Where should mutual funds invest their repo collateral?

By Felix Salmon
May 31, 2009

Jason Zweig is the lastest person to decide that the financial sector should take less risk. After looking at mutual fund practices when it comes to securities lending, he concludes:

Your fund should lend out your securities, but the proceeds should go to you. And fund managers should reinvest the collateral only in absolutely safe securities. The current system, where they keep half the gains and stick you with all the risks, has got to go.

He’s right that funds should lend out securities, he’s right that the proceeds should go to investors, and he’s right that the current system is broken. He’s absolutely wrong, however, about the “absolutely safe securities”.

Investing in absolutely safe securities is something of an oxymoron: if they’re absolutely safe, it’s not really investing. Investing is meant to be the means by which capital gets allocated to where it can be most used efficiently. Securities lending is an important part of that process, since without it shorting stocks would be almost impossible, and as a result there would be less liquidity and the price discovery process would be damaged.

Mutual funds are also an important part of the capital-allocation process, since they’re actually paid to assess and take risks with investable capital. Consequently, it’s ridiculous that a mutual fund — pretty much the definition of an active risk-taker — should be shunning all conceivable risk when it comes to investing repo collateral.

The only “absolutely safe securities” are short-dated Treasury bills, and the last thing we need is an institutionalized flight to quality whereby every repo transaction involves an uptick in demand for short-term government debt. After all, we’re meant to be getting credit flowing again — and short-dated credit securities are far less risky than the equities in which most mutual funds are paid to invest. So let’s have mutual fund companies taking small and sensible risks with their repo collateral: it’ll be much better for all of us.


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The vast majority of repo activity is in term repos and reverses. Mutual funds are already earning the repo rate on the transaction. Mutual funds shouldn’t be in the business of trying to goose an additional few bps by speculating in riskier securities for 30-days (or less) at a time. That’s not facilitating the efficient allocation of capital. It’s a time-honored recipe for wild and irrational swings in market prices — exactly what you’d expect when you incentivize mutual funds to become momentum traders.

Posted by Mark | Report as abusive

Mark: So it’s okay for a mutual fund to invest in GE common stock but it’s not okay for a mutual fund to invest in GE commercial paper or asset securitization? Huh?

This post also relates to the more recent post about Gary Gorton’s foolish idea to create government-backed securitizations so that the shadow banking system can function with no credit risk. T-Bills already provide everything that such a system would provide (plus a ready source of cheap funding to the government). Why should the government crowd out demand for T-Bills by subidizing the private-sector creation of high-denomination informationally insensitive assets? It would be yet another private profits/public risk situation – banks and depositors would profit from the spreads between T-Bills and these securities, while the government would take on the cost of regulation and the risks of bailing out securities or being subject to fraud.

Posted by cgaros | Report as abusive

When I select a mutual fund, it’s on the basis of my investment objectives (e.g. capital preservation vs return, etc) and with at least a vague view (what’s likely to happen to exchange rates, interest rates, which countries or industries likely to do well/poorly, etc.). I want a fund manager who’s going to invest in a portfolio that fits with my objectives and view. And that goes as well for how collateral is invested.

What I don’t want is a manager who, as Mark describes, is “trying to goose an additional few bps by speculating in riskier securities for 30-days (or less) at a time.” That’s not the portfolio I was buying, thank you very much.

Unfortunately for a small investor, the fine print in fund prospectuses often give the fund manager a whole lot of lattitude. So we’re stuck with having to trust the good sense of fund managers. Even though there are immense incentives for them to “goose their return”.

isn’t this how aig blew up. they were loaning out securities and taking treasuries as collateral then swapping the treasuries for MBS.

Posted by drscroogemcduck | Report as abusive

Mutual funds’ record with respect to repos and sec ending is far superior to that of pension funds, corporations and other market participants due to Investment Company Act rules that set standards for the amount, quality, and segregation of collateral.

Posted by David Schenker | Report as abusive

Felix, you’re dead wrong on this. If a fund can’t make money on lending when the collateral is invested in t-bills, it shouldn’t be lending. Have we learned nothing about the dangers of hidden risk?

Posted by Max | Report as abusive

Felix, it’s a question of getting the risks that you want to take. Why should I find out that I lost money on subprime ABS, when I thought I was buying a stock fund? Unless it is prominently disclosed that they are taking abnormal fixed income risks — warning kids, don’t try this at home — they should stick with safe, vanilla collateral.