[Senate Hearing 112-62]
[From the U.S. Government Publishing Office]
S. Hrg. 112-62
SECURITIES LENDING IN RETIREMENT PLANS: WHY THE BANKS WIN, EVEN WHEN
YOU LOSE
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HEARING
BEFORE THE
SPECIAL COMMITTEE ON AGING
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
FIRST SESSION
__________
WASHINGTON, DC
__________
MARCH 16, 2011
__________
Serial No. 112-3
Printed for the use of the Special Committee on Aging
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SPECIAL COMMITTEE ON AGING
HERB KOHL, Wisconsin, Chairman
RON WYDEN, Oregon BOB CORKER, Tennessee
BILL NELSON, Florida SUSAN COLLINS, Maine
BOB CASEY, Pennsylvania ORRIN HATCH, Utah
CLAIRE McCASKILL, Missouri MARK KIRK III, Illnois
SHELDON WHITEHOUSE, Rhode Island JERRY MORAN, Kansas
MARK UDAL, Colorado RONALD H. JOHNSON, Wisconsin
MICHAEL BENNET, Colorado KELLY AYOTTE, New Hampshire
KRISTEN GILLIBRAND, New York RICHARD SHELBY, Alabama
JOE MANCHIN III, West Virginia LINDSEY GRAHAM, South Carolina
RICHARD BLUMENTHAL, Connecticut SAXBY CHAMBLISS, Georgia
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Debra Whitman, Majority Staff Director
Michael Bassett, Ranking Member Staff Director
CONTENTS
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Page
Opening Statement of Senator Kohl................................ 1
Statement of Senator Corker...................................... 2
PANEL OF WITNESSES
Statement of Charles Jeszeck, Acting Director, Education,
Workforce and Income Security, Government Accountability
Office, Washington, DC......................................... 3
Statement of Anthony Nazzaro, Principal, A. A. Nazzaro
Associates, Yardley, PA........................................ 5
Statement of Ed Blount, Executive Director, Center for the Study
of Financial Market Evolution, Washington, DC.................. 7
Statement of Allison Klausner, Assistant General Counsel-
Benefits, Honeywell International, Inc., Morristown, NJ........ 8
Statement of Steven Meier, Chief Investment Officer, Global Cash
Management, State Street Global Advisors, Boston, MA........... 10
APPENDIX
Witness Statements for the Record:
Charles A. Jeszeck, Acting Director, Education, Workforce and
Income Security, Government Accountability Office, Washington,
DC............................................................. 28
Anthony Nazzaro, Principal, A. A. Nazzaro Associates, Yardley, PA 56
Ed Blount, Executive Director, Center for the Study of Financial
Market Evolution, Washington, DC............................... 59
Allison Klausner, Assistant General Counsel - Benefits, Honeywell
International, Inc., Morristown, NJ............................ 70
Steven Meier, Chief Investment Officer, Global Cash Management,
State Street Global Advisors, Boston, MA....................... 74
Additional Committee Documents:
Government Accountability Report to the Chairman: 401(k) Plans,
Certain Investment Options and Practices That May Restrict
Withdrawals Not Widely Understood.............................. 82
Summary of Committee Research: Securities Lending with Cash
Collateral Reinvestment in Retirement Plans: Withdrawal
Restrictions and Risk Raise Concerns........................... 155
Additional Statement Submitted for the Record:
ING Investment Management-US..................................... 184
SECURITIES LENDING IN RETIREMENT PLANS: WHY THE BANKS WIN, EVEN WHEN
YOU LOSE
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WEDNESDAY, MARCH 16, 2011
U.S. Senate,
Special Committee on Aging,
Washington, DC.
The Committee met, pursuant to notice, at 2:02 p.m. in Room
SH-216, Dirksen Senate Office Building, Hon. Herb Kohl,
Chairman of the Committee, presiding.
Present: Senators Kohl [presiding], Manchin, Blumenthal,
and Corker.
OPENING STATEMENT OF SENATOR HERB KOHL, CHAIRMAN
The Chairman. Good afternoon. I would like to welcome our
witnesses and welcome everyone attending today's hearing.
In recent years, most workers have seen their savings take
a hit, leaving many to wonder if they will ever be able to
retire. The gap between what Americans will need in retirement
and what they will actually have saved is estimated to be a
staggering $6.6 trillion.
Now more than ever we need to strengthen and protect our
pension and 401(k) systems. That is why we are examining
securities lending within retirement plans.
In simple terms, securities lending is when a plan lends
some of its stocks and bonds to a third party in exchange for
cash as collateral that is then reinvested. Many plans
participate in securities lending to generate a little extra
revenue. For many years, it seemed that there were only
benefits to these arrangements for all sides. The economic
downturn showed that securities lending is not a free lunch.
It was upsetting to hear reports about some 401(k)
participants actually losing money within their 401(k) accounts
due to these practices. Some employers were restricted from
accessing their worker's retirement savings in investments that
lent securities. This is troubling because employers are
required by law to be able to change the investment options
offered in their 401(k) plans.
Securities lending is a complex financial transaction that
goes on every day, often without employers and employees even
knowing it is going on within their plans. And if they are
aware, many do not understand the added risk, and ultimately
that risk lies with 401(k) participants because banks share the
cash collateral profits, but not the losses, so the banks
always win.
Last November, this committee began an investigation of the
securities lending market, which is being released today. We
surveyed employers that sponsored the 30 largest 401(k) plans,
and found that all had at least one investment option that
engaged in securities lending at some time in the previous five
years. However, after the downturn, five of these employers
stopped participating in securities lending. The committee also
surveyed the seven largest banks in the securities lending
market. In 2010, these seven banks provided services to 570
different employer-sponsored plans with a total of roughly $1.3
trillion in assets.
I hope today's hearing and our committee report will shed
some light on securities lending within retirement plans, and
the benefits and the risk associated with it.
We'll start our hearing with a review of the findings of a
new GAO report showing that securities lending is not widely
understood by employers or workers. We'll then hear experts on
securities lending and the reason why employers are
reconsidering their participation in securities lending within
their 401(k) plan. Finally, we'll hear from one of the major
providers of securities lending services.
We thank you all again for being here today. We look
forward to your testimony and a productive dialogue.
And at this point, we'll turn to my colleague, the ranking
member, Senator Corker.
STATEMENT OF SENATOR CORKER
Senator Corker. Thank you, Mr. Chairman, and thanks for
calling this meeting. And to all of you who are going to
educate us here in just a moment, we thank you for being here,
and looking forward to your testimony.
We are here today to talk about securities lending and
401(k) plans and the events that occurred during the crisis of
2008.
Because of liquidity constraints in the marketplace, gates
were put in place essentially to protect people from having
immediate access to funds being held in 401(k) plans. And
unfortunately some people did not understand why they could not
access their funds when they wanted to.
Defined contribution plans are taking over as a major
source of revenue for our retiring Americans, and so it is
important to understand how they work in a properly functioning
marketplace, and also to understand what happened during the
financial crisis to understand what may or may not have gone
wrong.
As is typical in the aftermath of a financial crisis, the
industry has improved. The leading agents and collateral
managers have largely self-adjusted since the crisis. They have
learned to adjust client investment objectives in collateral so
that they are more liquid, less exposed to interest rate and
credit risk by using more conservative investment models.
One of the things we need to be careful about is not to
overregulate, but to preserve competition and choice in
retirement savings plans for beneficiaries. If we overregulate,
there is a danger that the only options for beneficiaries will
be lower yielding options. And there is always risk obviously
involved when you try to seek those higher returns.
A better informed consumer is good, but we need to make
sure that we are not just piling on more disclosures that
consumers do not understand or read. We need to make sure that
we are not needlessly regulating where the market is already
corrected or where other laws and rules may be already
addressing concerns. More disclosure is not always better, but
certainly more meaningful disclosure could be very good.
I am here today to learn from the witnesses testifying
before us. I look forward to reading the majority report on
securities lending. I think it is being released right now, as
a matter of fact.
I urge all of us to take time to consider the majority's
report, the GAO report, being publicly released today, as well
as all of the laws we recently passed as part of the Dodd-Frank
Wall Street Reform and Consumer Protection Law.
Securities lending may pose risk, but it can increase
yield. So let us be careful about how we proceed forward in
order to preserve competition in the marketplace, allow
functioning markets to flourish, and promote choice for all
participants.
And, again, thank all of you for being here.
The Chairman. Thank you very much, Senator Corker.
Our first witness today will be Charlie Jeszeck, who is
acting director in the Government Accountability Office,
Education, Workforce and Income Security team. Throughout his
26-year career at GAO, Mr. Jeszeck has focused on health care,
unemployment insurance, private pensions, and social security.
Next, we will be hearing from Anthony Nazzaro, who is
principal of A.A. Nazzaro Associates, a securities lending
manager and consulting firm in operation since 1987. Mr.
Nazzaro has worked in the securities lending industry for 35
years.
The third witness will be Ed Blount, Executive Director of
the Center for the Study of Financial Market Evolution. The
organization works with practitioners, academics, trade groups,
and regulators to analyze practices in capital market sectors
that have developed ahead of formal disclosure and reporting
standards.
The fourth witness today will be Allison Klausner. Ms.
Klausner is the Assistant General Counsel-Benefits for
Honeywell International. Ms. Klausner is responsible for legal
matters relating to employee benefits at Honeywell within the
United States and also worldwide.
Finally, we will be hearing from Steve Meier, Chief
Investment Officer, Global Cash Management, for State Street
Global Advisors. Mr. Meier joined State Street in 2003. He has
more than 27 years of experience in the global cash and fixed
income markets.
We thank you all for being here today. And we will start
with you, Mr. Jeszeck.
STATEMENT OF CHARLES JESZECK, ACTING DIRECTOR, EDUCATION,
WORKFORCE AND INCOME SECURITY, GOVERNMENT ACCOUNTABILITY
OFFICE, WASHINGTON, DC
Mr. Jeszeck. Mr. Chairman and members of the committee,
thank you for inviting me here today to discuss the practice of
securities lending with cash collateral reinvestment. My
comments will focus on how these transactions occur in the
context of 401(k) plans. While this practice appears to be an
easy way for plans to make money, these transactions are
complex and pose challenges both to plan sponsors and
participants.
Before I continue, it is important to note that 401(k)
plans are now the dominant retirement savings plan in the
United States with over 49 million participants and plan assets
of $2.8 trillion. In our view, to foster national retirement
security in the 401(k) model, both sponsors and participants,
at a minimum, need to have the information necessary to enable
sound, prudent decision making.
Securities lending in 401(k) plans is a transaction where
assets held in 401(k) investment options are lent to third
parties, typically in return for cash, which is held as
collateral. The idea is that by reinvesting this cash, greater
returns can be earned for plan participants.
Many 401(k) investments that engage in securities lending
pool their money into commingled or pooled accounts. These
accounts are designed to combine assets of unrelated plans to
facilitate diversification and gain the cost advantages of
larger plans. While larger 401(k) plan sponsors may maintain
separate investment accounts and can choose directly to
participate in securities lending, it is the commingled account
manager, not the plan sponsor, that makes that decision for
commingled funds.
The figure to my left provides a basic example of a
securities lending transaction with a commingled account.
First, a plan sponsor sends contributions to the service
provider or account manager administering a commingled account.
The account manager then negotiates with the securities lending
agent the terms of the transaction, including the split of any
gains. The securities lending agent then negotiates with a
broker-dealer who is seeking to borrow securities for a client.
The broker-dealer provides cash as collateral for the borrowed
security to the securities lending agent for the length of the
agreement. The broker-dealer earns a rebate or interest on the
cash collateral being lent.
The securities lending agent then works with a cash
collateral pool manager, who may be affiliated with the lending
agent, to reinvest the cash. The pool manager earns a fee for
investing this cash. When the transaction is completed, the
assets are returned to the original parties.
As shown in the figure on my right, after the broker-dealer
and the cash collateral pool manager have received their fees,
the securities lending agent and the commingled fund split any
gains from the transaction. For the participants, these gains
are reflected directly in the values of the shares in the
commingled account.
It is important to note that the split is asymmetric. While
the gains are shared between the plan participant and the
securities lending agent--in our example, the split is 80/20 in
favor of the participant--the investment losses are borne only
by the participant; thus, a symmetry can also create an
incentive for the cash collateral pool manager to seek riskier
investments as they do not bear the investment loss.
Securities lending transactions poses challenges for plan
participants and sponsors alike. Participants may be unaware
that their plan investments are utilized in securities lending
transactions. We found that information about such transactions
is often buried deeply within investment option documents,
documents which, in many cases, may not even be received by
participants. New disclosure regulations by Labor may not be
helpful because they focus on information about investment
options, such as information on fees paid, and not the
practices employed by those options, like securities lending.
Plan sponsors may also be unaware or not fully understand
the risks involved in securities lending transactions. This
might be particularly the case for smaller plans with
commingled funds who may not be as sophisticated as larger plan
sponsors. This view is echoed by industry experts with whom we
spoke.
The SEC, FINRA, and the industry itself are already taking
steps to address issues related to securities lending. GAO has
made recommendations to Labor that we believe will enhance
disclosure and transparency for both sponsors and participants,
and assist in a negotiation of these transactions.
That concludes my statement, Mr. Chairman. I am happy to
answer any questions that you or other members may have.
[The prepared statement of Mr. Jeszeck appears in the
Appendix on page 28.]
The Chairman. Thank you very much, Mr. Jeszeck.
Now we'll hear from Mr. Nazzaro.
STATEMENT OF ANTHONY NAZZARO, PRINCIPAL, A. A. NAZZARO
ASSOCIATES, YARDLEY, PA
Mr. Nazzaro. Good afternoon. My name is Anthony Nazzaro. I
am the principal and owner of A. A. Nazzaro Associates. We are
a securities lending manager and consulting group in operation
since 1987.
I would first like to thank Chairman Kohl, Ranking Member
Corker, and the members of the committee for the opportunity to
appear before you today. It is a wonderful honor and a
privilege for me to do so.
I believe I was invited to appear and give testimony
because of my experience and the longevity of my career in the
securities lending industry. My participation in this industry
spans some 35 years in roles ranging from an in-house lender at
Yale University, to a custodian agent lender for the pension
funds of the Commonwealth of Pennsylvania, to a present status
as an independent manager for university and foundation
endowments. It is my hope that I can offer some perspective,
insight, and constructive counsel for pension funds, which
represent a large segment of the beneficial owners
participating as lenders of securities.
Many large pension funds that participate in securities
lending choose to do so through an agent lender, such as their
custodian bank. It is my sense that, when a fund enters into an
agreement with its agent lender, the fund may not fully
appreciate or understand that it has also hired an investment
manager. Many times the fund may be focused upon the lending of
securities side of the equation and less upon the reinvestment
of cash collateral. As a result, the focus or scrutiny is more
heavily weighted toward the counterparty risk of the borrower
and overshadows or obscures the reinvestment risk. This may
result in less scrutiny of the cash collateral investment
guidelines proffered by the agent lender. In addition, given
the wide ranging of authority of the agent lender over all
lendable assets and the reinvestment of cash collateral, the
size of the assets held in the cash collateral portfolio may
grow to become the largest portfolio in the funds universe, and
the agent lender may become its largest investment manager.
The omission or failure to perceive an agent lender as an
investment manager may result in a lack of sufficient reporting
and oversight of the cash collateral portfolio, and an
assumption that the reinvestment of cash is part of the agent's
custodial function in the management of the securities lending
program. The danger and risk in this perception was brought to
light and exposed during the recent financial crisis and brings
us here today.
The reason I'm highlighting this issue is because I believe
there are some basic steps that can be taken to protect pension
funds and limit their risk.
Step one, documentation. In addition to the execution of a
securities lending agency agreement, which is standard
documentation, pension funds should execute an investment
manager agreement. This elevates the duty and standard of care
by the agent lender/investment manager. The investment reports
would receive a heightened degree of visibility and are more
likely to come within the purview of those persons or
committees with oversight at the pension fund.
Step two, investment guidelines for cash collateral.
Implementation of stringent guidelines for the reinvestment of
cash collateral similar to those of a Rule 2a-7 money market
fund. This would limit holdings in the portfolio to only
securities of high credit quality, high liquidity, shortened
duration, or weighted average maturity.
Step three, reporting and valuation. Receipt of daily
reports as to the valuation of the cash collateral
corresponding to the securities lending loan balances. The
value of the cash collateral portfolio report should be equal
to or close to the 102 percent collateralization required for
loans and received from counterparty borrowers.
Step four, limits upon program participation.
Implementation of a limit or cap upon the amount or value of
securities which may be loaned in order to reduce exposure of a
portfolio. This limit may be expressed as a specific dollar
amount or as a percentage of the total assets.
The above recommendations are four steps that pension funds
can implement that I believe would be both constructive and
prudent. It is my opinion that implementation of some or all of
these steps could have mitigated the problems that funds
experienced during the financial crisis.
Thank you.
[The prepared statement of Mr. Nazzaro appears in the
Appendix on page 56.]
The Chairman. Thank you very much, Mr. Nazzaro.
Mr. Blount, we would like to hear from you.
STATEMENT OF ED BLOUNT, EXECUTIVE DIRECTOR, CENTER FOR THE
STUDY OF FINANCIAL MARKET EVOLUTION, WASHINGTON, DC
Mr. Blount. Chairman Kohl, Ranking Member Corker, and
members of the committee, thank you for the opportunity to
share a few thoughts with you today.
I approach this issue with the perspective gained from 35
years of varied roles in the securities lending community, and
the experience gained from having built and then sold a
profitable business that pioneered the analysis of performance
measurement for securities lending programs.
On the surface, the problems cited by the GAO report appear
to be a lender side issue; that is, the cash collateral lock
ups that froze the assets of 401(k) defined contribution
participants and others during and for up to a year after the
crisis. However, this is really an issue for the entire
investment community.
The effect of restrictions on the supply of lendable
securities could quickly degrade the liquidity and efficiency
of U.S. capital markets by raising the risks of settlement
failures and increasing the capital charges for brokers with
customer segregation deficits.
In particular, restrictive actions of regulators affecting
the lendable supply of securities could well impair the ability
of pension plan sponsors to offer passive index funds and to
hedge actively managed portfolios. The reduced availability of
index funds and hedges in turn would increase portfolio risks
and threaten the investment returns that pension beneficiaries
need and expect.
At a very fundamental level, securities lenders help to
make the markets more efficient. This has been documented in a
number of reports by international regulators.
And the supply of lendable securities is highly sensitive
to the actions of Federal regulators. I would cite the 1981
decision of the Department of Labor to amend the prohibited
transactions exemption as one example of this.
But let me pause here for a minute. If I say that
securities lending is important, I do not mean to say that
problems do not exist in the lending community, nor do I intend
my comments to be taken as a defense of the status quo such
that pensioners might once again be deprived of access to their
own funds in the uncertain days of financial crisis.
However, the cause of the lockups was the illiquidity of
certain asset-backed securities, which were included in the
cash collateral pools of those funds that lent out their
securities. In that regard, the problems of securities lenders
and their investor beneficiaries are the same as those of many
other commingled funds in the United States during the recent
market crisis. During that crisis, the suddenly illiquid
individual beneficiaries of defined contribution plan accounts
absorbed the effects of investment choices made by others; that
is, their plan sponsors and cash managers. Unfortunately, DC
plan sponsors, unlike defined benefit plan sponsors, have no
financial incentive to increase investment revenue, such as
securities lending income for their participants.
Plan participants gained the income from securities lending
while their administrators merely gain more work and more risk.
As a result, it is easier for DC plan sponsors to simply reject
as investment options those mutual funds which lend rather than
learn how to evaluate the ways in which risks and securities
lending evolve as market conditions change, so as to help
participants fine tune their exposures.
Such a decision appears now to have been made by many plan
sponsors, whose management mandates routinely reject the
possibility of income from securities lending services. As a
result, the investment performance of DB plans is exceeding
that of DC plans, even when offered by the same corporate plan
sponsor. In effect, we are creating a yield deviation between
DC and DB plans where there is not a good reason for it.
Going forward, however, it will be necessary to construct a
framework which more closely aligns the interests and
responsibilities of all those in the DC plan securities lending
community without unnecessarily impairing the ability of the
market system to contribute to the welfare of both DC and DB
plan beneficiaries.
Among the changes that I believe are necessary are an
improvement and extension of the disclosure regime for
securities lending cash managers. Furthermore, I believe that
an expert council should be established to define the limits of
prudence for collateral cash managers, one that is based on
close monitoring of changing market conditions. I do not--or I
do believe that educational programs should be funded by the
securities lending community, not the government, through
incentives, such as capital charge credits, and then provide it
to DC plan sponsors and participants as a way of improving the
awareness of their own responsibilities and those of their
service providers.
In conclusion, if all members of the service provider
community fulfill their responsibilities, I do not believe that
new legislation or regulatory actions will be necessary. The
cash lockups of the financial crisis were not attributable to a
failure of securities lending.
Thank you.
[The prepared statement of Mr. Blount appears in the
Appendix on page 59.]
The Chairman. Thank you very much, Mr. Blount.
Ms. Klausner.
STATEMENT OF ALLISON KLAUSNER, ASSISTANT GENERAL COUNSEL-
BENEFITS, HONEYWELL INTERNATIONAL, INC., MORRISTOWN, NJ
Ms. Klausner. Thank you.
My name is Allison Klausner, and I am the Assistant General
Counsel-Benefits for Honeywell. On behalf of Honeywell, a
Fortune 50 company, I want to express Honeywell's appreciation
of Chairman Kohl's and Senator Corker's desire to understand
the practice of securities lending in the context of employer-
sponsored defined contribution plans.
I understand that my testimony today has been requested to
provide the Senate Special Committee on Aging with insight into
how one plan sponsor's fiduciary committee has addressed
securities lending issues.
Over the years, securities lending has provided tremendous
value to participants and beneficiaries of employer-sponsored
DC plans, including those with employee deferrals and
contributions. I encourage the Senate Special Committee on
Aging to recognize that, if unnecessary actions are taken to
restrict fiduciaries from offering securities lending funds in
defined contribution plans, plan participants and retirees may
lose valuable opportunities, now and in the future, as they
strive to maximize retirement security.
Honeywell's primary defined contribution plan is a fairly
typical 401(k) plan. Participants are permitted to direct the
investment of their deferrals and contributions, as well as
their vested matching contributions. They have the opportunity
to select from a robust range of asset classes with varying
potential risks and rewards.
The Honeywell Savings Plan Investment Committee is a
fiduciary committee consisting of five professionals at
Honeywell. Two of the current committee members dedicate
significantly all of their time addressing issues relating to
ERISA plan assets, one of whom does exclusively for the
company's defined contribution plans. All the members have
fiduciary education and are counseled on an ongoing basis with
regard to their fiduciary duties.
The Honeywell committee members understand that
satisfaction of their fiduciary duties is critical to
supporting a long-term retirement security of the plan's
participants and the company's retirees. The company members
recognize they must engage in a prudent process, which
considers many factors when selecting and evaluating investment
funds, including, but not limited to, whether it has a
securities lending component.
I encourage the Senate committee to consider that the
matter of whether defined contribution plan assets are invested
in securities lending funds is one that should be evaluated in
the context of the fiduciary process.
A fiduciary's process in selecting a fund will be based on
many considerations: fees to be charged by the investment
manager, the type of fund, the asset class, the past
performance, and the plan's complete fund line-up.
Securities lending funds in the Honeywell defined
contribution plans fund line-up has in fact supported many
participants' retirement goals as those investment funds
typically charge lower fees than comparable non-securities
lending funds and historically had investment gains that
contributed to the investment returns for the assets invested
in such funds.
The take away is that, depending upon facts and
circumstances, offering defined contribution plan participants
the opportunity to invest in securities lending funds can
indeed be a prudent decision.
Notwithstanding the potential benefits, the Honeywell
Savings Investment Committee did determine in October of 2008
to transition from securities lending funds to nonsecurities
lending funds. The committee recognized that the then economic
climate, and that which was anticipated in the then near
future, and the gatekeeping measures which were being
implemented, weighed against continuing to offer securities
lending funds for investment of defined contribution plan
assets.
Although the plan's fiduciaries understood that the
gatekeeping measures were purportedly designed to stem the
possibility that there would be a run on the bank within the
sec lending programs, and that the gatekeeping measures did, in
fact, achieve such goal, the gatekeeping measures did handcuff
plan fiduciaries and restricted them from making decisions,
which could have impacted plan participants' opportunity to
maximize retirement security.
Today's legislative and regulatory framework permits
fiduciaries to offer defined contribution plan participants
access to investment funds with securities lending features. I
encourage the Senate committee to recognize the importance of
maintaining the flexibility currently available. Fiduciaries
should not be required to operate in a rigid environment which
prohibits them from providing plan participants and retirees
with valuable opportunities to achieve retirement security.
Securities lending employer-sponsored DC plans is a topic
that is worthy of your attention. However, we must take care
not to study the issue in a vacuum or elevate the matter of
securities lending over other issues of equal or greater
importance to define contribution plan participants and
retirees.
Plan administrators and fiduciaries, as well as third party
providers, are in the process of implementing new legislation
and regulation, all designed to protect participants. But there
does not appear to be an urgent need to address the issue of
employer-sponsored defined contribution plans and securities
lending features. Perhaps this is a time to rest and allow the
new rules to take hold before we consider any new rules or
requirements.
I want to thank you for asking me to be a witness today,
and I would be happy to address any questions you may have.
[The prepared statement of Ms. Klausner appears in the
Appendix on page 70.]
The Chairman. Thank you, Ms. Klausner.
Mr. Meier, we would like to hear from you.
STATEMENT OF STEVEN MEIER, CHIEF INVESTMENT OFFICER, GLOBAL
CASH MANAGEMENT, STATE STREET GLOBAL ADVISORS, BOSTON, MA
Mr. Meier. Chairman Kohl, Ranking Member Corker, and
members of the Special Committee, thank you for the opportunity
to appear today.
My name is Steven Meier, and I am the Chief Investment
Officer of Global Cash Management at State Street Global
Advisors, the investment management arm of State Street
Corporation. I hope my testimony will assist you in your
important work.
At State Street, we believe that securities lending can
play an important role in a balanced investment program for
professionally managed retirement plans. As you know, employee
retirement plans typically earn dividends and interest income
from the plan's investment portfolio.
If participants choose to invest in a plan option that
engages in securities lending, the investment portfolio can
earn additional incremental income. While the amount of income
varies by portfolio and depends upon a number of factors, it
can be significant and may be used to either offset expenses or
supplement the plan's investment return.
An investor like a 401(k) plan can earn this incremental
income when it lends a security it owns to a borrower, who uses
the security to settle another transaction, often in connection
with a short sale. The borrower provides collateral to the
lender for the borrowed security, typically in the form of
cash. During the course of the loan, as the market value of the
borrowed security changes, the lender either collects or
returns collateral based on changes in the value of the
security. If the lender has received cash collateral, it
invests the cash to earn investment income. When the loan
terminates, the lender returns the borrower's collateral, along
with an additional payment known as a ``rebate.'' The lender
shares the remaining income with the securities lending agent
as compensation for its services administering the program,
such as matching lenders to borrowers, reassigning loans when
the lender sells a security, and revaluing the securities on
loan and marking to market the collateral daily.
The lending agent's share of the securities lending income
also compensates it for indemnifying lenders against the
failure of a borrower to return a security if the borrower
defaults on its obligations.
As this Committee is aware, the events of the recent global
financial crisis were unprecedented and created challenges for
the securities lending business. State Street acted cautiously
and thoughtfully before and during the financial crisis to
protect the interests of our securities lending clients. Due to
our prudent management, none of our cash collateral pools
realized credit losses.
In addition, we maintained 401(k) plan participants' full,
unrestricted ability to make withdrawals from our lending
funds. Investors in our lending funds did not incur any
realized losses in connection with cash collateral reinvestment
unless they chose to take an in-kind distribution of securities
and sell them at a loss.
State Street believes that it acted in the best interest of
our securities lending clients and significantly mitigated the
potential adverse impacts from the financial crisis.
Our securities lending clients are generally long-standing
clients for whom securities lending is just one of many
services State Street provides. We believe our interests are
appropriately aligned with those of our clients. We are
committed to best practices in disclosure and risk management.
We also welcome the opportunity to learn more from you today
about how the industry can better serve its clients, and
particularly retirement plans.
Thank you for the opportunity to be here today. I will be
pleased to answer any of the Committee's questions.
[The prepared statement of Mr. Meier appears in the
Appendix on page 74.]
The Chairman. Thank you, Mr. Meier.
I would like to start out with a question and ask for a
response from each of you.
What are the risks for both the retirement plan and the
individual participants of participating in a securities
lending program? Do you think that both employers and their
workers are aware of the risks? We will start with Mr. Jeszeck
and then move to his left.
Mr. Jeszeck. In our firm, what we have found is that there
is an asymmetry. While the gains are shared between the
securities agent and the lending agent and the plan, the losses
are completely borne by the participant. So in that sense,
there is an asymmetry there, and, as I mentioned earlier, we
think it also creates an incentive for pool managers, because
they do not bear any of the loss, to possibly invest in more
risky assets.
As to whether participants and sponsors are aware of
securities lending with cash collateral reinvestment, our work
has found that in general there may be some savvy participants
who know, but in general, participants, frankly, have no idea
what securities lending is, much less whether they are aware of
whether it is going on in their 401(k) plan.
The other area, while an argument could be made that plan
sponsors should be aware of securities lending, during our work
in our report, we found a number of plan sponsors who were not
aware of securities lending with cash collateral reinvestment,
or securities lending at all going on in their plan. So that
was a disturbing finding.
The Chairman. Thank you.
Does anybody substantially disagree with Mr. Jeszeck's
description? Yes, Ms. Klausner.
Ms. Klausner. Thank you, Chairman.
In our experience at Honeywell, the fiduciaries are
extremely well aware of which funds are able to have securities
lending activity in the fund. We also are aware that we have
disclosure in our summary plan description and in other places,
perhaps like on our website and in other informal
communications, that identify in their description of the funds
that securities lending does in fact exist. So I would not
necessarily characterize all plan participants as not being
aware. I understand that disclosure doesn't always bring
awareness, but there are certain populations in Honeywell, as
well perhaps in other organizations where the sophisticated
professionals and other well-educated individuals do know that
it exists and understand it.
In terms of loss and risk, I also think they understand
that the varying funds that are available all have the
opportunity to go down in their account balance and not just
up. And so, this is something that I think in terms of
recognizing the variation between what is available to
individuals is true, and perhaps the bar needs to be raised.
But I would not characterize our plan participants as not
having the information readily available.
The Chairman. Does your company, Honeywell, take time and
make the effort to see to it that everybody involved
understands this transaction?
Ms. Klausner. May I ask, when you ask everybody involved,
do you mean at the plan sponsor/plan fiduciary level?
The Chairman. Yes, as well as those who are in the plan
itself.
Ms. Klausner. At the plan sponsor/plan fiduciary level, the
answer is absolutely yes. As to the plan participants at that
granular level, I would hesitate to say yes. Just like with all
aspects of the investment, they have high-level information
about the character of the asset class and the different
activities that might go on in terms of the fund. As to whether
or not they understand the granular level of securities
lending, I would say that is probably not likely.
The Chairman. Okay. Yes, sir, Mr. Blount.
Mr. Blount. Senator, I think the issue of comprehension by
participants and the disclosure by their service providers is
complicated. The service providers, I believe, attempt to
provide as much information as possible. Plan participants in
many cases are no different from the board members of defined
benefits plans. And I find when meeting with plan sponsors that
there are different levels of comprehension even at the board
level. There are members of the investment committee that might
have an extremely good understanding. Others are more concerned
with retirement issues and leave the investment matters to
other board members and directors.
I think when you start to talk about individuals who are
investing in any investment program, there is a presumption of
trust that they believe protects them. They will assume that if
they are being offered a program--an option--that it has been
thoroughly vetted, and there is, in effect, an imprimatur to
it. Whether they fully understand the details, I think, is
actually impossible for most of them. There are many--and I say
this with a smile--there are many contemporaries of mine who
have been in the business for three decades or more, very
closely in the securities lending world, and still don't
understand it all. It is an extremely complex and opaque area,
so there is a level of trust that I think goes beyond that.
The Chairman. Thank you. Mr. Meier.
Mr. Meier. Senator, at State Street, we are completely
committed to transparency in terms of all of our investment
strategies, including our securities lending activities, as
well as our cash collateral reinvestment pools.
In terms of our outreach, we tend to spend a lot of time
with plan sponsors and their consultants to go through our
program to make sure that there is that level of understanding.
I would say from an industry perspective, one of the
frustrations may be that we do not have the ability to actually
reach down and communicate directly with the plan participants.
Again, our activities are with the plan sponsors and their
consultants.
In terms of the characterization about a potential
misalignment of interests, I will say that our interests at
State Street are completely aligned with those of our clients.
We have been in the securities lending business since 1974. It
is a core competency of ours as a custodial bank, and we have
committed many resources to making sure that we continue to
manage those programs in a prudent manner.
We at State Street actually have a little bit of a unique
business structure in that we have a division of
responsibilities. For example, we have one division that is
responsible for lending the securities, and another division,
the investment managing arm that I work for, that actually
manages the cash collateral. In terms of the fee structure and
the revenue sharing, we actually work for a modest set fee on
the investment management side, of typically anywhere between
one to three basis points, to manage those portfolios.
We are acting as a fiduciary. We are not incented to take
on additional risk to increase the return so that State Street
Bank, for example, would earn a higher level of income off of
those activities.
The Chairman. Thank you. I will ask Mr. Jeszeck a question,
and then we'll turn to Senator Corker. And I think you have
alluded to it, but I would like to ask you directly.
Your report shows that the risk of securities lending with
cash collateral reinvestments are all borne by the
participants, while the rewards are spread around, as you
indicated. In fact, some of those involved in the transaction,
including securities lending agents, broker-dealers, and
collateral pool managers always win and never lose. Does that
make you nervous?
Mr. Jeszeck. Well, certainly from our work we have found
that participants and sponsors are not favored compared to
other actors in these transactions. Having said that, we
continue to believe that securities lending with cash
collateral reinvestment could benefit 401(k) participants if it
is managed responsibly. And I think that means getting more
information to plan sponsors so that they can negotiate these
transactions more prudently, for plan participants to be aware
of the existence of securities lending, the implications of
securities lending with cash collateral reinvestment for their
portfolios so they can make an informed decision consistent
with their general preference towards risk. Some individual
participants like risk. They like more risk and will be
comfortable with securities lending transactions. Others may
not like risk as much. And so for these reasons and others, we
made the recommendations in our report to the Department of
Labor.
The Chairman. Okay. Senator Corker.
Senator Corker. Thank you, Mr. Chairman.
Mr. Jeszeck, I am not the most sophisticated investor in
the world, but I have been fortunate and do do some investing.
I do not know if I have ever seen a scenario where it was
different than what you just said. I mean, typically when
investments are made, the investment manager participates in
the gain, and they do not participate--I mean, that is the way
hedge funds operate. It is the way most funds operate. I have
not been aware of managers who participate in gains as a way of
making fees, participating in losses. So I do not find anything
unique about that. Is there something--I could ask Mr. Blount--
but is that not standard that usually when people are making
investments, they participate in gains and incentive, but do
not participate in the losses? As a manager, is that not kind
of standard/typical in the industry?
Mr. Blount. I would say it is, Senator, yes.
Senator Corker. I know you have to have had involvement in
this industry other than just this report, right?
Mr. Jeszeck. Well, Senator, I--I've been at the Government
Accounting Office for the last 26 years, so in that sense I
have worked on pension issues. I have worked on issues
involving the industry. I have had interactions with the
industry, but I have not had any direct involvement myself in
the industry.
Senator Corker. Well, let me just state that as a guy who
is certainly no professional that it is a very standard typical
arrangement that you are describing, and there is nothing--I
mean, that is typical of the way it is. It is very asymmetric.
Is there anybody that disagrees with that? I mean, so I just
find you making a point out of that odd when, you know, just
for the little bit of looking into what is happening in the
industry you would understand that that is the way the industry
operates.
Mr. Jeszeck. Well, sir, I think the point--what we come
away from here is that it is unclear whether plan sponsors know
that there is an asymmetry here. In some other cases----
Senator Corker. Yes. Yes.
Mr. Jeszeck [continuing]. Many other transactions there may
be--both sides may have some skin in the game. When we looked
at these transactions in this instance, in the case dealing
with cash collateral reinvestment, the losses are borne by the
participants.
Now, the other issue here is, is that the participants, at
least from the work that we have done, are not aware--they are
not even aware of securities lending in general, much less the
fact that they are bearing an additional risk here. And I think
that is the issue. It may be typical in the industry, but I
think in general, it would be--I think it would be more--I
think it would be nice--I think it would be helpful for plan
participants, who, after all, it is their money, and we are
placing the responsibility on plan participants to invest
prudently, to have information about these transactions and the
implications of these transactions. And it may be in that case
that many plan participants may choose to assume the risk of
these transactions and go forward. We know that risk
preferences for individuals vary across the board. But I think
for us, the key thing is that plan participants should be aware
of the particular relationship--the dynamics of these
agreements.
Senator Corker. I appreciate what you are saying. I have to
tell you that I would go back to one of the earlier witnesses.
I think plan participants sign up more on a sort of global
basis of what they think the fund does. I would assume that
Honeywell has hedge funds in their fund, and I would assume
that there is all kind of long, short, all kinds of activities
taking place that a standard typical plan participant would
have no idea what that means, nor the risk involved in that.
But they would assume that the plan sponsor is making a prudent
allocation of resources there.
I can assure you that if I had to know all of those things
myself--signing up for a defined contribution plan--again, I am
not the most sophisticated person. I do not want to know all
that, and I do not know that you are really doing the
participant a lot of good in knowing that. I assume a long
disclosure form would be okay, but, again, I do not see--I
think we are barking up the tree.
Mr. Blount, do you want to add to that?
Mr. Blount. Senator, I think we can even go beyond the
mutual fund or the investment world. People buy stocks for
airlines, and airlines engage in hedging strategies to protect
their cost as fuel prices change. Some do, some do not. If you
buy an airline stock, you do not necessarily understand what
the hedging strategy is.
Senator Corker. You might not know that Southwest made
inordinate profit for years because they had a great hedge that
was going to disappear in a month, right?
Yes, ma'am.
Ms. Klausner. Thank you. I just wanted to make sure I made
sure the record was correct. I am not confident that we
actually have hedging or hedge funds specifically in our
Honeywell 401(k) plan funds.
Senator Corker. But you might.
Ms. Klausner. We clearly--it is possible. What I wanted to
note was that we certainly have many funds that are index based
and some that are actively managed. And our participants do
understand, through a lot of disclosure, not only through our
summary plan description, which I discussed or noted before,
but through what we call our fund fact sheets, which are very
dense pieces of information about all aspects of each fund,
including with charts so that those that are better to
understand things through, you know, a description of whereas
others through an illustration. There are varying ways to
understand what is there.
In terms of getting to the granular level of talking about
securities lending and how that may or may not impact the fees
of a fund manager, I think that goes to your earlier question,
does that provide meaningful information to the individual, or
is it just piling on additional information so that the salient
points that you want them to know about actually get lost in
the density and the volume of information being provided.
Senator Corker. Now, I know that I have used a lot of time.
I just--we did some calculations yesterday, and for a young
person beginning to invest in a defined contribution plan and
not having the option of lending securities as part of that
portfolio, it makes a huge difference at their time of
retirement. We looked just on a sort of an ordinary, very
conservative basis that if that option were not available to an
individual starting out at age 25 and working, that it is
likely they would actually have to work a minimum of a year
longer, if not more, if that option is not readily available to
them. Would any of you all like to comment on that? So, in
essence, if we sort of regulate it out and make it so it is
very difficult for that to occur, what we are really doing is
hurting individuals from the standpoint of amassing a
retirement that allows them to retire at an age they would like
to retire.
Yes, sir.
Mr. Nazzaro. Senator, I would say that just by that fact,
securities lending has merit. The issue before me as I looked
at this is really about how much risk one is willing to accept.
Done in its basic form, it should be as low risk as possible,
and that is how securities lending has always been. I think it
got away from us a little bit in the 2003 to 2008 period. All
we are really talking about, from my perspective, is reining
that in a little so that it becomes the modest, low-risk
activity that it should be. It is only meant to hit singles,
not home runs, and that is what I would like to see it get back
to.
Senator Corker. Do you think the industry, as Mr. Blount
mentioned, has the ability to take care of that themselves and
learn from what has just occurred?
Mr. Nazzaro. Yes, Senator, I do, and I think they are
already moving in that direction, to their credit.
Senator Corker. Thank you. Somebody wants to speak. I do
not know if I have taken too much time.
The Chairman. No, go right ahead.
Senator Corker. Thank you. Mr. Meier.
Mr. Meier. Thank you, Senators.
I would just like to comment. I agree. I do think that
securities lending is a very viable, long-term strategy. I
think it is an excellent source of low-risk incremental income.
I think you have to look at the risks associated with
securities lending in light of the unprecedented financial
crisis that we have been through and potentially are still in,
hopefully at the tail end of it.
But I think what we saw over the last three and a half to
four years is really a perfect storm in terms of excess
leverage in the marketplace. Credit spreads are very tight. I
do not think what we saw happen over the last few years is
going to happen again, and I would hate to see us eliminate
securities lending as a viable investment strategy for
individual plan participants as a result of that. And, again, I
would agree with your assessment. It can make a significant
difference in a young person's retirement savings over a period
of time.
Senator Corker. Thank you, Mr. Chairman. Thank you.
The Chairman. Thank you, Senator Corker.
Senator Blumenthal.
Senator Blumenthal. Thank you, Mr. Chairman. And I want to
express my appreciation to you for holding this hearing on a
very profoundly important topic. And I apologize for my
lateness, but like many of us, I had several hearings and
meetings at the same time, and I have been following your
testimony. I want to thank everyone who is here today to
educate us for the very important testimony that you have
given.
And it is important because obviously this issue is of
profound and growing importance. We have made great progress in
fighting poverty among our seniors. The rate is down from 50
percent in 1939 to 10 percent now, largely because of Social
Security, which is one of the reasons why I have strongly
opposed any measures to cut Social Security. But in 2009, 49
million Americans were active 401(k) plan participants--many
thousands in Connecticut as well--dependent on these plans for
their financial well-being, and, in fact, for many of them, a
primary way to save for retirement. And I understand your
point, Mr. Meier, and others here, that the recent crisis--the
near collapse of our economy--may have been a perfect storm,
but there remains the possibility that there may be similar
storms, perhaps not of the same severity, but equally impactful
on the lives and livelihoods of people saving for their
retirement.
So, my first question is to you. I understand that State
Street has effectively managed securities lending funds during
even this very difficult time. In terms of disclosure, you
mentioned that you went above and beyond the Federal guidelines
to keep your clients informed. But do you believe that more
clear Federal banking regulations are appropriate and necessary
to assure that others--other service providers follow that
lead?
Mr. Meier. Thank you for that question, Senator. As I
intimated earlier, we are completely committed to transparency.
And I do think transparency certainly helps level set
expectations. I think as an investment manager, it sets for a
clear discussion around investment goals and objectives. I, for
one, do not want to be in a conversation with a client that is
suddenly surprised at the outcome. So, again, we are committed
to transparency.
In terms of the specific Federal regulations or changes
that you are talking about, Senator, I am not familiar with
those. I would be happy to look at them and perhaps come back,
if that is appropriate, and give you some feedback on whether I
think that would help the situation. But I just have not seen
them at this point.
Senator Blumenthal. So, your answer would presumably be--
and I do not mean to put words in your mouth, but what I hear
you saying is in spirit, yes, and you would want to see the
specifics before you either approve or disapprove of the
particular regulation.
Mr. Meier. Yes, sir. That is correct.
Senator Blumenthal. Anyone else have a--yes, sir.
Mr. Blount. Senator, I think that if we draw a line between
the crisis problems that we are discussing here and Federal
banking regulations, at the moment--and I am not a lawyer, so
there this probably needs to be vetted--if a bank were to
guarantee the investments of any securities lending pool, there
would be 100 percent risk capital charge to the bank, which
would basically put it off the table. It would make it too
expensive. But when the banks--State Street, I think, in
particular--applied for a work around to that, the FED was
pretty flexible in saying, well, it depends on what you invest
in. If you were to invest in overnight treasury repos, then
there is a way to reduce those capital charges.
Now, the unfortunate part of that is that you really cannot
make any money in the securities lending pool if that is what
you are investing in. But the concept of reducing the capital
charges as a result of a more conservative investment strategy
is, I think, a direction that might be explored further. And I
believe that it is possible to create incentives for the banks
and brokers relative to their capital charges, especially as
Basel III comes in, that would encourage either more
conservative--not implying that the current strategy is too
aggressive--but more conservative implementation of strategies,
as well as disclosures that help cash managers themselves know
where they are.
One of the problems in the securities lending cash
management world is there is virtually no contemporaneous
information. You do not know what is happening at other pools,
so if you are to protect your competitive position, there is an
incentive to try to be a little bit more aggressive. So a
little bit more information perhaps combined with an incentive
in the capital charges might be worth exploring.
Senator Blumenthal. Well, I really welcome that comment
insofar as it says that more information, in effect, more
education might be welcome and specific incentives for the kind
of steps that you would recommend. Do you have more specifics
about the kinds of incentives, to use your word, that might be
provided?
Mr. Blount. Well, I tend to think in terms of metrics,
having run a data business, rather than information. So I
would--which is a calibrated form of information--write the
metrics that allow you to compare where you are to others.
I think the SEC looks at these matters, among other
directions, in terms of systemic risk. So the capital charge
credits or the capital credits might be somehow tied to some
reduction and overall systemic risk through a conversation
between the FED and the SEC, but that is beyond my pay grade.
Senator Blumenthal. Well, whether it is within your pay
grade or outside it, I would welcome additional specific
thoughts you may have. You may want to consult with some of
your colleagues and anyone else now or afterward. I think
normally we keep open the record for additional comments, so I
would welcome specific responses, both Mr. Meier, to the
question I asked you and others. We do not always have all of
the answers at our fingertips, as I know from having been on
your side of the table. So if you want to follow up, we would
welcome it.
Mr. Blount. I would be happy to do that, Senator.
Senator Blumenthal. Thank you very much, Mr. Blount.
Mr. Nazzaro, your suggestions to protect pension funds and
limit their risk include increased documentation, and more
stringent guidelines for cash collateral reinvestment, and more
reporting requirements and loan limits. What do you think the
effect would be on loan servicers? And I apologize if you may
have covered this point in part. And would that kind of
increased regulation be too much of a burden, in your view?
Mr. Nazzaro. I do not know if it would be too much of a
burden on loan servicers. What I am trying to--the message that
I am trying to get across is that securities lending is a
short-term, overnight, week, day activity, and there is an
imbalance when corresponding cash collateral investments are
five, six, and seven years. There is no correlation there. So
what I am suggesting is the maturity ranges of the cash
collateral portfolio should be much shorter than the broader
guidelines that had been in place. But as we mentioned a few
minutes ago, the industry has recognized that because of what
has happened in 2008, and I believe there has been self-
correcting in that regard. So I think the large providers of
this service are shortening their maturity guidelines and
tightening up their regulations and their investment portfolio,
and that is what I think is important to protect retirees and
pension plans.
Senator Blumenthal. Do you think the self-correcting has
been sufficient?
Mr. Nazzaro. That I don't know because it is not possible
for me to monitor industrywide the banks. But some of the
larger providers, I believe, have moved in that direction, but
I cannot speak for all of them.
Senator Blumenthal. Where would be the best place to get
that information?
Mr. Nazzaro. I don't have the answer to that. I do not
know. You would have to be privy to the programs within each
individual provider. I am not privy to that.
Senator Blumenthal. So if we asked each individual
provider, that would be the best way.
Mr. Nazzaro. I suppose so. Yes, Senator.
Senator Blumenthal. Thank you.
Thank you, Mr. Chairman.
The Chairman. Thank you, Senator Blumenthal.
To Mr. Nazzaro and Mr. Blount, both of you have been in the
securities lending business for over 30 years. Could you
explain some of the problems that pension funds experienced
during the financial crisis with respect to their securities
lending programs? And based on that experience, what might you
recommend that we do to prevent these things from happening
again?
Mr. Nazzaro. I would be happy to start.
The Chairman. Mr. Nazzaro.
Mr. Nazzaro. As I stated in my prepared remarks, Chairman,
the guidelines are the first place I would start. I think that
the large providers of securities lending services to the plan
sponsors and pension funds, because it is a worthwhile
activity, as we have agreed upon, but I think because of the
profit that has been in there from 2003 to 2008, I think it was
easy to extend maturity guidelines and to just go a little bit
far out on the risk curve and the yield curve, and I think that
needs to be reined in a bit. So, the shorter the maturity of
these investments would reduce the risk and exposure. I think
that is probably the single most important point.
Also I would--many times it is easier to think about this
as an equation. You have the securities lending side of the
equation, then you have the cash collateral reinvestment side
of the equation. Banks, custodian lenders, very large entities
have done a wonderful job on the securities lending side of the
equation. They have protected their clients' assets. They have
demanded 102 percent from the counterparty borrowers and marked
that to the market every single day. That side of the equation
I think has done extremely well. What I am talking about is now
that you have the 102 percent from counterparty borrowers, it
is the preservation of that 102 percent at all times. And I
think you can do that well as long as your maturity range is
short. If you are going to then take that cash collateral and
go out three years, four years, five years, six years, I think
you are adding risk as you go further out with those
investments. That was the lesson, I believe, we learned a
couple of years ago, and that is why it is part of my
recommendation.
The Chairman. Thank you. Mr. Blount.
Mr. Blount. Senator, I would affirm what Mr. Nazzaro says
in general. But I think there are a couple of lessons that can
be taken from the crisis. I think historically it has been very
easy for pension funds and their consultants to look at income
projections expected from securities lending programs and the
revenue split as the primary metrics when you evaluate
different service providers. Those are easy, either 70/30 split
or 80/20. You take the 80/20. Sounds great. Income of an
expected $10 million a year versus $5 million a year, take the
10. But there has to be a greater focus on what I call a
holistic review of the risk within a lending program.
Historically the industry has corrected very well. In 1982,
there was a default by a firm called Drysdale, which caused
Chase Manhattan to step up and write a $200 million check to
cover its customers. After that, the industry decided that they
had to market all the loans, so that was a self-correction.
There were several others, and I will not go through all the
details. But the industry corrects constantly.
Holistically, the big risks in a lending program, if you
assume that the collateral margin of 102 percent is enough to
cover defaults, the big risks come from the difference between
the assets and the liabilities, just like a bank. So on the
liabilities side, it is what the lending program owes to the
borrowers because the borrowers, being brokers, will return the
securities that they have borrowed and say, give me back my
cash collateral. That is a huge risk. That is like the risk of
depositors coming to a bank and saying, give me back all the
money that I have deposited.
Just like a bank, securities lending programs have invested
with a gap--a maturity gap that generates a profit, so pensions
have to look at what those redemption patterns are, the
possibility that depositors may come back. The consultants have
to take this look, too. They have to look at the assets, so not
just focusing on the assets and the quality of the assets, but
the potential for a run on the bank, the risk of the
liabilities coming in and making it illiquid. And I think that
has been missing by most of the pension funds and their
consultants up till now.
I think the service providers have been saying it, but most
of the focus from the consultants to the pension community has
been on give me a better split and come up with a better income
projection, and really now has to be given more balance
holistically.
The Chairman. Yes, Mr. Nazzaro.
Mr. Nazzaro. I think we are saying the same thing on that
side--securities lending side of the equation. If all of the
counterparty borrowers were to return the securities at the
same time, i.e., a run on the bank, you would have to have the
liquidity in that cash collateral portfolio to repay all the
counterparty borrowers. If you did not, you would be in default
and it would be a huge default. So if your collateral portfolio
had to be liquidated quickly, unless it were in short-term
securities or longer-dated securities, such as we found in
2008, large losses would have been realized.
And, Chairman, we only look to the example of AIG. That
was, in fact, what happened. All of the counterparty borrowers
wanted their money back at the same time. AIG did not have the
liquidity to give them their money back; hence, the bailout and
the $20 some odd billion infusion that went to cover
counterparty collateral. So we know what that looks like, and
that is a very--that is a doomsday scenario. And Mr. Blount is
right; we want to learn from that.
The Chairman. Mr. Meier.
Mr. Meier. Senator, if I can comment. I work at a very
conservative firm. We manage our assets prudently. We managed
through this crisis. If I can give you a couple of data points.
From June of 2008 to December of 2008, we saw a 50 percent
reduction in our securities lending balances. We were not a
forced seller of any securities and in the liquid market
throughout the crisis. And I think it is important to remember
that prudent management doesn't mean taking unnecessary risks.
If you look at our portfolios, irrespective of whether they
can invest a little further out on the curve, certainly not
five or six years, at the heart, all of our portfolios--our
cash collateral portfolios or money market portfolios--was what
I refer to as a spread product overlay where we might buy
unsecured debt in a 1- to 3-year space or asset-backed
securities in the 1- to 3-year space. And those investments
typically provide diversification benefits away from unsecured
credits, away from M&A risk, and risks of downgrades associated
with rating actions.
So I do think when you look at risks, you look at the
management of these portfolios, they need to be managed
prudently. They do need to be managed to a very high standard
of liquidity.
There is also the concept in these portfolios of latent
liquidity, where a lender has the ability to simply put out
more loans as opposed to sell assets in a declining market.
And, again, we use those tools in terms of managing that very
important asset liability mismatch.
Mr. Blount. And I think there is one more point, to extend
Mr. Meier's point, that it has been overlooked that during the
fourth quarter of 2008, which was the worst of the crisis, that
the securities lenders recognized the risk that they were
dealing with, and they increased the rebates to the borrowers
in order to hold those balances in place. And it got to a point
where they were paying out what amounted to negative rebates.
They were encouraging the broker-dealers to keep the funds in
place, and it was pretty effective. It kept the balances until
the worst of the crisis was over. So it was a holistic
approach.
The Chairman. Yes, Ms. Klausner.
Ms. Klausner. I would just like to add a comment to try and
maybe put this all in a bit of perspective. Clearly I am not an
investment specialist, and my knowledge is based upon my
personal experience in being counsel to the Savings Investment
Committee and learning a great deal from them.
However, we are talking about liquidity, and we are talking
about whether or not there should be potentially new rules or
new guidance in terms of how the securities lending funds
should be managed in terms of their liquidity, and whether or
not, you know, there is undue risk in the event of certain
doomsday events occurring and there being a potential run on
the bank.
But those concepts exist at varying levels in a defined
contribution plan. So, again, just to put this in perspective,
here's my example. We have a Honeywell common stock fund. Now,
we are very clear that it is not 100 percent stock. There is a
cash buffer there. I believe our cash buffer is targeted to be
about 3 percent. It allows that there would be daily trades and
to be liquidity.
There are some individuals who actually will be
disappointed that there is cash in the fund in order to allow
for liquidity and daily trades because they caught a drag on
the market when the Honeywell common stock is going up. On the
other hand, there are people who are disappointed that there is
not enough cash when stock is going down.
The point here is that at all levels, not just with regard
to the small portion of the fund that has securities lending,
is liquidity issue. It is an issue that we look at as a
fiduciary at a larger level as well. So, in terms of take-
aways, the question might be, do we have to or should we create
a situation where we are creating rules about liquidity
specifically only for securities lending feature, or are there
basically prudent rules that are already out there today with
regard to the investment funds as a whole, including the
securities lending feature.
And so, I caution, again, not to look necessarily in a
vacuum----
The Chairman. Sure.
Ms. Klausner [continuing]. But to look at the larger
picture as well.
The Chairman. Well, that brings me to a question for you,
Ms. Klausner. When your company, Honeywell, reviewed the
securities lending practices within your own 401(k) plan,
Honeywell decided to transition out of securities lending
within your plan. What happened?
Ms. Klausner. A couple of things. One is we had our
doomsday. We had our crisis, so there were a lot more issues to
be reviewed at a very high level. When we were looking at what
was going on with Lehman Brothers and all of the other players
that were showing signs of collapse, one of the things that we
looked at was whether or not the securities lending funds and
the collateral there were at risk. Not my personal review, but
the review of the investment managers who brought the
information back to us, said the answer was no. As long as we
allowed the collateral to stay put and we did not try and cash
in on it and then ultimately realize a loss, we would not be at
risk.
So why did we move out? We recognized that because
securities lending relationships were going to change, we would
no longer in the future have an opportunity to get the benefit
in the same manner as we did before. Securities lending would
no longer be as--I do not want to use the word aggressive--but
maybe not as conservative. We knew that the fees that were
going to be charged and the differentials between non-
securities lending funds and securities lending funds would be
a smaller differential.
And so at some point, the potential benefits of having
those funds would not really necessarily outweigh the risks,
coupled with the idea that we were in a gatekeeping situation,
as Mr. Meier pointed out, not at a participant-directed level.
Participants at each level were able to make their daily trades
if they so chose or if they wanted to rebalance on a quarterly
basis. They were welcome to do that, and there was no impact to
them.
But should we want to, from a fiduciary perspective, add
perhaps a different investment manager in the same asset class,
or if we wanted to put a competing one, which was a nonsec
lending fund, we would have had adverse impact because of the
gatekeeping measures.
So given that then economic environment and the one that we
expected in the then near future, we really believed it was not
going to be in the best interests of our plan participants. We
do, however, want to have the door open because, as with
everything, there is a lot of learning that goes on. There is
change in our economic environment, our financial environment,
as well as our regulatory and legislative. And we want to leave
open the door that should it be prudent to allow people to get
the benefit as the landscape continues to change, to go back in
and provide that opportunity to our participants and our
retirees so they can maximize retirement security.
The Chairman. Okay. Senator Blumenthal, any other thoughts?
Senator Blumenthal. No thank you, Mr. Chairman.
The Chairman. I would like to thank all of our witnesses
for your presence here today and for your very informative
testimony. I think we have had a very productive conversation.
In light of today's hearing and the findings of our committee
investigation on securities lending, I would like to make some
common sense recommendations.
First, employers, I believe, should increase their
knowledge on securities lending within their defined
contribution plans. The committee report outlines a few simple
questions that all employers should know the answer to. For
example, employers should ask their fund manager, ``Do the
investment options within my plan participate in securities
lending?'' They should. I'm not saying we should have a law.
They should know.
Number two, the Labor Department should help employers
better understand this practice by developing basic information
and tools for them on securities lending within their
retirement plans.
Three, participants should be given easy to understand
information about securities lending to help them make informed
decisions when selecting investments within their plans.
And, four, there is currently no comprehensive public data
available about securities lending, including securities
lending in retirement plans.
Therefore, we recommend that companies in the business of
securities lending report information about their business
practices to the Federal Government.
I notice you were all writing it down as I was talking.
Before we conclude the hearing, would anybody have any
disagreement on those recommendations?
Yes, Mr. Blount.
Mr. Blount. Senator, just to reiterate a point I made
earlier, I think the--if I was an editor, I would offer
changing the word information into metrics.
The Chairman. Okay.
Mr. Blount. Something that is a little bit more precise,
relative rather than piling on information.
The Chairman. Good suggestion.
Mr. Blount. Thank you.
The Chairman. Yes, Ms. Klausner.
Ms. Klausner. The only additional comment I would make is
when you talk about giving participants easy to understand
information, and I completely concur that any information they
are provided must be easily understood.
I have suggested in other hearings and platforms, I think
that there is an opportunity here, even as an aging committee,
to recognize that there should be some coordination so that
employers, employer plans, employer sponsors, third party
administrators, you know, do not bear the full brunt on
educating our community--our society--on what it means to
invest, whether it's invest through a plan, invest a plan with
assets that are or are not with a securities lending feature.
And if there is an opportunity here to recognize, as you
said before, that our youngest workers need to understand from
the first day they start working and the first day they start
earning pay, an opportunity to make investments. You know what
is out there in terms of the current landscape. And that that
opportunity is not something that should be a burden on
employers, plan sponsors, third party providers, that we should
be players in that opportunity. But perhaps, you know, other
departments and other regulatory agencies could participate in
getting individuals in society prepared so that, when we give
them information or disclose to them information as workers,
they are ready to receive it.
The Chairman. Well said.
Mr. Jeszeck. Senator, I would say----
The Chairman. Yes, Mr. Jeszeck.
Mr. Jeszeck [continuing]. This would be consistent with the
findings of our report. We would support all of those
suggestions. I think in particular, something we did not talk a
lot about in the report, but the issue of data. One of the
handicaps we had in doing our work here was the lack of data,
really getting our arms around the world of securities lending.
How much is going on? Who does it involve? How much does it
involve defined contribution plans? And I think that would be--
data in this would certainly, I think, make our understanding
of the issue and coming out with some solutions to the extent
that there are problems there much more easy.
The Chairman. Yes, you are right. As I am sure you know, we
refer and cover that in our final recommendation, the
accumulation of data, so we understand what the dimensions of
this whole issue are.
Yes, Mr. Meier.
Mr. Meier. Senator, my only comment or suggestion would be,
to focus on informed disclosure or data information with
context, because I do think it is dangerous, for example, to
simply publish a list of holdings without context in terms of
the benefits of the portfolio, or the structures that underlie
those specific securities.
I can give you an example, the Rule 2a-7 disclosure
requirement. We are required to post our holdings in a money
market fund on a weekly basis. We do it on a daily basis. But
the issue is, if a client looks at a holdings report and sees
an asset-backed commercial paper conduit, they do not
necessarily know who the liquidity support provider is, or the
due diligence that we have done in the assets. They do not
understand whether it is an appropriate and reasonable
investment. And, frankly, that was what, I believe, started or
was a considerable contributing factor, to the liquidity crisis
in August of 2007. It was investors in money funds pulling out
of money funds because of asset-backed commercial paper
holdings without context--they had knowledge that they had
those holdings, but they didn't have context around the risks
associated with those conduits.
The Chairman. Thank you. Good comment.
Mr. Meier. Thank you.
The Chairman. Yes, Senator Blumenthal.
Senator Blumenthal. Yes. Thank you, Mr. Chairman. I think
those suggestions or recommendations are excellent as a
starting point, and certainly we may want to consider going
beyond them based on what we've heard and what we may find out.
But I think the Staff Report, combined with the GAO Report,
provide a really important source of information and a
beginning point. And I would support those recommendations as
well.
Thank you.
The Chairman. Thank you very much, guys. You have been
great.
[Whereupon, at 3:20 p.m., the hearing was adjourned.]
APPENDIX
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