Enduring the markets distress, it appears that Northern Trust’s securities lending program has created a $13.5 billion cash collateral pool.
Northern Trusts executives announced a “historic volatility” had In an update this March, Northern Trust marked the company’s Collective Short Term Extendable Portfolio, leaving an unfathomable loss of 1.35% for the month of March. The portfolio mentioned is the depository for 75% of the cash collateral for one set of index funds’ securities lending activities.
With 16 years of gains for the firms securities lending business, this marked the fourth unsatisfactory month for STEP since August.
According to CEO Steven Fradkin, the STEP fund’s losses contributed to a 30% decrease in Northern Trust’s securities lending fees for the first quarter since the year before.
Credit market dislocation negatively impacted the returns achieved in the one mark-to-market cash collateral investment fund used for securities lending, which accounts for roughly 5% of the firm’s $267 billion in securities lending cash collateral, Fradkin said.
The cash collateral pool’s valuation troubles in March stem from “extreme illiquidity,” instead of credit issues, says John O’Connell, Northern Trust spokesman. He says the portfolio “hasn’t experience any defaults…and does not employ leverage.”
Even though STEP’s 1.35% loss in March is overshadowed by other managers losses since credit markets clinched up last summer, investment consultants are saying the ripple effects could be distressing to the firm who dedicates themselves to aiding clients in matching benchmark gains.
In that same index fund update, Northern Trust officials reported that seven collective daily index funds suffered collateral damage from STEP’s woes.
An example of this, according to the update in March, the company’s Standard & Poor’s 500 index fund for securities lending clients dragged its benchmark by 12 basis points and a mortgage-backed securities index fund dwindled behind its benchmark by 53 basis points.
Investment consultants are divided over how big an issue this tracking error could prove for Northern Trust.
O’Connell said Northern Trust doesn’t discuss its dealings with clients.
We don’t see a massive problem out there, but it’s a surprising problem, says Jack Marco, chairman, Marco Consulting Group Inc.
Northern Trust executives have told clients and consultants that the company’s use of a mark-to-market services like STEP is not typical for securities lending programs, which more often use funds constantly valued at $1. The performance goal for STEP is the London interbank offered rate plus 20 basis points.
Northern Trust officials stressed that all of STEP’s losses are unrealized, and that the underlying portfolio holdings should pay off in full once hitting maturity. Those unrealized losses should reverse over the next 18 to 24 months and that tracking error for these funds will revert to long-term averages during that period, the March update said.
For clients who need to take advantage of daily liquidity, a long-term recovery will not help them. The affected index funds might recoup unrealized losses over the coming years, but in the interim clients looking to move money in and out can only do so by locking in some of those losses, says Gregory T. Williamson, director of trust investments, BP America. BP is a client of Northern Trust. Williamson says It raises the question of why a daily index fund would invest in something that’s not liquid.
Some clients say they don’t feel Northern Trust has anything to apologise for, adding that the millions of dollars they lost on their securities lending programs in March have been somewhat compensated by gains in April.
It’s unclear if the latest performance numbers are having any impact on Northern Trust’s success in acquiring new securities lending business.
On March 28, the firm announced that Lincoln Financial Group had selected Northern Trust as custodian for Lincoln’s $1.1 billion defined benefit plan, including securities lending.
On April 1, the $11 billion Hawaii Employees Retirement System, Honolulu, hired Northern Trust as its global custodian, including securities lending.
The $37.9 billion Colorado Public Employees Retirement Association, Denver, while recently rehiring Northern Trust as its global custodian, decided to hire a third-party securities lending firm to run part of the securities lending Northern Trust has been handling. Spokeswoman Katie Kaufmanis says the March volatility for Northern Trust’s cash collateral pool wasn’t a factor in Colorado PERA’s decision to diversify its program.