WASHINGTON, D.C., December 1, 2008 — Watson Wyatt, a leading global consulting firm, has recommended that its clients suspend securities lending activity where possible if they are in any doubt about their lending guidelines and arrangements. The firm asserts that the risk-reward trade-off around this activity has changed and that, in some instances, it may no longer be worthwhile. However, it also warns that suspending securities lending can crystallize a loss in some cases, which should be avoided.
“Recent market events have underscored the risks associated with securities lending,” said Lisa Laird, head of U.S. custody research at Watson Wyatt. “It is imperative that pension funds review their lending arrangements to ensure that they fully understand the risks involved and confirm their lending guidelines are appropriate.”
Watson Wyatt identifies counterparty risk, collateral and indemnification as the three key areas that pension funds should focus on when dealing with their lending agents, typically custodians. Regarding counterparty risk, agents were able to re-purchase most clients’ assets within two days of the Lehman Brothers default. While the lending industry coped well with the process, the default highlighted the counterparty risks involved.
On collateral, the firm is advising that pension funds ensure that the collateral received in the course of their lending program is in line with their risk tolerance and that it is generally high quality. While it acknowledges that only an extreme chain of events would invoke a lending agreement’s collateral indemnification clause and then cause indemnification provisions to fail, Watson Wyatt recommends that its clients be aware that the current environment is exacerbating both counterparty and collateral risks embedded within lending programs and adding pressure on even the most carefully negotiated contract indemnification provisions.
“We recommend pension funds first research collateral types and amounts as well as their reinvestment guidelines, particularly where cash collateral is taken. Next, they should investigate counterparty restrictions and any collateral indemnification provisions provided by lending agents,” said Laird. “Having done this, if they find the risk relative to the reward unacceptable, they should immediately suspend securities lending where possible or initiate a gradual withdrawal.
“Alternatively, they could remain in the program once they have changed the lending guidelines by amending the collateral requirements, reviewed the borrowers and indemnification structure and strengthened any cash collateral reinvestment guidelines.”
To view the note, visit: http://www.watsonwyatt.com/securitieslending
About Watson Wyatt Investment Consulting
Watson Wyatt Investment Consulting, a division of Watson Wyatt, is focused on creating financial value for institutional investors through independent, best-in-class investment advice. We are specialist investment professionals who provide co-ordinated investment strategy advice based on expertise in risk assessment, strategic asset allocation, and investment manager selection. Watson Wyatt Investment Consulting provides investment advice to some of the world’s largest pension funds and institutional investors, and has more than 500 associates in Europe, the Americas and Asia.
In the US investment advisory and investment consulting services are provided by Watson Wyatt Investment Consulting, Inc., which is a subsidiary of Watson Wyatt Worldwide Inc. Watson Wyatt Investment Consulting, Inc., is a registered investment adviser with the Securities and Exchange Commission.
About Watson Wyatt
Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organizations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,600 associates in 32 countries and is located on the Web at www.watsonwyatt.com.