From the Lending Desks: Equities

Overview

Global equity markets rallied from their March lows, helping balances and revenue for non-dividend related trades. The equity rally was driven by: pledges from G20 leaders at the London summit to give the IMF one trillion dollars to fight the global economic crisis; reduced risk of further bankruptcies or government bailouts of financial firms (confirmed by good stress test results); and the market sentiment that stability is returning. The biggest beneficiaries of the market rally were stocks that had been hit hardest in the bear market (e.g. financials, retail & automakers). The downside was that rising shares prices caused short covering, resulting in borrowers refinancing loans and driving down fees on specials.

Lending activity focused on the large number of companies raising capital, as they looked to strengthen their balance sheets and pay down debt. Arbitrage and directional opportunities created by rights and convertible bond issues resulted in borrowing demand for shares of the issuer. CB arbitrage in particular had a terrible year in 2008, and has bounced back strongly in 2009 as issuance has increased.

Hedge fund performance continued to improve, but borrower demand remained subdued. Higher hedge fund returns led to fewer redemptions and some money being invested back into the markets by funds (as the need to hold cash to cover redemptions lessened). However, a lot of money still appears to be on the sidelines due to risk aversion, with more short term trading off the back of market volatility and little conviction on market direction that would result in longer duration and more stable loans.

Asia Pacific

Australia and South Korea relaxed short-selling restrictions, supporting the return of favorable lending conditions. Australia removed the covered short-selling ban on financial stocks at the end of May, providing a big boost to the lending market. Although all Australian shares can now be shorted, uncertainty remains regarding how investors prove they are able to cover the short sales. South Korea also removed the covered short-selling ban for non-financial stocks on June 1. This will be positive for the lending market, but it will take time for trading activity to increase.

Rights issues in Australia (Rio Tinto Ltd) and South Korea (CapitaMall Trust and Golden Agri-Resources Ltd) brought a welcome return of lending activity. Rio Tinto Ltd was expected to merge with the Aluminum Corporation of China, but ultimately entered into a joint venture with BHP Billition Ltd facilitated by a rights issue. Demand to borrow Rio Tinto shares for the rights issue was strong, reversing the declining balances the Australian market has experienced since the beginning of the financial crisis. Singapore was also active with right issues in CapitaMall Trust and Golden Agri-Resources Ltd. We remain concerned about Singapore regarding the exchange’s proposal to initiate buy-ins on the settlement date, which would not allow enough time to settle client sales with shares being returned from a loan. The industry raised its concerns and continues to lobby SGX.

Loan balances declined in Japan, but remained strong in Hong Kong. Balances in Japan came off rapidly after the March dividend record date, as borrowers flipped loans back into the domestic market (from cheaper dividend international lenders). Hong Kong balances remained strong with capital raising by companies generating new loans (e.g., China Resources Power Holdings, Bank of China and China Construction Bank). Rallying share prices in Hong Kong led to short covering in the financial sector and resulted in borrowers refinancing specials to lower fees, and closing out loans (e.g., ICBC Ltd, China Merchants Bank Co Ltd and Bank of Communications Co Ltd).

Europe

Lending activity in Europe focused on the dividend season and the second quarter increase in capital raising. European dividend season peaked in April and May with greater than expected demand. Corporate earnings, however, were significantly down year over year, and many companies made large cuts to their dividends to conserve capital. Lending revenues were thus also down year over year. Companies further tried to pay down their debt with active capital raising, including rights and convertible bond issues. The issues produced arbitrage and directional opportunities and increased borrowing demand for shares of the issuer. A capital raising can significantly increase the demand for a directional short due to the dilutive effect of the capital raising on the share price. Europe and the U.K. were particularly active due to capital raising by companies (e.g., Danone S.A, Pernod Ricard S.A. and Imerys S.A in France, Debenhams Plc and Anglo American Plc in the U.K., Bulgari Spa in Italy, and National Bank of Greece). As issuance has increased in 2009, CB arbitrage has bounced back strongly, following a terrible year in 2008.

Financials overall continued to be in demand for directional trades. Exposure to Eastern Europe and the Baltic states, particularly amongst Swedish and Austrian banks (e.g., SEB AB of Sweden and Erste Bank AG of Austria) resulted in strong borrowing demand and high fees. High demand existed for Germany’s Deutsche Bank and Commerzbank Bank, with the latter’s takeover of Dresdner and the associated losses driving directional demand.

Greece, Netherlands and Italy relaxed short-selling restrictions, while Germany extended them. Greece and the Netherlands removed their short-selling bans on financial stocks, and Italy removed its ban on covered short selling of financial shares except for companies that have announced a capital raising (until the new issue is complete) and for naked short sales. Germany extended its ban on naked short selling on financial stocks until January 1, 2010.

U.S.

The Citigroup Inc special and the conclusion of the GM bankruptcy dominated second quarter equity market activity. Citigroup started to trade with a lot of value at the end of February on the announcement that investors, including the Government, would swap preferred shares for common stock in order to improve the bank’s capital position (e.g., Tangible Common Equity and Tier 1). This created an arbitrage opportunity as investors went long the preferred and short the common stock. Citigroup will close the exchange offer at the end of July, ending the lending opportunity. Throughout second quarter, old loans were rerated to reflect increasing borrower demand. Shares of General Motors Corp (GM) also generated significant borrower demand as investors bet the company would eventually file for bankruptcy and the common shares would become virtually worthless. GM entered Chapter 11 in June, signalling the demise of the lending opportunity as clients sold their positions and loans were recalled. The GM position had been one of the top-earning stocks of recent times, trading special on several occasions over the years.

The market rally led to short covering and borrowers refinancing their loans, lowering overall fee revenue for select trades versus first quarter (e.g., M&T Bank Corp, Sears Holdings Corp and Alliance Data Systems Corp). Secondary offerings and convertible bond issuance were very active this quarter, contributing to a decline in special fee revenue (e.g., MGM Mirage and Wynn Resorts). As investment yields continued to decrease on the cash collateral reinvestment side, we amended our U.S. equity general collateral rebate rate. Previously pegged at the Fed Funds opening rate, we started to charge a spread off that benchmark rate. Shortly thereafter our major competitors followed our lead.