From the Lending Desks: Equities

Market Recap

After a brief start-of-year rally, equity markets were soon in negative territory again, before ending the quarter with moderately increased investor optimism. Equity markets fell 15 to 25%, reaching their lowest levels of the crisis in early March, on the back of dividend cuts and concerns about financial companies. Toward quarter-end, economic data suggesting that the pace of the economic decline had started to ease, positive news regarding early-year revenues from financial companies, and optimism after the G-20 summit cumulatively helped spur a strong rally in the market. However, speculation that the rally was driven by short-term traders rather than by long-term investors suggested that investor sentiment had not substantially improved. At quarter end, equity prices remained down by 40 to 45% versus one year ago.

The regulatory environment continued to be challenging, with an ongoing focus on short-selling. Although we had hoped the short-sale bans would largely expire by the end of the first quarter, several countries, as detailed below, continued to restrict naked and covered short-sells. When the bans are lifted, we expect heightened oversight and new regulations. Several reviews of short selling are either in progress or have reported initial findings, and the International Organisation of Securities Commissions, a forum for regulators, proposed common principles to help create a globally consistent approach to short selling.

Hedge fund performance generally improved, redemptions declined, and some investors increased their exposure to the sector. Trading activity amongst the funds also moderately increased, although remained at historical lows. Because hedge funds were long cash (i.e., not fully invested), borrowers continued to prefer cash collateral, reflecting a complete reversal from quarter three and four 2008, when noncash was preferred.

Europe, Middle East and Africa

Active first quarter deal activity throughout Europe and particularly in the U.K. emphasized capital-raising as companies sought to shore up their balance sheets. Rights issues by companies such as HSBC Holdings Plc of the United Kingdom, SEB AB and Nordea Bank AB of Sweden, Compagnie de Saint-Gobain of France and by the U.K. REIT sector offered significant discounts to market prices, leading to arbitrage and directional trades. Although M&A activity in the U.K. was at its lowest since 2004, at roughly half of its 2008 level, arbitrage opportunities created by takeovers generated further borrowing demand. The U.K. government bailout of RBS Group and Lloyds Banking Group did not generate increased lending to those companies; instead, investor demand focused on Barclays and HSBC. Deutsche Bank AG became the most heavily shorted stock in Europe when it announced a fourth quarter loss. Commerzbank AG came in second place, with heavy losses in its Dresdner unit, acquired in January. Other financials in demand included Banco Popular Espanol and Banco De Sabadell of Spain, and SEB AB of Sweden, off the back of its rights issue. Outside of financials, Actividades de Construcción y Servicios SA of Spain, EADS of France and Volvo AB of Sweden all generated high revenue from trading activities.

The European dividend season brought lower or cancelled dividend payments, with overall revenue lower than 2008. Markets traded include Finland, Sweden and Switzerland, along with some early-paying German stocks.

Several countries continued to restrict the short-selling of financial companies, banning naked short sales in Austria, Belgium, France and Germany, and covered and naked short sales in Italy and Netherlands. Switzerland and the United Kingdom both lifted their restrictions.

Western Hemisphere

U.S. equity activity focused on directional trading of financial and auto stocks, with deal activity almost nonexistent. Sentiment swung between positive and negative, depending on the latest news, as government bailout plans were announced and analyzed by the market. Citigroup Inc became J.P. Morgan’s highest earning security in March as the U.S. Government announced its intention to convert its holding in the company from preferred to common stock. Ford Motor Co traded special the entire quarter with revenue spiking in March, as the deadline for its debt for equity swap approached. Levels dropped rapidly once the swap was completed and additional shares hit the street. General Motors Corp traded at very high fees the entire quarter, as the possibility of a structured bankruptcy increased. Other high-earning securities included M&T Bank Corp, Sears Holdings Corp, Factset Research Systems and Wynn Resorts Ltd. General collateral balances remained under pressure as agent lenders competed for cash to fund investments. General collateral continued to trade at or above the Federal Funds Open rate, compared to a spread below the rate during normal market conditions. Outside of the U.S., Wal-Mart de México was a directional trade, earning good revenue throughout the quarter.

As with equities, American Depositary Receipt trading focused on directional demand, especially in the Far East and in the alternative energy and entertainment sectors. Highest-earning securities included LDK Solar, Suntech Power, Yingli Green, Shandra Interactive and Melco Crown Entertainment. Yield enhancement activity resembled that of other international markets, with good demand from borrowers, but revenue significantly impacted by lower dividend payments.

Asia Pacific

Directional and dividend trading in pockets of Asia Pacific generated favorable lending activities, although continued short selling restrictions in Australia and South Korea weakened regional demand. First quarter saw strong demand for dividend trades, with borrowers trading the arbitrage created by the stock discount on dividend reinvestment plans. CapitaMall Trust of Singapore announced a rights issue leading to strong borrowing demand. In Japan, balances increased due to the end of March dividend record date, as borrowers swapped domestic loans into low-dividend offshore stock (i.e., reducing dividend cost of their shorts). On the specials side, high revenue earners included Resona Holdings, Mitsubishi Motor Corp and Mizuho Financial for convertible arbitrage and directional trades. Hong Kong was our most active market with directional trading in the sectors hit by the recession and credit crunch. Top earning securities included Industrial & Commercial bank of China Ltd, China Construction Bank Corp, China National Building Material Co and Alibaba.con Ltd.

Proposals to restrict fails pose longer term challenge, if implemented. Singapore announced a proposal to buy in failing trades on settlement date, effectively giving an investor only until noon to settle a transaction. If this proposal is adopted, it will make lending very difficult, with a very short timeline to settle a loan return and a client sale. South Korea also demonstrated concern over fails.