From the Lending Desks: Equities

The equity market rally continued into the third quarter. Although a positive for balances as values increased in line with the market, the rally resulted in a lot of short covering and a lack of new directional trades. Borrowers were active in refinancing loans (returning loans at high fees to re borrow at new lower fees) in those stocks experiencing lower demand due to short covering. Although balances remained strong, revenue was negatively impacted by declining spreads/fees. Many equity market participants continue to anticipate a market correction on concerns that share prices have outpaced earnings growth. Markets did fall back slightly before quarter-end, and prime brokers reported some increase in directional trading on the back of a possible correction.

In the U.S. equity market, the Citigroup arbitrage trade closed, ending one of the most profitable loan opportunities in a long time. The U.S. Government took a 34% stake in the company, as preference shares converted to common stock. The Citigroup trade accounted for a significant proportion of US equity lending revenue in second and third quarters. Revenue fell significantly at the end of July when the trade ended.

Continuing the trend from the second quarter, capital raising by companies drove demand. Capital-raising included rights and convertible bond issues, and share placements. Directional trades were still amongst the biggest revenue earners in the financial, retail, technology, shipping, gaming and alternative energy sectors.

On the regulatory front, Italy lifted the remaining restrictions on naked short selling at the beginning of August (other than for companies that had already announced a capital-raising). France extended the ban on naked short selling of financials until January 2010. In the U.S., the hard close out rule 204T became permanent, having made a significant impact on reducing fails in the market. Talk of a 'hard locate' requirement generated concern, as implementation would be very difficult. The market views the concept as redundant after the close out rule was made permanent. As mentioned in the regulatory update at the beginning of the newsletter, J.P. Morgan remains engaged with regulators with respect to any additional restrictions on short selling.

The environment for hedge funds continued to improve as redemption requests declined and performance remained strong. The number of hedge funds reached 2006 levels, creating more opportunities for those that have survived, and leading to some start up funds spinning off from the larger firms. Strategies that have done well include equity long-short and convertible arbitrage (up as much as 30%). The worst-performing strategy has been dedicated short selling (down 20%). The quarter ended with an announcement from the SEC and FSA to explore a common approach to hedge fund regulation.

Asia-Pacific

Directional demand centered in the financial, shipping, building/materials and consumer sectors. High revenue earners included Golden Eagle Retail Group (Hong Kong), Alibaba (Hong Kong), Angang Steel & Shipping Container (Hong Kong), Fairfax Media Limited (Australia), Rio Tinto Ltd (Australia), Leighton Holdings (Australia), Ten Networks Holdings (Australia), Western Areas NL (Australia), Resona Holdings (Japan) and Mitsubishi Motor Corp (Japan). Asian and Japanese markets were active with capital-raising trades, including Mizuho Financial (Japan), Orix Corp (Japan), Elpida Memory (Japan), and Genting (Singapore), amongst others, and in Hong Kong we saw continued interest to borrow H shares to hedge Chinese A share positions. Australia was quiet apart from arbitrage trades on company dividend reinvestment plans, with demand for stocks that included Commonwealth Bank, Brambles and Lend Lease. Toward quarter-end, borrowers began the process of switching out of high dividend Japanese domestic stock into low dividend international shares for the September 30 record date. In previous years, there has been demand for yield enhancement trades, but due to high funding costs and low yields, interest has disappeared this year.

Europe

Lending activity in Europe declined in the third quarter, as the main European dividend season drew to a close. Some large dividend paying shares did remain, most notably France Telecom and ENI, plus interim dividends in Netherlands and Spain. In general, borrowing demand continued to be driven by directional trades in the financial, alternative energy, retail/consumer and building materials sectors, together with arbitrage opportunities created by companies raising capital (e.g. rights issues, convertible bonds and placements). Continued concern about European banks' exposure to the Baltic and Eastern European States and the expectation that the European banks will need more capital created heavy directional interest, and meant that financials were the best-performing sector from a revenue perspective. However, several banks, including Banco de Sabadell and Bco Popular Español (both Spain), Commerzbank (Germany) and OTP Bank (Hungary), did experience share prices rallies, leading to short covering and reduced borrower demand. Q-Cells (Germany), Amer Sports (Finland), Immofinanz (Austria), A3TV (Spain) and Solar World (Germany) were also high revenue generators. Q-Cells, one of the highest revenue generators, is a directional trade off the back of poor earnings and poor outlook for the European solar power industry. Capital-raising trades included companies such as Soitec (France), Swedbank (Sweden), National Bank of Greece, Bco Popular (Spain), Heidelberger Cement (Germany), Wienerberger (Austria) and BNP Paribas. Demand for Volkswagen shares increased after the announcement of its takeover of Porsche, with fees increasing over the quarter as the stock lost 50% of its value and Qatar Holdings took a large stake in the company.

U.S.

In the U.S. equity market, the Citigroup arbitrage trade closed, ending one of the most profitable loan opportunities in a long time. As the preference shares were exchanged for common stock, arbitrageurs quickly closed out their shorts bringing about an abrupt end to the trade, and having an immediate impact on revenue. Loan balances were not impacted, as the position was relatively small. After the Citi trade ended, companies such as Sears, AIG, M&T Bank and Synaptics became the biggest revenue earning securities. AIG fees have increased this quarter on the back of directional interest. Shares of CIT were in demand as it sought to avoid bankruptcy (although borrowing interest declined later in the quarter). In general, fee levels were volatile in all these names, as demand waxed and waned. A slight increase in M&A activity toward the end of the quarter (e.g. Disney/Marvel, Kraft/Cadbury, Adobe/Omiture, etc.) did not create significant lending opportunities, but the uptick in deal activity was encouraging. Cash reinvestment rates continued to decline in line with Libor, negatively impacting revenue. The Fed Opening rate, which is the benchmark for U.S. equity rebates, consistently opened below the target, leading to lower rebates on general collateral loans. Overall, balances continued to grow in line with the equity market rally, bouncing back strongly from March lows.