From the Lending Desks: Equities

General

Main drivers of demand continued to be directional with some capital raising and deal activity, together of course with dividend trades. Sectors driving revenue include financial, consumer (cyclical and non-cyclical), industrial and energy.  In the US the consumer sector is most in demand, whereas internationally it’s financials. Non-dividend related business is slow due to a lack of hedge fund activity. European sovereign debt crisis, regulatory uncertainty, concerns about a double dip recession, etc, mean hedge funds are lacking in conviction and are wary of putting on new trades.

Equity markets had a volatile quarter, starting off well in April but falling in May as the Euro sovereign debt crisis took centre stage. Euro Stoxx 600 fell 7.6%, Hong Kong’s Hang Seng fell 5.2%, Japan’s Nikkei fell 15.4% and US S&P 500 fell 12% in Q2.

Regulatory - Greece banned naked and covered short selling in all securities on 28th April. The German market regulator BaFin moved to ban naked short selling in 10 German financial stocks, together with Euro-zone Government bonds and credit default swaps. The unexpected move further undermined investor confidence in the Euro-zone, sending equity markets and the Euro sharply lower. From an equity lending perspective there was no impact as covered short selling is still allowed. We did see an increase in demand for some of the banks on the list, as these firms are more heavily impacted by the rules than non-German entities, which is seen as a negative for them. Lastly in June the German Govt approved expanding the naked short selling ban to all stocks. In Spain they issued amendments to their short selling disclosure rules, which broadly followed the CESR recommendations. At a regional level the EU continued to work towards controversial new hedge fund and private equity regulation, with directives being voted through in May by both the Parliament and EU finance ministers, despite opposition from the US and the UK. The two directives need to be merged into one final draft which can be passed into legislation. Most controversial aspects are rules to limit leverage, restrictions on where assets can be held, oversight of compensation  and rules on ‘third country’ funds’ access to investors in the EU. The European Commission also came out with a consultation paper on short selling, covering disclosure and rules to prevent naked short selling. With all proposed legislation J.P. Morgan is an active contributor to the feedback requested by regulators and legislators both individually and through industry bodies such as the International Securities Lending Association, AFME, (Association for Financial Markets in Europe), ISDA, BBA (British Bankers Association, etc. Out of all the proposals the biggest concern for the industry is the requirement for public disclosure by funds of short positions.

Hedge fund performance was good through April, with event driven and relative value strategies the best performers. This led to increased optimism with funds  increasing the size of their positions. However, May saw a big reversal of fortunes with most strategies  and funds losing money, compounded by the larger positions taken in April. Increased market volatility created by the European debt crisis and the fact many funds had a long bias led to losses. The market turbulence and additional margin calls resulting from it, led to hedge fund de-risking, evidenced by borrowers calling the lending desks to refinance and return loans.  On a more positive note reports are that money continues to flow into funds, it’s just they are reluctant to invest in the current volatile and uncertain environment.

Asia-Pacific

Anti Government protests turned violent in Thailand, with the share index falling as foreign investors withdrew money from the country. J.P. Morgan temporarily suspended new loans of Thai securities, but after the Government put an end to protests we started lending again.  We had dividend activity in Australia with borrowers taking shares for the arbitrage trade on the drip (dividend reinvestment plan). The biggest revenue generating trade was in ANZ Bank Grp, but another potential big earner NAB cancelled their drip. We also lent shares in Singapore for scrip dividend arbitrage trades, with DBS Group and United Overseas Bank being the two most profitable. In Hong Kong, along with demand in the financial sector (off the back of capital raising and a tightening of lending), there was lending activity in industrials/metals sector stocks  e.g. Chalco, Angang Steel,  Maanshan Iron & Steel. Top earning specials in the region included BYD Co, China Zhongwang Hdgs, Tencent Holdings, PICC Property & Casualty and Alibaba.com Ltd all in Hong Kong, Shinsei Bank in Japan, Genting Singapore and Olam Intl in Singapore. Taiwan continued to be the growth market for us with balances increasing over the quarter.

Europe, Middle East, Africa

European debt crisis came to a head in early May with equity markets suffering steep falls on the back of concern about the size of budget deficits at peripheral Euro nations and their ability to finance their debt. Banking stocks were in demand as they act as a proxy for the overall state of a nation’s finances and due to their direct exposure to sovereign debt in the countries affected. Stocks in demand included Bco Comercial Portugues, Bco Espirito Santo and Bco BPI in Portugal, Bco Popular and Bco Sabadell in Spain, Commerzbank in Germany and OTP Bank in Hungary. After a weekend of crisis meetings, European policy makers unveiled an unprecedented loan package worth €750bn, leading to a big equity market rally, with the main European markets rising by 4% to 14%, with banks up on average 20%.  However, concern returned to the markets the following day as investors expressed doubts that the bailout package would solve the region’s debt crisis or avert a slowdown in the economy. Market uncertainty continued later into the month as Germany unilaterally banned short selling and on continued progress of key regulatory reforms both in Europe and the US. The uncertain environment led to de-risking by investors, including hedge funds.
High revenue generating specials included Banco de Sabadell and Bolsas y Mercados Espanoles in Spain, OTP Bank of Hungary, Galenica in Switzerland, and Commerzbank and Aixtron of Germany.

European dividend season hit its peak period. In general securities lending trading levels and borrower demand have been as good if not better than the prior year, however, actual dividend payments by companies are still at depressed levels and we don’t expect a broad based recovery until 2011. For clients electing the cash option for French scrip dividend paying stocks we were able to realise additional revenue off the back of the arbitrage opportunity . In addition for clients taking revenue in USD the weakness of the Euro has had a significant impact, lowering USD earnings. Big earning dividend positions included: E.ON AG, BASF, Allianz, Bayer AG and RWE AG of Germany; Sanofi-Aventis, Total and BNP Paribas of France; Telefonica of Spain; ENI of Italy; Nokia and Sampo of Finalnd.
As dividend season comes to a close we’ve started to build loan balances against Euro cash collateral. This collateral type is attractive to borrowers who are long euros from the short sale of the equity and for European borrowers who are finding dollar financing expensive. Hitting the euro cash benchmark of EONIA can be more challenging than the equivalent US Fed Funds target, so additional flexibility in cash guidelines is required to make the most of this opportunity. We expect this collateral type to be a major growth area over the next few months.

In the UK BA continued to be one of the biggest revenue earning stocks globally (non-dividend related) on the back of its merger with Iberia and directional demand due to the ongoing employee dispute and poor earnings. In the UK we had dividend activity with scrips in companies such as HSBC and National Grid. Prudential received regulatory approval but failed to obtain shareholder support of it’s acquisition of AIA after failing to renegotiate the price. Borrowers took stock in expectation of the rights issue to finance the takeover and fees even spiked briefly as supply was squeezed as investors recalled shares for the vote. However, once the deal collapsed borrowers were quick to return shares.  Despite a huge fall in it’s share price due to the oil leak in the Gulf of Mexico, interest to borrow BP shares was almost non-existent. No doubt the stock is being shorted but given the liquidity of the shares we expect borrowers are covering from long inventory. The cancellation of the dividend had a negative impact on securities lending earning as we had to unwind the scrip trade and the dividend trade will not occur for at least the remainder of 2010.

Americas

US share prices plunged on 6th May, with $1,000bn temporarily wiped off share valuations before recovering. Regulators struggled to identify the cause, but it was widely accepted that heavy trading in futures, fragmented markets and computer driven models combined to create the fall. Trades executed within a 20 minute widow were subsequently cancelled. Regulators introduced circuit breakers to prevent a repeat performance. There was no impact on lending volumes, but the market still closed down over 300 points leading to large down marks the next day. Term rebates moved higher tracking higher fed opening rates and increased reinvestment opportunities as the debt crisis in Europe led to higher yields. There was heavy dividend activity on ADR’s, the highest revenue generators included Total, Sanofi-Aventis and Nokia. Outside of dividend trades the highest earning ADRs included Suntech Power and Shanda Interactive. The oil leak from the BP well in the Gulf led to short interest in several oil and drilling related companies, on expectations of a clamp down on future exploration and drilling. Stocks in demand included ATP Oil and Diamond Offshore Drilling. Fannie Mae and Freddie Mac announced the delisting of their shares from the NYSE as they no longer met the minimum listing guidelines which require stocks to trade above $1 a share. The announcement caused the stock prices to fall nearly 40%. These stocks have been in demand since the start of the credit crisis back in 2008. Biggest revenue generating specials in the US included Amedisys Inc,  Talbots Inc, Garmin Ltd, AIG and Petmed Express Inc.

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