*****Unregulated Securities Lending Has Kept Insovent Banks Alive Since The 1980s*****

Some of might remember a blog entry I made about inconsistencies in The SEC's Annual Reports.

(emphasis mine) [my comment]

Look at the unconsolidated balance sheet of broker-dealers from the SEC's 1983 Annual Report. Notice the numbers for Receivable from Other Broker-Dealers and Payable to Other Broker-Dealers. These numbers are opposite sides of the same transactions between broker dealers. Securities borrowed from one broker are owed to another. As expected, in 1981 and 1982, the numbers for Receivables and Payables between broker dealers are fairly close to each other



Now look at the unconsolidated balance sheet of broker-dealers from the SEC's 2003 Annual Report (the last one available). The numbers for Receivable from Other Broker-Dealers and Payable to Other Broker-Dealers are completely disconnected. For example, in 2002 Broker-Dealers claim other broker-dealers owe them either 939 billion or 387 worth billion of borrowed securities. These are the same securities!



[I originally thought the discrepancies might be explained by how the numbers were reported (accounting gimmicks). The reality is worse]

Well, I found the answer to explain these inconsistencies: bank securities activities (including security lending) are not subject to broker-dealer regulation. This means that when banks lend securities to other broker-dealers in exchange for cash, only one side of the exchange gets reported to the SEC. In essence, since the 1980s, banks have been operating as unregulated, "invisible" broker-dealers.

As
David S. Ruder remarked in 1988, the barriers to securities activities by banks was significantly eroded by new interpretations of Glass-Steagall during the 1980s.

Remarks of David S. Ruder
Chairman

States Securities and Exchange Commission
Before the American Bar Association
Section of Corporation, Banking and Business Law
Annual Spring Meeting
Philadelphia, Pennsylvania
March 25, 1988

...
III. Glass—Steagall Reforms

...
Originally the Glas-Steagall Act, enacted in 1933, strictly limited the extent to which banks could engage in securities broker-dealer, underwriting, or investment advisory activities. However, during the 1980s the barriers to securities activities by banks have been significantly eroded as a result of new interpretations of Glass-Steagall by banking regulators and by courts. Glass-Steagall — once thought to be an impenetrable barrier to such activities — is today a barrier full of gaping holes.

Because banks' securities activities are not subject to broker-dealer regulation, the expansion of these activities has concerned the Commission for some time. As a result, in 1985 the Commission adopted Rule 3b-9, which was intended to fulfill the Commission's goal of achieving adequate and consistent regulation of securities activities of banks. The rule required any bank engaged in the business of effecting brokerage transactions, or dealing in or underwriting non-exempted securities to either register as a broker-dealer or enter into a contractual or other relationship under which a registered broker-dealer would in fact be the provider of such services. Following the Commission's adoption of Rule 3b-9, over 170 banks and bank holding companies established registered broker-dealer subsidiaries.

...
Additionally, I urged that, if banks are permitted to underwrite and distribute investment company securities, the Investment Company Act and the Investment Advisers Act must be amended. Because the two Acts were drafted in the context of the separation between banking and securities manated by GlassSteagall, they do not adequately address the investor protection concerns that will arise if banks are permitted to engage generally in the investment company business. These concerns arise from bank custody of assets of affiliated investment companies, transactions between affiliates, investment company borrowing from affiliated banks, bank advising of investment companies, the independence of directors, and the use of a bank's name by an affiliated investment company.

On December 9, 1987, I testified before the House Banking committee emphasizing again that the Commission would be unable to support repeal or modification of the Glass-Steagall Act unless the Commission's investor protection concerns were met.

Subsequently, at Senator Procnire's request, the Commission staff met with the Federal bank regulators to draft legislative language addressing the Commission's investor protection concerns.
Compromise language resulting from those meetings was included in the version of S. 1886, the Glass-Steagall reform bill sponsored by Senators Proire and Garn, that was approved on March 2nd by the Senate Banking Committee by a vote of 18 to 2. In order to achieve an agreement, the Commission had to make some significant concessions [to Federal bank regulators]. Nevertheless, the compromise, taken as a whole, provides adequate investor protection, and provides significantly better protection for investors than that likely to exist if banks' securities activities increase through regulatory interpretation and court decisions.

...
Now you may wonder why in the world the Commission supports repeal of Glass-Steagall. Well, for starters, we believe that repeal of Glass-Steagall will increase competition in the financial services industry and will make U.S. financial services providers more competitive in world markets. Moreover, investors will be better protected with the S. 1886 compromise legislation than by continuation of the de facto circumvention and creative regulatory interpretation that has eroded Glass-Steagall. To my mind, it has not been a healthy development for the Commission to lose control over the bankin g segment of the securities industry -- not healthy, that is, if you want securities regulation to do the job intended by Congress.

Below, the SEC explains how Banks and FDIC-Insured Savings Associations can avoid registerering as broker-dealers.

Staff Compliance Guide to Banks on Dealer Statutory Exceptions and Rules

...

Special Rules for Banks and FDIC-Insured Savings Associations

If a bank — or an FDIC-insured savings association or savings bank (which we will refer to as "savings banks") — is engaging in dealer activity, it does not necessarily have to register as a dealer with the Commission [and doesn't show up in SEC statistics]. Rather, Section 3(a)(5) of the Exchange Act and certain Commission rules provide transaction-specific exceptions and exemptions from the definition of "dealer" for banks and savings banks. These exceptions and exemptions are outlined below.

...
Exemptions from the Definition of "Dealer"

In addition to the four exceptions from the definition of "dealer" outlined above, banks and savings banks should also consider two exemptions adopted by the Commission by rule. These exemptions pertain to riskless principal transactions and securities lending transactions.

...
2.
Securities lending transactions. [17 CFR 240.3a5-3.] This exemption, under Rule 3a5-3, permits banks to engage in, or effect, securities lending transactions with certain counterparties. A "securities lending transaction" is a transaction in which the owner of a security lends the security temporarily to another party under a written securities lending agreement. Through this agreement, the lender retains the economic interests of an owner of the securities. Subject to any terms agreed upon by the parties, including an agreement to loan the securities for a fixed term, the lender also has the right to terminate the transaction and to recall the loaned securities.

...
A final note about safekeeping and custody activities: Banks also have a conditional exception under Section 3(a)(4)(B)(viii) from the Exchange Act definition of "broker" for safekeeping and custody activities. Under that exception,
banks may engage in securities lending services for custody customers without meeting the requirements of this exemption. For example, the safekeeping and custody exception permits a bank to engage in securities lending transactions for custody customers that are not "qualified investors." Of course, because the custody exception is only an exception from the definition of "broker," it does not cover "dealer" transactions.

lawprofessors reports that bank securities activities has been within the regulatory purview of the Federal Banking Agencies, not the SEC.

October 02, 2006
SEC Extends Exemption for Banks

On Sept. 29, 2006, the SEC gave banks another extension until January 15, 2007. Before the Gramm-Leach-Bliley Act of 1999 ("GLBA"), banks had a blanket exemption from the requirements of the Securities Exchange Act of 1934 governing "brokers" and "dealers". Bank securities activities were within the regulatory purview of the Federal Banking Agencies, not the SEC. Under GLBA, banks must either engage in securities activities through a registered broker-dealer or they must make sure their activities fit within a functional exception to the new securities laws definitions of "broker" and "dealer". SEC is now the primary functional regulator for securities activities, even for banks. The SEC is still evaluating comments on its proposed Regulation B and has extended the pre-GLBA exemption until January 15, 2007.

Graphs showing bank securities lending activity





To put this in perspective, the ultimate cost of the S&L; crisis is estimated to have totaled around only $160.1 billion, about $124.6 billion of which was directly paid for by the US government. By 1994, banks had used securities lending to raise over $200 billion in cash. Without this security

Some charts of the S&L; crisis


Example of bank securities-lending activity

The Star Tribune reports about Wells Fargo's securities-lending program.

Bank blamed for big losses to charities
Local foundations are fighting Wells Fargo in court, saying it lied about safety of investments made before market plunge.
By CHRIS SERRES, Star Tribune
Last update: December 9, 2009 - 8:14 AM


David Joles, Star Tribune

Monica Nilsson is street outreach director for St. Stephen's Human Services and chairwoman of the Minnesota Homeless Coalition. Like many people who work for nonprofits, Nilsson has seen her job affected by funding cuts by the Minneapolis Foundation -- the state's second largest community foundation and one of the largest donors to hundreds of small charitable groups across the Twin Cities. It has made her job more difficult. Here, Nilsson pauses with Frank Killsright, an Army Vietnam vet who was a member of the 82nd Airborne 175th Ranger Regiment Special Forces, who is homeless and lives under a bridge in Minneapolis after the two visited Killsrights living quarters. Nilsson is working to get Killsright into permanent housing as well as get him Veteran's benefits. Killsright, who is Sioux and Cheyanne, served in Vietnam from 1970 to 1975 and suffers from war-related PTSD.

Graphic: How Wells Fargo's securities lending program worked


For years, some large charitable foundations in the Twin Cities tried to earn a little extra cash by hiring Wells Fargo & Co. to lend the securities they owned to Wall Street.

Now, those foundations are engaged in a high-stakes lawsuit that accuses Wells Fargo of costing them -- and the charities they support -- tens of millions of dollars by violating the conservative investment principles that the bank's top executives preached publicly.

The Minneapolis Foundation, Minnesota Medical Foundation, the Robins Kaplan Miller & Ciresi Foundation for Children and the Minnesota Workers' Compensation Reinsurance Association together accuse Wells Fargo of lying about the safety of the investments they made with it in the months before the market's plunge. Instead of safe, plain-vanilla investments, their money was tied up in securities that became so toxic they couldn't be sold except at fire-sale prices, according to the suit filed in state District Court in St. Paul.

The losses likely will reverberate through the Twin Cities for years to come. Many non-profit groups have already seen their funding cut this year.

For smaller charities, the cutbacks can be deadly, as a single grant from the Minneapolis Foundation -- the state's second-largest community foundation ranked by grants paid -- can make or break their chances of attracting additional money.

"Every dollar lost is a dollar that's not available for the community," said Mike Ciresi, partner in the Robins Kaplan Miller & Ciresi law firm and one of the attorneys in the case.

Wells Fargo said in a statement that it "categorically denies" the allegations made in the lawsuit, and that "as with all investments, the investors bear the risk" of losses.

"We continue to vigorously defend against the allegations," the bank said. "We continue to assist clients in working through the extraordinary market events of the past several years." Citing the litigation, the bank declined to comment further.

'On life support'

The full extent of the losses won't become clear until the nonprofits finally untangle themselves from Wells Fargo's securities-lending program.


The nonprofits declined to comment or to make executives available, citing the litigation, and referred calls to attorneys at the Ciresi firm.

But judging from the amount of capital they previously committed to securities lending, the losses are significant.

The latest annual financial statements from the Minneapolis Foundation shows that, for the year ended March 31, 2008, it had $95 million worth of securities loaned to brokers. By March 31 of this year, that figure stood at $30 million, though much of the reduction was due to simply shifting assets away from securities lending.

For the Minnesota Medical Foundation, securities on loan declined from $42 million to $17 million in the year ended June 30.

The asset declines will have a direct impact on how much the foundations give away, since their annual payout rates are calculated as a percentage of assets. And the losses from securities lending come on top of the plunge in value that foundations have seen in their stock investments since last year. The Minneapolis Foundation's investments, outside of securities lending, declined 29 percent in the year ended March 31.

Some nonprofits that have relied on the Minneapolis Foundation recently received notices informing them that their funding will be cut or eliminated for 2010. The foundation has narrowed the scope of its community grant-making to organizations and activities that can demonstrate that their programs benefit Minneapolis residents. It previously supported causes throughout the Twin Cities.

The Minnesota Coalition for the Homeless, a statewide group that represents 150 homeless organizations, last month was turned down for a grant, after receiving money from the Minneapolis Foundation for eight consecutive years. Monica Nilsson, president of the coalition, said the decision means fewer people will be advocating for the homeless, at a time when more families are being forced onto the street or to homeless shelters.

Also turned down was Fund for an Open Society in Minneapolis, which sought $75,000 to advocate for racial equity in public schools and housing.

"We're on life support," said Catie Royce, executive director for Fund for an Open Society.

"The people most hurt by something like this are the ones who can least afford to bear it in this economy," said Steve Paprocki, an adjunct professor of philanthropy at Hamline University and managing partner of Access Philanthropy, a firm that researches nonprofits. "It's a huge black eye for everyone involved."

A $4 trillion business


Thousands of documents and dozens of motions have been filed by both sides since the suit was filed last year. The documents are held in 28 bulging folders stacked high inside a judge's chambers on the 15th floor of the Ramsey County court building in St. Paul.

Many of the details related to Wells Fargo' securities-lending program are sealed, though more information likely will emerge as the suit grinds on. The case is so complicated that a state court judge appointed a special master to oversee the discovery process.


"In my 40 years of practicing commercial trial law," wrote the special master in a report to the court, "I cannot recall a case in which discovery has been more contentious."
[discovery is the pre -trial phase in a lawsuit in which each party can request documents and other evidence from other parties and can compel the production of evidence]

The case is being closely watched by attorneys across the country, including those whose clients have lost money in securities-lending programs. It is viewed as the first securities lending case involving a large bank likely to head to trial, now slated for April. Some similar disputes were settled out of court, with the banks agreeing to make good some of the losses.

Securities lending was long considered a risk-free way to squeeze slightly better returns from large investment portfolios. Earlier this decade, as the demand for loaned securities mushroomed along with the stock market, assets in securities-lending programs reached nearly $4 trillion. But the strategy backfired after some of the firms that manage the programs began to invest in riskier securities backed by loans tied to the housing market.

Lending began in the 1980s

Wells Fargo began promoting securities lending to larger institutional investors, such as foundations and insurance companies, in the early 1980s, when it was still Norwest Corp. in Minnesota.

Under its program, Wells Fargo would lend out the securities held by institutional clients for temporary periods to broker-dealers who like to borrow securities for short-selling. (Short-sellers try to profit by selling borrowed shares in the anticipation that the stock will fall, hoping to buy them back later at a lower price and pocket the difference.) Wells Fargo would ask for cash collateral for the loaned securities, then invest that cash to generate a small return, splitting those returns with its institutional clients.

According to the lawsuit, securities-lending agreements signed between Wells Fargo and the nonprofits limited the bank to investing their collateral in "short-term money market instruments," which can be bought and sold easily. The agreements further said that the "prime considerations" of the investments "shall be safety of principal and liquidity," the suit says.

But in recent years, the bank invested in securities, some backed by subprime mortgages, with maturities "that reach out nearly 40 years," according to the suit. These securities lost much of their value and became harder to sell when housing prices began to fall in 2007. Wells Fargo also parked client money in so-called structured investment vehicles, or SIVs -- pools of money also invested in subprime-tainted securities, according to the lawsuit.

The nonprofits say they first learned something was amiss in November 2007 when Wells Fargo informed clients that one of its SIVs -- called Cheyne Financial -- was in receivership. Wells Fargo also said it would no longer value the cash collateral within its securities program "at par," meaning that investors might not get all their principal back.

Alarmed by the losses, the Minneapolis Foundation and other plaintiffs said they tried to withdraw from the program, but Wells Fargo "unlawfully barred the doors," by requiring them to repay any lost cash collateral.

The nonprofits argue that the bank should foot the bill. They accuse it of fraud, breach of fiduciary duty and civil theft, among other things. They demand that Wells Fargo compensate them for their losses and return the securities still tied up in the program.

The nonprofits allege that at one point Wells Fargo even "misappropriated the proceeds" from an unrelated bond fund held by the Robins Kaplan Miller & Ciresi Foundation For Children to compensate for the losses of securities-lending collateral, according to court documents.

"The highest levels of Wells Fargo management knew, or should have known, that Wells Fargo was systematically investing the cash collateral in a risky and unlawful manner," the lawsuit says.

...

Wells Fargo was not the only bank to run into trouble with a securities lending program. Insurance giant AIG and Northern Trust, among others, were sued on similar grounds over client losses. Though investing in mortgage-related securities "appears reckless now," many of these securities were considered safe just a few years ago, said Andrew Gogerty, a fund analyst at Morningstar.

Conclusion:

1) Federal bank regulators led the push to repeal glass steal, and the reason is obvious. Without the cash banks generated through securities lending, the cost of the S&L; crisis would have been at least double what it was.

2) Broker dealers are completely insolvent, as they are owed 1 trillion dollars from insolvent banks.

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One Response to *****Unregulated Securities Lending Has Kept Insovent Banks Alive Since The 1980s*****

  1. bidrec says:

    Excellent summay of a complex topic.

    An earlier case (from Australia) is summarized here:

    http://www.thefreelibrary.com/Securities+Lending+Contracts+Mean+What+They+Say.-a0179086547

    The ruling is here:

    http://www.austlii.edu.au/au/cases/cth/FCA/2008/594.html

    Unstated is that the plaintiffs claimed that they thought they had margin agreements, not retail securities lending agreements (which are peculiar to Australia).
    They used the collateral from lending the securities to buy more of the exact same securities which were held as collateral. When the market value dropped the value of their securities (collateral) dropped and they lost the opportunity to reclaim the lent securities (they had already lost title in the act of lending). And their collateral was seized.

    When this case went to trial the whole Securities Lending world was watching.

    The ASX, Australian Stock Exchange, had to be closed for two days.

    "ON January 29 and January 30 stock lending and Tricom were at the heart of a market stoppage that lasted for two days when Tricom failed to settle a huge trade in shares. When Tricom tried to settle the trades, the stock was not available to settle - it was on loan."

    http://www.smh.com.au/business/asic-knew-it-all-but-did-nothing-20080627-2y4d.html

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