From the Lending Desks: Equities

Highlights World lending markets were constrained by plunging equity markets, deleveraging, hedge-fund redemptions and closures, and short-selling bans. In addition to pressures felt globally, the U.S. equity lending market faced a challenging cash collateral environment in the fourth quarter, as the fed funds rates opened as low as 0.04% and general collateral loans were priced off the target instead of the traditional open as agent lenders competed for cash to fund reinvestment programs. A dislocation between the fed funds opening rates and overnight repo, relative to the fed funds target, resulted in challenging conditions for loans collateralized by cash, especially for those clients with overnight cash reinvestment guidelines. Short-selling bans continued around the globe, although unevenly, as some countries relaxed their bans (U.S., Australia) while others extended theirs into 2009 (France, Germany and Greece). Although the fourth quarter was extremely challenging, the year overall has been a good one for equity lending. Markets that were particularly profitable included Australia, Hong Kong, U.K. and U.S.

John Shellard Global Head Equities

Market Recap
Although the Lehman bankruptcy during the third quarter 2008 was the year’s defining moment, it was in the fourth quarter that we felt the full impact of that event, with shell shocked investors and financial firms, and a rapid contraction of credit globally. In October, equity-loan balances embarked on a quick and rapid decline. By the end of the year, depending on the market, balances were 40% to 60% down from their peaks. Plunging equity markets, de-leveraging, hedge-fund redemptions and closures, and short-selling bans all contributed to the decline.

Hedge Funds went long cash, with estimates as high as 50%, to cover large investor redemptions and to protect capital. The alleged Madoff fraud was a further blow to an industry already under pressure, particularly the fund-of-fund sector, which is supposed to filter out poorly managed funds and diversify investor risk (objectives that several fund-of-funds failed to achieve). Even with this bleak news, hedge funds on average still performed better than equity markets and long-only funds, with losses of roughly 20%.

Struggling financial institutions and government bailouts kept the focus very much on counterparty risk management, as our business analyzed the terms of any deals and the likelihood of government bailouts.

Borrowers started to switch from government bond collateral back to cash, reversing the trend from earlier in 2008, as the flight-to-quality made sourcing government bonds expensive. Of course, the preferred collateral overall continued to be equities. Given how quickly collateral preferences can change, clients that can be flexible in terms of lending guidelines stand to benefit most. In general, we saw a reduction in the size of the term book, as borrowers became nervous about committing balances as business rapidly unwound.

Heightened competition for cash collateral among agent lenders, who needed to fund cash reinvestment programs as interest rates headed towards zero in the U.S., resulted in very high rebates being paid by some. The dislocation between the fed funds opening rates and overnight repo, relative to the fed funds target, resulted in challenging conditions for loans collateralized by cash, especially for clients with overnight cash reinvestment guidelines, as some of those clients may have experienced negative earning loans.

The short-selling bans continued around the globe. As the U.S. and Australia relaxed their restrictions, other countries extended theirs into 2009. Support for short-selling gained strength as academics and market participants spoke out about the benefits of short selling (e.g., liquidity and price discovery). Data indicated that the bans had not had the intended effect on equity prices, given that prices still declined and many banks still needed to be bailed out.

In general, we saw an overall lack of deal and IPO activity, with global M&A down 30% from 2007. A lot of the deals that were done were of course concentrated in the financial sector.

Although the fourth quarter was extremely challenging, the first three quarters were so strong that overall the year has been a good one for equity lending, with the Australian, Hong Kong, U.K. and U.S. markets the most noteworthy.

APAC
Two of the largest lending markets, Japan and Hong Kong, did not impose short-selling restrictions, which meant business as usual. Toward the end of the quarter, Japan imposed additional disclosure requirements on sellers, such as the need to advise brokers of the custodian holding the shares. Japan closed the year down 42%, marking its worst ever performance, as exports crashed and GDP contracted sharply.

Hong Kong has long had a regulatory environment that has tracked short-sale and lending activity, and the industry view is that this has helped the authorities in deciding not to impose any blanket bans. Hong Kong has been a very active market for lending, with high utilization levels, even in the fourth quarter.

In general, the hedge-fund market is driven by long/short, long only and convertible bond funds, so a lot of the short-selling activity is to hedge long equity and CB positions.

We had some relief in Australia, where the ban on short selling of non-financial stocks was lifted on November 19, 2008. There was an initial pickup in lending, but unfortunately, it did not last. Also in Australia, BHP Billiton Ltd. decided not to proceed with its takeover of Rio Tinto Ltd. Both stocks had been in demand.

Taiwan also announced its intention to remove the short-selling ban at the start of the new year, commenting that shorting reflects market forces and is not as “horrible” as some may think.

In general, across the APAC region, sectors in demand included financials, retail, commodities and mining. Highest-earning stocks included Macquarie Group Ltd., Leighton Holdings Ltd., Bank of China, Alibaba.com Ltd., ICBC and Sumitomo Mitsui Financial Group.

EMEA
Several countries imposed short-selling bans that negatively impacted lending, mainly in financial stocks, as European governments moved to bail out their banking sectors. In the markets in which we lend, these included: Austria, Belgium, Denmark, France, Germany, Greece, Ireland, Italy, Netherlands, Norway, Spain, Switzerland and the U.K. Most were due to expire at the end of the year or in early January. However, regulators appear to be cooperating and extending deadlines out to the end of the first quarter 2009. At the time of this writing, the following countries had extended their bans, with more expected to follow: Belgium (March 20), France (at least until end of February), Germany (March 31), Greece (May 31) and Switzerland (until further notice).

The end of year is an active dividend trading period and performance this year-end was mixed. In general, demand and levels were down from levels set in 2007. This is a trend we expect to see continue into 2009, with fewer counterparts due to bankruptcies and mergers, continued pressure on borrowers’ balance sheets and lower company earnings leading to lower dividends.

The main dividend-paying markets in the fourth quarter included France (with Total SA being the largest position), Italy (ENI and ENEL being positions of note) and the Netherlands (Akzo Nobel and Unilever being positions of note). On the specials side of the business, one of the most talked about trades was a long term short by hedge funds in the German auto company Volkswagen AG, as they bet the ordinary shares would fall in value relative to the preference shares. However, as Porsche unexpectedly disclosed in October that it had taken a 74% controlling stake in the company, there was a massive short squeeze and the price of the ordinary shares quadrupled in two days as short sellers were forced to cover positions at a massive loss. Lending fees also spiked as borrowers tried to cover shorts.

The collapse of the Icelandic financial sector and its currency led to a flight of direct foreign investment from European emerging markets and companies exposed to Iceland. We experienced increased demand for companies such as Swedbank AB (exposure to Baltic states), OTP Bank Hungary and PKO Bank Polski, and overall balances increased in the Czech Republic, Hungary, Poland and Turkey, bucking the trend in the mature European markets.

We are pleased to announce that we added Ireland as a new market in the fourth quarter. Prior to the short-selling ban, the main interest was in financials, such as Anglo Irish, with current demand focused on construction companies.

In general, across the EMEA region, sectors in demand were financials, retail, auto makers, construction/housing and energy/commodities. The highest-earning stocks were generally dividend related and included the French companies Total S.A, BNP Paribas and Societe Generale and the Italian stock ENEL SPA. Outside of dividend names, Volkswagen AG, Renault, Hermes International, Deutsche Telekom A.G and Deutsche Bank were big revenue generators.

U.S.
In addition to the challenges facing all equity lending markets this quarter, including falling markets and a wave of hedge-fund redemptions, the U.S. equity market faced a challenging cash-collateral environment. Typically, the business is priced off the fed funds open rate, but this consistently opened below the fed funds target. For example, in November, after the target was dropped to 1%, funds opened well below that level, at roughly 0.25%, and, in December, opened as low as 0.04% on the last day of the year. However, due to competition among lenders for cash collateral business to fund reinvestment programs, general collateral (GC) loans were priced off the target instead of the traditional open. The overnight repo markets of course traded closer to the open than the target, which meant clients that invested heavily or solely in overnight repo were not able to participate in GC loans. Although this issue affected the international equity markets as well, the impact on the U.S. business was greater, as the U.S. is almost exclusively a cash collateral market.

During the quarter, we also saw a significant decrease in our term balances due to a combination of borrowers not wanting to commit to balance (given business levels were falling so rapidly) and the competition paying extremely high rebates to support aggressive cash reinvestment programs. On the specials side of the business, deal activity was extremely slow, as global M&A activity declined 30% from 2007 and the IPO market completely dried up. This left the bulk of the specials demand to directional trades in the financial, retail, gaming, auto and housing sectors.

Despite the expiration of the short-selling ban in the U.S. on October 8, 2008, there was no pickup in lending activity. The biggest-earning stocks included Sears Holdings Corp, Ford Motor, Wynn Resorts Ltd, Wells Fargo & Co and Vulcan Materials Co. In American Depositary Receipts (ADRs), we saw good demand for emerging-market companies, especially in commodities, as they were hit by the global slowdown. These included Lukoil, Surguteftegaz and CPFL Energia. Also in demand were alternative energy stocks such as Suntech Power Holdings, Trina Solar Ltd and LDK Solar Co Ltd.

2009 Outlook
To a certain extent, we expect a continuation of some of the issues we saw in the fourth quarter 2008. We certainly view 2009 as being a challenging year, and would not expect to see a material recovery in business in the first two quarters. The recovery will be slow, but eventually, the focus on the demand side should shift from survival and conserving capital to taking risk and generating revenue. Factors impacting the business include:

• Fewer players in the market, including both investment banks’ proprietary trading desks and hedge funds, leading to a reduction in demand for certain trades. In addition, assets under management at hedge funds have reduced significantly, as has leverage. The alleged Madoff fraud has resulted in an additional wave of redemption requests in first quarter 2009, requiring funds to maintain high levels of liquidity.
• Equity markets fell 40 to 50% in 2008. Deal activity will continue to be low. We anticipate a recovery only once investors perceive that all the bad news has run its course. We expect that there is pent-up demand to do deals once markets have bottomed out, as companies look cheap after such large share price decreases.
• Given the lack of deal activity, we expect demand to be directional in sectors like financials, commodities, construction and housing, retail, alternative energy, gaming and auto makers.
• We expect companies to pay lower or no dividends in 2009. In addition, reduction in demand will negatively impact some yield enhancement business.
• Collateral flexibility will continue to be paramount, as the cost to borrowers changes.
• The regulatory environment should continue to be challenging. While short-sale bans should be largely gone by the end of the first quarter 2009, there will likely be heightened oversight and new rules with which to contend.