SAN FRANCISCO — Los Angeles County, alerted to the dangers of one of its more esoteric money-making practices by last month's stock market panic and crash, is suspending the program.
The Times has learned that the county treasurer has halted at least temporarily a controversial, billion-dollar securities-lending program that was started last year. The program was designed to boost income on the treasurer's pooled fund, a short-term account that contains money earmarked for schools, roads and other county expenditures.
"The volatility of the markets was such that we did not want to have an exposure," said Sandra Tracey, the county's treasurer and tax collector, in an interview. "For the past two weeks, we have been unwinding our positions and instructing our agent, the Bank of America, to refrain from making further loans of securities."
Added George W. Jeffries, the county's chief investment officer: "On the heels of Black Monday, we thought it prudent to reassess."
The decision applies only to the $4 billion in the county's pooled fund, which invests in such short-term instruments as U.S. Treasury bills, Treasury notes and bank certificates of deposit.
The county's $7.8 billion employee pension fund, which invests in stocks, bonds and real estate, will continue its securities-lending program under a separate arrangement with Security Pacific Bank.
Securities lending is an arcane financial practice engaged in by pension funds, mutual funds and other large holders of stocks and bonds to boost the yields on their holdings. For the institution doing the lending, the practice provides a smidgen of extra income at little risk.
For the borrowers--typically, brokerage firms that need to get their hands on certain securities to settle customers' trades--borrowing is often the cheapest way to consummate a transaction.
"Say you're a broker and you sell $1 million of Oregon water bonds to a customer," explained a New York bond trader. "Then you realize, 'Holy Christ, I don't have them.' Rather than depending on some little old lady in Eugene going to her safe deposit box to get the securities she sold to settle the trade on time, you borrow them temporarily."
In most securities lending programs, the lender requires that the borrower put up collateral worth 102% of the value of the borrowed securities, minimizing the credit risk. But there are risks.
"If the firm you are lending to goes out of business, you have got the collateral--but you're also going to get mired in bankruptcy proceedings working things out," noted Perrin Long, an analyst for Lipper Analytical Securities in New York.
And while the wheels of justice are grinding, the owner would be exposed to market risk. That is because he would be locked into his securities holdings and be unable to sell them during bankruptcy proceedings.
"The real risk is of having our principal tied up," said county investment officer Jeffries. "The pooled fund is an operating fund, so the risks were considered much more immediate. A pension fund is a much longer-term vehicle. Therefore, the lending of securities (by pension funds) is much more common."
The rewards of securities lending are small, with returns typically ranging from 0.5% to 0.8% per year on stocks and less than that on Treasury securities. Moreover, the bank custodians administering the programs for securities owners take about half of those premiums in fees.
Indeed, the rewards are so small--county officials estimate Los Angeles earned about $2 million by lending an average of $1 billion of securities this year--that some financial professionals are astounded that the county took the risk in the first place.
"I am more than a little surprised to hear they were doing it," said the president of one West Coast brokerage firm. "Municipalities are supposed to be ultraconservative."
He cited two instances of municipalities that deviated from this rule with other financial practices and suffered the consequences.
San Jose suffered $60 million in losses in 1984, and the city was forced to delay capital projects after officials there bet wrong on the future direction of interest rates.
Undue Risk Denied
In 1982, Los Angeles County itself lost $17.5 million and filed suit charging fraud against securities firm Donaldson Lufkin & Jenrette after a treasurer's office employee took risks with county funds. The suit and a countersuit were settled a year later after a change in the market wiped out the county's losses.
Tracey and Jeffries, however, denied they were taking any undue risk. They note that Bank of America has not had any difficulty collecting securities that it loaned to brokers on the county's behalf.
Indeed, Jeffries said the county will likely resume lending out its securities if markets settle down and questions about the financial health of certain brokerage firms are cleared up. Noting that the county deals only with the best-capitalized firms, he said: "The risk is pretty moderate given the quality of our borrowers, their reputations and their long-standing experience."