In their latest "Short-Term Fixed Income" weekly, J.P. Morgan Securities' strategists Alex Roever and Teresa Ho feature a piece entitled, "Revisiting the Sec Lenders." It says, "For better or for worse, money market funds have been the subject of many people's attention over the past few years. With $1.6tn of assets under management, prime money funds have the ability to influence many parts of the short-term markets. Other investors, like securities lenders, who also play a large role in the money markets, tend to get lost in the shuffle. Although securities lending balances have declined significantly since mid-2007, we estimate that they still hold as much as $1.5tn of short term investments."

The piece explains, "Agent Securities Lenders (Sec Lenders) are banks that lend securities that their clients have in custody. In return, Sec Lenders receive cash as a form of collateral. The cash is then reinvested, usually in shortterm securities as well as in some highly-rated securities just outside of 2a-7 guidelines. This structure allows the clients, subject to predetermined investment guidelines, to earn an extra return on their securities portfolio for a fee paid to the Sec Lenders. During this process, Sec Lenders manage the spread earned on investments and the return distribution to clients."

Roever and Ho write, "At their peak in mid-2007, we estimate that the cash reinvestment portfolios of Sec Lenders measured around $3.0tn. We say estimate because the securities lending industry is largely an opaque market, unlike money market funds that are regulated by the SEC and have become more transparent recently. Not only are they less transparent, Sec Lenders also have fewer restrictions in terms of their investment strategies than money market funds. Historically, they used to be large participants in longer-dated (i.e., greater than 397 days) floating-rate securities from ABS and corporate issuers that 2a-7 funds are not permitted to buy. Their participation fueled the growth of corporate FRN outstandings from 2005-2007 as well as term ABS securities such as credit card and auto ABS."

They add, Not surprisingly, the onset of the credit crisis has prompted them to adopt more conservative investment strategies, particularly after experiencing losses related to their FRN and ABS holdings. The value of those securities suffered dramatic losses as credit spreads widened. Today, cash reinvestment portfolios of Sec Lenders are much more 2a-7 like, driven primarily by the lower risk tolerance of their clients. According to the most recent data released by the Risk Management Association, holdings of floating-rate instruments fell from 36% in 2Q2007 to 23% in 3Q2010, as they pursued more fixed-rate or repo instruments. At the same time, the overall size of their portfolios was cut roughly in half. Investments beyond 13m also declined by 21%, in favor of securities with very low interest rate and credit risks.

The weekly writes, "Similar to 2a-7 portfolios, the median weighted average maturity of Sec Lenders has increased recently (from 53 days to 61 days) as they try to enhance yields in today's low interest rate environment. Allocation to repo has increased from 26% to 30%, driven most likely from elevated repo levels and their desire for liquidity. Composition of their repo collateral has also gradually shifted toward higher yielding collateral like corporates and equities, and away from US Treasuries and Agencies."

Finally, it says, "Interestingly, Sec Lenders' allocation to money market funds has increased by 10% since June 2007. During 3Q2010, they held on average 12% of their cash reinvestment portfolio in money funds. This is relatively surprising as investments in other short-term instruments, most of which earn higher yields than money funds, have experienced a decline or modest gain in asset allocation. There are several reasons for this behavior. The supply of money market securities has shrunk.... There are counterparty exposure limits.... With that said, not all money funds are the same.... Money funds provide some operational advantages over repo.... Non 2a-7 money funds exist."

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