In 2011 the technology giant Cisco Systems disclosed for the first time in a filing with the Securities and Exchange Commission that its corporate treasury has been an active participant in a little-known market for loaned securities. “We periodically engage in securities lending activities with certain of our available-for-sale investments,” the company explained. Cisco’s executives disclosed that in 2010 its corporate treasury had lent out $1.5 billion worth of securities, and $1.6 billion in 2011. In 2010 Google first revealed its large securities lending program in a few sentences in its annual report. According to Google’s filing, the company lent out securities worth approximately $2.3 billion over the course of the year. It’s unclear just how long both companies have been on the lending side of this vast market for stocks and bonds. It’s also unclear how many other Internet and technology giants with spare cash are involved, but in doing so these companies are facilitating a specialized trading technique used by hedge funds and other wealthy investors to siphon money from markets.
Securities lending is the necessary first step that sets in motion a multi-hundred billion dollar market in borrowed stocks and bonds, mostly shares of publicly traded corporations. Hedge funds, private equity firms, and other secretive investors borrow securities from lenders in order to sell them short. A short sale is simply a bet that the value of a particular stock or bond is going to drop. When a hedge fund borrows the stock and sells it immediately to a willing buyer they are paid the current face value of the shares in cash. If the price subsequently drops they’ll be “in the money,” as they say in the industry. Hedge funds aim to repurchase the shares at a lower price, and when they return the stock to its original owner the hedge fund keeps most of the cash difference between the high sales price, and the lower repurchase price. Borrowing the securities makes it all possible. At least that’s how it’s supposed to work.
Short selling is one of the primary methods that hedge funds use to extract money from markets, especially in bear markets. Although “shorting” stocks has been done for hundreds of years, and while many say that it serves a legitimate price-finding function in financial markets, short selling became a controversial problem during the Financial Crisis. Wealthy investors shorted the stocks of distressed banks and insurance companies to squeeze out billions in value. In the process, many believe the short sellers actually worsened the crisis by driving share prices down and causing liquidity to disappear from some markets.
Between 2006 and 2010 a handful of hedge funds made billions by shorting stocks and bonds. The SEC briefly instituted a ban on the short sale of a few dozen companies’ stocks because of its impact during the crisis, and in Europe there has been talk of outright banning the practice. Many corporate executives hate short selling because it’s used to profit off the decline of their enterprises. Some have accused short sellers of manipulating markets and using the size of their gambles to actually drive down share prices — in a self-fulfilling prophecy.
Short sales were the subject of intense investigations after the stock market crash of 1929. According to Charles Jones and Owen Lamont, economists at Columbia University and Harvard University, a crackdown on short selling by government officials in the early 1930s led many financiers to abandon the technique. The U.S. Investment Company Act of 1940 placed significant restrictions on short selling, but in time the tactic made a comeback.
Lamont, and another economist, Jeremy Stein of Yale University, measured this comeback over several decades by calculating the ratio of the value of shares sold short to total shares outstanding for the NASDAQ stock exchange between 1995 and 2002. They did roughly the same for the New York Stock Exchange. Their study of the NASDAQ showed an enormous bursts of short selling in the early 2000s as the DotCom bubble bursts, and hedge funds came in to squeeze out value from the declining shares of corporations. For the NYSE, between 1962 and 2002 short selling activity increased substantially over the entire time frame, “perhaps reflecting the growing popularity of hedge funds,” for wealthy investors, according to the authors.
As of today short selling is perfectly legal, and hundreds of hedge funds and other wealthy, sophisticated investors employ the risky tactic to make money.
During the burst of the DotCom bubble, and during the Financial Crisis of 2007-2009, hedge funds mostly borrowed the shares they want to short from big custodial banks that hold shares of thousands of companies that are ultimately owned by pension funds, mutual funds, foundations, and other large institutional investors. Institutional investors hold stock for the long haul and don’t care if a price fluctuates over relatively short time frames. The big institutional investors that loan some of their stock portfolio charge a small fee in order to make a profit, and they re-invest cash collateral provided by the hedge funds in safe, short-term bonds for an added return.
Big tech companies are a new player in the short selling food chain. Their entrance is likely due to the enormous un-taxed earnings that many tech companies now command. Tech companies have become so valuable, and they have become so adept at minimizing their effective tax rates, that many are amassing billions in cash. Most tech giants can’t profitably re-invest these piles of cash in their company — by building a new office, factory, or plowing earnings into R&D, for example. Instead corporations like Cisco, Google, and Microsoft are holding this cash “offshore” in tax havens, and investing their treasure into the stocks and bonds of other companies.
Many tech companies now have internal investment offices or specialized subsidiaries that are tasked with managing their billions. These in-house money managers at companies like Apple, Google, and Cisco control more stocks and bonds than most hedge funds and private equity firms, even if their investment strategies are much more conservative. Some companies have upwards of $100 billion in investments, mostly in government bonds, but enough in corporate bonds and stocks to provide a multi-billion dollar source for hedge funds to borrow from.
No tech company contacted for this story would agree to talk about their securities lending operations. Tim Drinan, a spokesperson for Google, the only corporation to respond to an e-mail said, “we’re not able to share any details about the securities lending program beyond what’s in our public filings.”
Little is known about the securities lending operations of cash rich tech companies other than what appears in their SEC filings, and it appears that only a few tech companies have disclosed their operations.
In its most recent annual report with the SEC, Microsoft disclosed its operation that loaned out somewhere in the ballpark of $1.4 billion in stocks and other securities over the last year. Microsoft added that “intra-year variances in the amount of securities loaned are mainly due to fluctuations in the demand for the securities.” In other words, the company’s lending rises and falls depending on the appetite of hedge funds to sell the shares of companies short.
The securities lending market has been opaque for years. There is no way to see who is lending what securities to a particular borrower. Thus if Microsoft, through a custodial bank, is lending shares of Apple to a hedge fund that is betting on the iPhone maker’s decline, there’s no way to tell. If Apple is lending shares of Samsung to a hedge fund that is betting on a fall in the Korean phone maker’s stock, we’re in the dark. Custodial banks sit in the middle of these transactions so it’s very unlikely that any company even knows how its vast holdings of stocks are being lent out, and to whom, other than in very broad-brush strokes.
The major stock markets do track short selling in the aggregate, and for individual stocks, but they do not report who is lending and who is borrowing. In August the technology heavy NASDAQ reported that 6.9 billion shares of 2,128 companies listed by the exchange were being sold short. Microsoft, Cisco, and Google each saw 63 million, 53 million, and 4 million of their shares traded in short selling strategies, respectively. Indeed, some of each company’s shares sold short may have been provided to hedge fund arbitrageurs out of their competitors’ securities lending operations.