From the Lending Desks: Equities

The expected increase in hedge fund activity in the first quarter did not materialise. At the end of 2009, the prime brokers were very optimistic their clients would step up trading activity and add more risk to their books. A combination of factors has discouraged this (e.g., continued regulatory uncertainty, sovereign default risk on the back of the Greek crisis, concerns about the strength of the global economic recovery and a premature withdrawal of stimulus government measures, etc.).

Equity markets had a couple of significant anniversaries in March. It was ten years since the NASDAQ peaked on the back of the dotcom bubble, followed by the crash and the eventual drop by nearly 80%. Equities also marked the 1 year anniversary of the bottom of the most recent bear market, having enjoyed their best 12 month performance since the 1930’s with the S&P up over 60% from its March 9th trough. Both these events of course had a significant impact on the lending business resulting in reduced activity and lower loan balances, and although the business has recovered from last year’s lows, balances and revenue have still not recovered to pre-crisis levels.

Concern about the risk of a sovereign default in Greece fed through to the equity market, which fell to a 10 month low at one point. We did see an increase in borrowing demand, particularly in Greek financials which act as a proxy for the health of the overall economy. This concern was furthered by the risk of contagion to Portugal, Spain, Ireland and Italy, with Spain and Portugal falling to 14 month lows, and of course all this was negative for the Euro.

European dividend season started in earnest, with borrowers looking to secure supply ahead of the peak months of April and May. In general, demand is good and levels are up on 2009, although there have been challenges with changes to tax legislation and the cancellation/reduction of dividend payments by certain companies.

Europe, Middle East, Africa

In the UK, British Airways became one of our top revenue generating stocks, with three different trades driving demand: Iberia merger, directional on the back of industrial action by employees and concern over pension fund liabilities, and convertible bond arbitrage. The other high profile UK trade involved the Kraft takeover of Cadbury. Depending on a client’s election, there was an opportunity to make money lending the shares for arbitrage trades. In Europe, the sectors in demand included alternative energy and banking, with individual high revenue generating specials including QCells (alternative energy directional), Immonfinanz (financial directional), and Commerzbank (financial directional), which experienced a sharp increase in demand off the back of profitability concerns.

European dividend season started trading in the first quarter, although activity will peak in the second quarter, when the bulk of the dividends have their record dates. Early high revenue and balance generating dividend payers included: Siemans and Thyssen of Germany, Santander of Spain, Roche and Novartis of Switzerland, Arcelor Mittal in the Netherlands, Sodexho of France, and Kone and Wartsila of Finland. In addition, due to good early demand from borrowers wanting to fill their seasonal capacity, we committed to loans – which will not settle and start generating revenue until later in the season – in the following countries: Austria, France, Germany, Netherlands, Norway and Sweden. Also traded were UK scrips in companies such as HSBC and Standard Chartered, where clients electing the cash option benefited from increased lending revenue. In general, borrowing demand and levels for yield enhancement trades are up on 2009. In terms of the actual dividend payments, we expect them to be flat to slightly up on 2009 (after large falls last year). Headwinds for the business include a reduction in demand and levels in Switzerland and Denmark, companies cancelling dividends (e.g., Daimler and Deutsche Lufthansa of Germany), and tax changes in Netherlands, Norway and Spain affecting certain investor types.

European plans to regulate hedge funds under the so called Alternative Investment Funds Managers directive made the news, as the UK and US complained about the proposed regulations. At the centre of the dispute are plans to make hedge funds seek permission to operate in the EU (to market to professional investors within the region) and comply with EU rules regardless of where they are based (e.g., on transparency, compensation practices, custody practices, etc.). The US and UK have branded the proposal protectionist and are concerned it will have a negative impact on what is an important industry for both countries.

Asia-Pacific

Expected capital raising in Hong Kong from Chinese financial institutions started to materialise, leading to good borrowing demand in companies such as China Merchants Bank and Bank of Communications. The broader market still struggled to launch new capital raisings and Hong Kong became the first major market to suffer a correction (fall of more than 10%) as the Chinese Government took steps to cool the economy by restricting the availability of credit. Japanese balances started to grow in March as the end of month dividend record date approached, with borrowers swapping out of high dividend domestic stock into cheaper dividend offshore stock. After the recent launch of our Taiwanese lending product, balances continued to grow strongly throughout the quarter. This is currently the hottest APAC market in terms of demand and revenue. In Australia, there was demand for companies with dividend reinvestment plans such as QBE and Commonwealth Bank, with an arbitrage opportunity available for clients electing the cash option. We also had demand for scrip trades in Hong Kong companies, with a cash election clients could benefit from any arbitrage opportunities. Stocks traded included Espirit Holdings, Sino Land and Bank of East Asia. On the specials front, sectors in demand included financial, industrial, communications and consumer discretionary. High revenue generating stocks included Genting Singapore plc (directional), BYD Co Ltd, China Zhongwang Hldgs, China Shipping Container Lines Co and Alibab.com Ltd in Hong Kong (directional), and Jupiter Telecommunications Co Ltd of Japan. As mentioned already, Hong Kong introduced a short position disclosure regime. The threshold is very low at 0.02% as the regulator believes this is required to capture a meaningful amount of data. A good aspect of the rule is that only aggregate data will be disclosed, not individual fund positions.

Americas

Continued low interest rates and the Fed’s pledge to keep them low for an “extended period” helped support the US equity market. Spreads continued to improve as yield enhancement business hit the book, specials activity continued to be strong and we pushed for greater spreads on general collateral (GC) loans. Yield enhancement business was very active, particularly in Canadian companies (e.g., Sun Life, Fairfield Financial, Brookfield Properties, etc.). Philippine Long Distance was another notable large revenue generating dividend stock. Specials demand was primarily directional in nature with very few lending opportunities driven by deals (e.g., M&A, capital raising, etc.). The IPO market did show signs of life toward the end of January with borrowing demand in some, although loans and the underlying IPO’s were small. Sectors in demand included financial, medical, alternative energy and consumer discretionary. High revenue generating specials included Amedisys Inc (directional), Sears Holdings Corp (directional), Synaptics Inc (directional), Realty Income Corp (directional), First Solar Inc (directional), Talbots Inc (M&A). Toward the end of the quarter, supply became tight in certain proxy voting stocks (e.g., AIG), resulting in increased fees.   However, in general borrowers continued to actively refinance where they could, resulting in high loan turnover. As already mentioned, the SEC introduced a restriction on short selling a stock once the price had fallen 10% from the previous day’s close. Once the threshold is triggered, traders can only execute short sales at a price above the market’s best bid. The rule becomes effective the end of April and brokers have 6 months to be in compliance (e.g., enhance systems). Market opinion from the demand side appears to be that this will have a limited impact on demand.