern about the quality of collateral and counterparty risk," said Ian Dale, senior vice-president of communications for CPPIB, which manages $127.7-billion of assets in the federal government's national pension plan. "Under normal market conditions, we would see it as an extremely low-risk program, but the risk-return balance had swung dramatically."

As credit markets deteriorated amid the collapse of Lehman Brothers and other financial entities in mid-September, the computerized systems CPPIB uses to monitor its risk-management practices started kicking off warning signals about the lending program's growing risk exposure. The warnings were serious enough to convince officials at CPPIB to suspend the lending program. "We felt the risk-return equation was out of kilter, so we shut it down," Mr. Dale said, noting that CPPIB traditionally takes a conservative approach to risk exposure.

He said the fund will reconsider resuming the program if and when credit-market risk returns to more normal levels, adding that the board believes securities lending "is important to the efficient functioning of the market."

But while credit quality concerns, as well as worries about fuelling the market slump, have prompted some big pension funds in the United States and Europe to re-examine their lending practices, many of Canada's biggest funds are leaving their lending programs unchanged - many of them motivated by profits.

While CPPIB doesn't disclose lending program profits, annual gains are probably in the tens of millions of dollars. For the entire Canadian industry, profits from securities lending may have topped $1-billion last year.

Tight credit conditions have sharply escalated the premiums being paid for the privilege of borrowing stock.

Fees for borrowing stocks, which normally run around 5 per cent of the loan value per year, soared in late October to as much as 50 per cent for some stocks in heavy demand. Meanwhile, funds are demanding that borrowers pledge collateral of as much as 125 per cent of the value of the stocks borrowed, up from 105 per cent normally. "You can make a ton of money in this environment," one money manager said. "The incentive to [lend stock] is big right now."

This despite a growing public unease with the practice, which came to a head in September, when shorts were accused of triggering the collapse of storied financial institutions on both sides of the Atlantic.

On the same day CPPIB suspended its lending program, several leading U.S. pension funds announced they were suspending their lending of some of the most stressed U.S. financial sector stocks, citing concern that they were fuelling a short-selling firestorm.

But while many of these funds claimed to be acting in the interest of the public and market stability, critics said their real concern is growing risk exposure.

That's particularly true in the U.S. market, where the bulk of securities lending is done with cash collateral - which the funds reinvest in short-term money market instruments to maximize their returns.

British research firm Spitalfields Advisors said that as the credit crunch brought about widening credit spreads, returns soared on reinvestment of cash collateral. "Return on cash reinvestment has become a major driver of lending programs," said Ed Oliver, senior consultant at Spitalfields.

But at the same time, a lot of money market instruments have become tainted by exposure to crumbling mortgage-backed debt and the collapse of key financial players.The use of cash collateral has been slowly gaining acceptance in Canada, but it's still relatively uncommon. That means that lending programs are both less important to the bottom lines of Canadian funds, and pose less of a danger to those funds.

Among Canada's biggest pension funds, only CPPIB curtailed its lending as a result of the current turmoil. However, Ontario Teachers' Pension Plan got out of the securities-lending game almost two years ago on concerns that it couldn't vote with its lent-out shares in key shareholder votes at some of the companies in which it holds stakes.

The providers of Canada's largest exchange-traded funds, Barclays and Claymore Investments Inc., are maintaining their lending programs.

As for the concerns over abetting the short sellers in driving down the market, many players in the lending game say that's a red herring. Spitalfields noted that after many securities regulators placed temporary bans on certain short selling in September, stocks continued to slide and volatility indicators continued to climb. "Short selling has gotten a bad rap," said Claymore president Som Seif.

"It is not the root cause for the fall in the market."

***

MAKING MONEY WHEN STOCKS FALL

What is short selling?

Short selling involves selling a security in order to buy it back later at a lower price. The short seller profits on the difference between the higher price at which he sells the security and the lower price at which he buys it back.

What is securities lending?

Short selling is typically done by borrowing the securities from someone who owns them. Securities lenders are typically large funds that have a sufficiently diversified asset base that they can provide borrowers with a wide range of readily available securities. Pension funds have traditionally been prominent providers of securities lending programs. In 2001, Canadian regulators opened up securities lending to mutual funds.

How does it work?

Borrowers put up collateral for the securities they borrow - typically equalling about 105 per cent of the value of the borrowed securities.

When the collateral is in the form of other securities, the lender charges a fee to the borrower - normally about 5 per cent of the value of the loan per annum, though those rates can climb much higher depending on market conditions.

In the case of cash collateral, the lenders pay the borrowers interest on the cash, but at a discount to prevailing market rates. They then reinvest the cash in short-term securities at higher interest rates, and profit on the difference.

How big is stock lending?

According to London-based research firm Spitalfields Advisors, shares valued at $13-trillion (U.S.) were available for lending worldwide at the end of last year, representing more than 20 per cent of the global equity market. Of that, $2.1-trillion was actually out on loan, representing 3.5 per cent of the world's stocks.

Canadian securities lenders had almost $340-billion (Canadian) of equities available for lending at the end of 2007, of which about $50-billion were out on loan - 3 per cent of the total Canadian equity market.

But the credit crisis and recent regulatory restrictions on short selling have hurt securities lending. By late October, total Canadian stocks available for lending stood at just $200-billion, and securities on loan had dropped to $19-billion.