From the Lending Desks: Equities

The fourth quarter started well with equity markets hitting 12-month highs in October. In November, markets were weaker on concern that the financial sector still had a lot of problems (e.g., Lloyds and RBS of U.K. capital raising announcements, large reported losses at UBS, and CIT Group bankruptcy), fear of an early withdrawal of government stimulus packages and concern about the strength of the economic recovery and company earnings. In December, markets strengthened, closing at or close to 2009 highs. As mentioned previously equity market rallies, led to a lot of short covering and refinancing by borrowers.

As reported in our hedge fund commentary, in general, hedge funds had a good 2009 with average returns of 12%-18% across the sector. Convertible arbitrage funds led the pack, returning more than 50%, with equity long/short returns averaging 20%+.  The worst performing strategy was dedicated short-bias that index data indicated ended the year down 20%. As the year drew to a close, hedge funds focused on holding onto gains and were reluctant to add any new risk to their trading books. Activity at year-end was more reactionary and event-driven (e.g., corporate events like M&A, capital raising, etc.).

Specials activity increased in the United States with several large new revenue-generating trades, including Mead Johnson Nutrition Co, AIG and Barnes and Noble. Internationally big revenue generating specials were thinner on the ground with declining directional interest in the financial sector (e.g., Banco De Sabadell and OTP Bank) and less profitable opportunities in capital raising trades.

End of year dividend season was the main driver of international balances and revenue. Demand and revenue was significantly higher than last year, which was severely impacted by the credit crisis and various restrictions on short selling. Markets of note included Italy, France, Spain, Netherlands and U.K.

In November, J.P. Morgan executed its first Taiwanese equity loan. Taiwan is a nonstandard market requiring client sale prenotifications and the reporting and payment of tax on lending transactions. However, the market has proved to be very profitable for those clients that can accommodate these requirements.

In summary, 2009 was a very tough year for equity lending with lower dividend revenue, more short covering due to the equity market rally and a lack of big deals. Positives for the business included the large number of capital raising deals, especially in the financial sector, the Citigroup arbitrage trade, which was the single most profitable stock of 2009, and the equity market rally that increased the value of loan balances (although, as already mentioned, also led to short covering).

Our 2010 outlook is positive on many fronts: analysts predict an increase in M&A and IPO activity; prime brokers report that, off the back of a good year in 2009, hedge funds will have money to invest and will trade more actively than in 2009; and the market expects a continued equity rally with a strengthening global economic recovery. There will however still be headwinds. Most significantly, we expect company dividend payments to be down again in 2010, although not as dramatic a reduction as in 2009.

Asia-Pacific

The big news in Asia this quarter was the launch of our Taiwanese equity lending program. This has proved to be a very profitable market with good demand and high fees. However, it is a nonstandard lending market in that clients have to prenotify J.P. Morgan of any sales (due to mismatch in the timing of purchase and sale settlements) and tax has to be reported and paid on lending transactions.

In Korea, changes to the timing of optional corporate actions, specifically Board of Director Merger Consent and Repurchase Offers, have created challenges in the market. The Korea Securities Depository (KSD) does not support these types of events for securities on loan, and changes to the timeline means loans cannot be closed out and securities returned in time for clients to qualify for the corporate action. The solution is to close out the loan and sell the stock back to the borrower for the tender price, a process which we are currently formalising with clients and borrowers.

In other news, we had some Australian dividend activity. ANZ Banking Group, Westpac Banking Corp and NAB Ltd were the most notable trades as borrowers traded the arbitrage opportunity on the dividend reinvestment plan (DRIP). In general, 2009 DRIP trading returns were consistent with 2008 as clients had a preference for the cash option (election that enables the arbitrage) and demand was strong from borrowers. Other top earners in the region were mainly off the back of directional trades and included: China Zhongwang Hdgs, Angang Steel Co, China Shipping Container Lines, BYD Co and Alibaba.com in Hong Kong, GS Yuasa Corp, Mitsubishi Motors and Mixi Inc in Japan, and Genting Singapore for both the rights issue and directional trades.

Europe, Middle East, Africa

The fourth quarter was an active period for dividend trading in Italy, France, Spain and Netherlands. Last year business was severely impacted by the credit crisis and short selling restrictions. Italy and Spain were hit particularly hard last year due to the uncertainty about whether a client selling a position on loan was considered a short sale. With comfort provided on the status of client sales and more recently the final part of the Italian ban removed (restriction on companies involved in a capital raising), demand and pricing levels were good this year. Big revenue generating positions included: ENEL, Atlantia & SNAM in Italy; Total SA & GDF Suez in France; Telefonica & Repsol in Spain; and Unilever & Royal Dutch Shell in Netherlands. In addition, HSBC of the UK was lent for a scrip dividend arbitrage trade, with clients taking the cash option able to benefit from a revenue pickup. Also in the UK, Lloyds Bank announced a rights issue to strengthen its balance sheet and avoid having to take a government guarantee. Issue was at a deep discount to the market price, creating an arbitrage opportunity and good demand to borrow shares.

Across Europe, other financial institutions also announced capital raising in an effort to repair balance sheets, improve capital ratios and pay back government bailout money (e.g., ING Groep of the Netherlands, Erste Bank of Austria, DnB Nor of Norway and Alpha Bank in Greece). All were in demand from borrowers. British Airways of the U.K. became one of our top earning stocks this quarter with directional interest from borrowers on the back of its well publicised problems. Greece was in the news as its credit rating was downgraded on concerns about its budget deficit; however, we did not see any noticeable increase in demand for Greek equities. Other top earning stocks included Q-Cells & Solar World in Germany (alternative energy directional trades), and Immofinanz in Austria (property directional/merger play). Demand for Immofinanz was high on plans to merge with Austria’s other large property developer, Immoeast. In general, the sectors most in demand were financial and alternative energy.

Americas

Specials activity increased in the fourth quarter. . The most notable special was the spin off of Mead Johnson Nutrition Co in an exchange offer by Bristol-Myers Squibb Co. This presented lending opportunities for shares of Mead Johnson and non-tendered Bristol -Myers. MJN briefly became the highest revenue-earning stock prior to the deal closing on December 22. Barnes and Noble traded special due to a lack of liquidity in the lending market as borrowers tried to cover directional shorts and, not for the first time, AIG & Freddie Mac became special as directional interest picked up. Other more long-standing specials that continued to drive revenue included: Sears Holdings, M & T Bank, Synaptics, Buckle Inc, First Solar Inc and Chipotle Mexican Grill. Citigroup repaid its TARP money in December, generating demand to borrow the shares, but the stock was very liquid and thus, was not a big revenue generator. ADR dividend trades gave a boost to revenue. Notable trades included Total of France and Brookfield Properties of Canada. Cash reinvestment rates remained at depressed levels, negatively impacting revenue, and the Fed continued to open below the target, resulting in low general collateral rebates and low overnight reinvestment rates as repo tracked the open. However, our non-cash book gained some traction and expanded significantly this quarter, as did the amount of business matched against equity repo on the reinvestment side. Both transactions are attractive to borrowers from a balance sheet perspective.