90’s Part I: The Main Attraction

Stock lending may have hit the big time in the 1990s, but in doing so it attracted the attention of the regulators, especially after the publicity surrounding the Maxwell case. Meanwhile, in the US, there was a little upset by the name of Orange County. John Piccitto explores the murky years of the early 1990s.

In the 1990s, the previews were over - stock lending became a main attraction. Often combined with other complementary products under the name of equity finance, stock lending operations became powerful, global profit centres at virtually every major brokerage house. By the end of the decade an equity finance operation could produce a bottom line 20 times greater than its profits from the previous decade. This made opportunists and regulators sit up and take notice.

But a cloud hung over the business. The ghost of Robert Maxwell haunted every sales pitch, and lurked behind every contract analysis, ably abetted by the long train of chancers and wideboys who followed Maxwell’s crooked path and blackened the reputation of some of the industry’s most respected institutions. Somehow, the more successful the business became, the more it was associated with the antics of people who made great headlines, but appalling role models. As a result, international stock lending, which was an interesting new idea in the 1980s, became a much harder sell in the 1990s.

And yet it had all started so hopefully. In the spring of 1990, the Bank of England formally recognised securities lending as a business. Following Recommendation 8 of the G30 that “…Securities Lending and Borrowing should be encouraged…” the Bank established a Stock Lending and Borrowing Committee (SLBC) - to improve securities lending arrangements in the UK, and to bring present practice into line with G30 recommendations. The objective of this exercise may well have been to prevent the business from moving to Paris, Frankfurt or Zurich, all of which had been mentioned in the press at the time as possible havens for international broker/dealers.

The SBLC (which in 1996 became the Stock Lending and Repo Committee, or SLRC) was a body of professionals from all parts of the business: borrowers, lenders, intermediaries, the Inland Revenue, and the regulatory authorities. The working party would consider and deliberate, and after this the Inland Revenue might produce a helpful extra-statutory concession. This institutionalised earlier ad hoc practices, providing stock lending with a legal and regulatory structure, made the business easier to monitor and book-keep, and ensured that the UK Exchequer got its fair share.

The early deliberations of the SBLC concerned loaning UK government securities and borrowing securities to cover fails, practices already very much in evidence in the UK. Then they turned a new light on old territory - tax treatment of lending overseas securities, and of the dividends manufactured in the process. In the 1980s, the Inland Revenue had not been pleased with the way dividends were treated during the lending of overseas securities. It preferred that the dividends from the securities on loan be paid directly to the owners of the securities involved, so as to make clear who owed withholding tax when and on what.

In January 1991 the SBLC’s Tax Working Party managed to resolve the problem of permitting dividends manufactured for stocks on loan being paid in gross form. Previously, this had not been acceptable to the Inland Revenue, which feared that income would be lost to the UK Exchequer, so another avenue had to be found. The new regulation - SI 2552 - permitted stock lending of overseas securities whose dividends were paid via UK collecting and paying agents, on the condition that these agents would account for any taxation once deemed by the Inland Revenue to be “lost” to the government.

This formal recognition and regulation of the stock lending business conferred legitimacy and order just in time. After the publicity that followed the Maxwell scandal, reluctant lenders would always raise the name during a sales visit. Yet the scandal had very little to do with stock loan.

The curse of Cap’n Bob
Robert Maxwell, boss of the Mirror Group of Newspapers, had been born into poverty in central Europe. In some people Maxwell inspired fierce loyalty. Others felt differently; the satirical magazine Private Eye referred to Maxwell as Cap’n Bob, since he was also the owner of a rather conspicuous yacht, the Lady Ghislaine. In November 1991, Maxwell disappeared over the side of this yacht and died. Subsequent investigation of his business affairs revealed that Maxwell had emptied his employees’ pension fund to finance his other enterprises.

Maxwell’s Byzantine business dealings included self-investments approved by the Mirror Group board of directors (on which sat Maxwell and his two sons, Ian and Kevin). But more disturbingly, money had been withdrawn from the Mirror Group pension funds to purchase other entities. And some of the techniques Maxwell used involved the borrowing of securities as collateral to obtain cash for these exploits. Unfortunately, two words caught the popular imagination - borrowing and securities.

The public reaction to this betrayal cannot be overstated. Some were appalled that Cap’n Bob would have done such a thing, others were amazed that he had finally been found out. But the money was gone; Maxwell’s employees had no pensions – they could only line up behind the other creditors. And other pension funds got very wary, very fast. The idea of lending stock was dimly understood, but much worried about. For example, some county councils in the UK date their statutory prohibition against stock lending from the Maxwell days.

However, Maxwell’s activities gave an impetus to the formation of corporate governance rules; disclosures, funding arrangements, and protection of member’s rights are now an important consideration in the operation of every pension or mutual fund.

A Gulf War complication
The next problem emerged from a rather different source. After Iraq invaded Kuwait in 1991, the US Treasury Department created the Office of Foreign Asset Control (OFAC) in an attempt to prevent Iraq from using the considerable assets of the country it had just invaded. All relevant assets, and the companies that deployed them, were placed on the OFAC list, and for US broker/dealers, as well as their foreign-based subsidiary companies, everything on that list was frozen unless specifically exempted.

OFAC continued to add entities with the slightest tie to either Kuwait or Iraq almost daily.
Hastily, the lists were disseminated throughout US companies and their international subsidiaries. In those days, before the advent of e-mail, compliance sheets listing the latest untouchable companies drifted across trading desks like autumn leaves, sometimes getting lost beneath piles of coffee-stained order forms.

The minute an entity appeared on the OFAC list, all dealings with it had to cease under threat of prosecution by the US government for violation of OFAC rules. So securities borrowed from people whose names appeared on the list at any time during the life of the loan had to remain with the borrower indefinitely. Collateral could not be returned without fear of triggering an OFAC violation. This occasioned great dismay on the part of lenders and borrowers who did not consider themselves subject to OFAC rules, and were less than sympathetic to the plight of those of us who were. Keeping lender goodwill suddenly consumed a lot of time, especially if a trade had been transacted in a neutral country like Switzerland or Luxembourg, which were reluctant to be badgered into compliance with any international effort that limited their sovereign right to secrecy.

The episode engendered a new caution on the part of sovereign lenders and their functionaries when disbursing assets. Concerns focused on the ability of borrowers and middlemen to get the stocks and collateral back to their rightful owners in the light of major world events.

Equity finance is born
By 1993 the world of securities lending had begun to experience a reorganisation that would change the way business was transacted globally and the way individual profit and loss accounts were calculated. The stock loan desk was combined with the prime broker desk, a contract for differences (CFD) unit, a collateral management trader, or an equity swaps/equity repo dealer and labeled equity finance. The business operated via a trading book that circled the world each day.

Borrowers - often hedge funds, newly important and rapidly expanding - were now able to deal on a 24-hour basis. Located (or iced) issues were passed from desk to desk, from Sydney to Tokyo to Hong Kong to London to New York and around again. And not only was the moveable equity finance desk able to locate a particular issue for a borrower, its prime broker unit could lend money, transact a CFD or organise an equity/bond repo deal. Things got very complex, and very profitable.

The specialised, often very technically-oriented people who worked in this new organisation were different from the earlier waves of expats – principally, they were a whole lot more expensive, and so were on board for a shorter time. The idea was that if a specialist job needed to be done, a specialist should be imported, along with their family, and when the job was over they would be sent back home.

Unlike the wave of US expats in the previous decade, the specialists tended to be less knowledgeable about, and less enamoured of, European culture - it was as if even in the middle of Europe, the new folks were still on Eastern Standard Time. One asked me if the reason that German was spoken in Zurich was because Hitler had conquered Switzerland during the Second World War. Another seemed stunned to find that trades in Sweden were not settled in US dollars: “What’s a krona?” he shouted. “You mean I gotta take a currency hit here?” He had tried to market a portfolio of Swedish securities without contacting any Swedish broker/dealers.

However much it cost in imported staff, the business became a very profitable, globalised, computerised operation, feeding profit into other aspects of the financial industry. The phrase ‘one-stop shopping’ gained currency among hedge funds, now doing a roaring business not only in the States, but also in Europe. For a time, prime broker operations tried to be the exclusive resource of a particularly active hedge fund, but soon hedge fund managers found that even though one broker/dealer’s supply chain might be superior, a competing outfit would make deals possible by negotiating prices a little closer to the bone. And hedge fund managers shopped around.

Rocket science and Orange County
By the mid-1990s, the product had expanded exponentially. Joint marketing trips united equity stock lending, fixed income and swaps in an effort to spread the word. Huge client dinners in Hong Kong and more focused seminars in Jakarta pushed a wide range of products. Hedge funds flourished in a volatile market, and broker/dealers sometimes marked-to-market three times a day. About this time the term ‘rocket scientist’ began to be used to describe those boffins who did very esoteric things with the financial instruments just becoming available.

But keeping track of who was selling what to whom was becoming a problem. Such efforts limped along behind the inventiveness of the rocket scientists, several of whom hardly got off the launch pad; others fell apart on re-entry. Enter Robert Citron, the appropriately named treasurer of Orange County, California.

In 1994, Citron leveraged $7.6bn from the Orange County Treasury and other local agencies to purchase $21bn in a variety of investments such as reverse repos, long-term bonds, treasury notes, agency fixed rate notes, agency floating rate notes, mortgage-backed securities and other short-term paper. But interest rates moved against him and disaster was inevitable.

The immediate aftermath of the crisis was characterised by the usual hand-wringing excuses, the silliest of which was that Citron and Orange County were under unconscionable constraints because California taxpayers had mandated Proposition 13 – that no new taxes could be levied without their express consent. Much noise was made about the need for better corporate governance, such as pro-active rather than reactive supervision of investment officers.

But then Orange County decided to sue the broker/dealer that had advised Citron, arguing that Citron himself had been ill or incompetent (he was rumoured to have consulted astrologers) and that the broker/dealer had taken advantage of a naïf victim. It was pointed out that before 1994, Citron had done very well with his investing strategy, but the broker/dealer finally paid up to the tune of $420m. And Orange County’s chief executive said that the resolution “assures county taxpayers that those responsible for the losses that caused the County’s bankruptcy are being held accountable”. Citron himself escaped a jail sentence.

Maybe the problem is that for local government supervisory staff, it’s hard to tell whether an investment officer is smart or just lucky. But the message to the industry after the Orange County pay-out seemed to be that it didn’t matter: it lost out either way. That let to a clamour for better corporate governance, higher standards for fiscal oversight and accountability. The rights of shareholders and the limitations on the use of funds at the disposal of pension schemes were discussed and implemented. Independent auditors and board members were appointed. The lead in these matters taken by the California Public Employees’ Retirement System (Calpers) has been a positive and appropriate response. But the general reaction was simply dismay that one person could bankrupt an entire county without anyone else understanding what was going on.