Updates From the Desks

Lending Desk: Equities

Third quarter was a bad quarter for global equities with markets ending the period down, many falling more than 20% from their peaks and entering official bear market territory. The S&P 500 fell 14% during the quarter, its worst decline since the fourth quarter 2008. Volatility levels were high during the quarter, as markets reacted to news and events, with the VIX (volatility index) at its highest quarterly reading since the first quarter 2009. Concern over the European debt crisis and the strength of the global economy led to a flight from risk assets to the safe havens of Government bonds and cash. Correlation between equities became extremely high, as risk assets moved in lockstep in response to macro events. This kind of market is poor for stock pickers, including many hedge fund strategies.

The negative sentiment for equities led to increased levels of short selling, which in turn drove increased demand to borrow stock. This trend was particularly evident in Asia and the U.S. U.S. short sales have risen at their fastest pace since March 2009, the bottom of the last bear market, as concern grows about the U.S. economy. In Asia, bets that Hong Kong stocks will fall have risen to their highest levels since January 2008, as investors worry about a slowing Chinese economy, a bursting of the real estate bubble and reports of corporate governance and accounting fraud at several companies. Even though European equity prices fell, short selling was less prevalent as investors were cautious of adding risk given the uncertainty over the debt crisis. A positive statement from the European Union (EU) dealing with the crisis would likely cause a big relief rally, hurting short positions. Also constraining lending activity are the short selling bans on financial stocks in France, Italy, Spain and Belgium, which were introduced in August. In addition to the increased levels of short selling in Asia and the U.S., hedge funds selling down long positions and reduced leverage, meant that prime brokers had less internal inventory to cover client shorts. They therefore had to borrow more stock from the street, driving up lending balances at the agent lenders.

Hedge fund performance in general was poor during the quarter, with August being the worst month since the aftermath of the Lehman Brothers collapse. A lot of funds had bet on an economic recovery in 2011 and were hard hit by the market sell off. They also had large holdings in financial stocks, which were of course particularly hard hit. We also heard reports that funds had not hedged their positions as much as they could have (i.e., taken short positions), which again hurt them as markets fell. Those funds that did take a negative view on the global macro outlook, made big returns as markets fell in August.
In terms of the sectors most in demand:

• Asia-Pacific– Demand across Asia was broad based. Chinese companies traded on the Hong Kong Exchange were in demand. Property and construction stocks, consumer goods, mining and commodity companies, technology, gambling, retail and industrial companies were in all demand, as investors bet on a slowing global economy. Financial stocks were also in demand off the back of the European debt crisis.
• Europe – Europe was the weakest region this quarter in terms of activity. Financials, alternative energy and semi-conductor provided the bulk of our top revenue generating securities. We also saw increased interest in property and construction stocks, especially in Spain.
• U.S. – Retail, alternative energy, technology and shipping were all in demand.
• Demand across the globe was primarily driven by directional trades. Third quarter was a very weak quarter for corporate activity as market volatility made it difficult for firms to raise capital, and made companies reluctant to commit to takeovers, preferring instead to hoard cash. Investment banking fees from M&A and capital raisings have slumped to lows not seen since the Lehman Brothers default, with Europe being the worst effected. IPOs were also significantly impacted as companies pulled deals, with the number completed in third quarter being the lowest in two years.

On the regulatory front, Spain, Italy, Belgium and France all introduced short-selling bans on financial stocks. Apart from Belgium, which didn’t specify an end date, the other bans were supposed to last for 15 days. However, the durations have been extended and are still in place going into fourth quarter, although France has said its ban will end at the latest November 11. Discussions continued between the European Parliament, Council and Commission on EU wide short-selling regulation, however agreement is proving difficult to reach, with disagreement over naked short selling of sovereign CDS. Greece also introduced a short-selling ban across all equities, as did South Korea. We continued to lend in all markets, as existing shorts could be maintained and there are exemptions for activities such as market making. Also worth noting was the announcement by the EU of a proposed Financial Transactions Tax that would take effect in 2014. In its current format, the tax would capture securities lending and repo transactions, although it is not clear exactly how it would impact each counterpart. However, there is a lot of opposition to the proposal, which would be very far reaching and have a huge impact on markets.

Lending Desk: Fixed Income

Treasuries and Agencies

The summer months in the U.S. are typically slow and less volatile for the markets as traders take their vacations and enjoy the seasonally warm weather. Looking back, there will likely be many words used to describe the summer of 2011 but ‘quiet’ and ‘less volatile’ will certainly not be among them. First, there was intense focus on Eurozone banks and extreme volatility in global markets as a result. Second, the almost unthinkable happened when Congress and the administration took the U.S. to the brink of default by not coming to an agreement to raise the debt ceiling until the last possible day on August 2. While the U.S. did increase the debt ceiling in time to avoid default, Standard & Poor’s nonetheless downgraded the U.S. one notch from AAA to AA+, citing, in their opinion, “that the fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics.” Within weeks of the S&P downgrade, both Moody’s and Fitch reaffirmed the U.S. credit rating as Aaa and AAA, their top credit ratings respectively. Ironically, the U.S. Treasury market experienced a massive flight to safety because of all of the uncertainty.

Treasury general collateral (GC) averaged 9 basis points rebate rate for the quarter, while the Federal Funds open level averaged 11 basis points. Market demand for Treasury repo increased because of risk aversion stemming from concerns over Europe and this led to lower GC rebate rates. Additionally, the Supplementary Financing Program (SFP) was suspended in July in anticipation of the U.S. nearing its debt limit, removing $200 billion in Treasury bill supply from the market. The increased demand for Treasuries, combined with the reduced supply, resulted in Treasury GC rebate rates averaging 2 basis points below the Federal Funds open level.

Trading activity continues to be driven by primary dealers’ emphasis on balance sheet allocation. Because of the increased focus on balance sheet, the desk engaged in various short-dated term trades to help maintain liquidity over the quarter-end turn. These term trades were inclusive of Treasury, Agency and Mortgage-Backed Securities (MBS). As a result, the desk secured term commitments from dealers as early as possible. This quarter-end, Fed Funds opened at 8 basis points while Treasury GC traded as low as 8 basis points rebate rate in the morning and as high as 40 basis points rebate rate late in the day. Agencies and MBS rebate rates traded 10 to 17 basis points higher respectively than Treasuries. The majority of borrowers were not actively involved in new loan activity on quarter-end as reducing balance sheet usage remained paramount. The benefits of balance sheet neutral trades and the need to secure longer term financing (as compared to overnight), has led to greater demand for non-cash trades.

During the quarter, the most special Treasury issue was the current 10-year note, T 2.125% 8/15/21 (cusip 912828RC6), which averaged 50 basis points below GC at -39 basis points rebate rate. All of the other benchmark Treasury issues traded less special and within 10 basis points rebate rate of the GC level.

Agency and Agency Mortgage-Backed collateral continues to trade above Treasury collateral on an overnight basis as has become the norm in recent months. Agencies traded 1 to 2 basis points above Treasury GC rebate rates, while Mortgage-Backed collateral traded 3 to 5 basis points above Treasuries. The world economic situation, where on any given day the debt of several countries is in danger of a rating downgrade, has made the reinvest climate a bit precarious at best. Balance sheet considerations continue to be the prime concern for dealers and thus challenges month-end and quarter-end positioning for banks as well. This makes the partnership with our reinvest desk more important than ever.

The Treasury Market Practices Group (TMPG) has clarified its recommendations concerning trading practices for Agency debt and Agency Mortgage-Backed Securities issued or guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae. The TMPG recommends fail charges be applied to transactions in Agency debt and Agency MBS transactions entered into on or after February 1, 2012, as well as transactions that were entered into prior to, but remain unsettled as of February 1, 2012. For Agency debt and Agency MBS transactions entered into prior to, and unsettled as of February 1, 2012, the TMPG recommends the fails charge begin accruing on the later of February 1, 2012, or the contractual settlement date. For fails in Agency debt securities, the TMPG recommends a settlement fails charge be calculated each day based on the greater of a 3%per annum minus the Federal Funds target rate. For fails in Agency MBS, the TMPG recommends a settlement fails charge be calculated each day based on the greater of a 2%per annum minus the Federal Funds target rate. The TMPG has recommended a lower charge level for the Agency MBS market, given differences in this market compared to the Agency debt and Treasury markets. These differences include monthly settlement conventions, which make failed transactions more common and more challenging to resolve in a timely manner. If the level of failed transactions does not decline satisfactorily within the initial period after the charge takes effect, the TMPG had said it would consider raising the charge level.

At the August 9 Federal Open Market Committee (FOMC) meeting, the Federal Reserve announced that they intend to maintain exceptionally low Federal Funds rates through mid-2013 due to the weak economic recovery. This was the first time that the FOMC attached a formal date to their interest rate forecast. The minutes of the meeting were released on August 30 and we learned that there was also some discussion of linking the forward rate guidance to either the level of unemployment or to inflation levels, though nothing was ultimately adopted.

At the September 21 FOMC meeting, the committee announced its decision to initiate “Operation Twist” and begin lengthening the duration of its Securities Open Market Account (SOMA) portfolio. By June 2012, the Fed will sell $400 billion of short-dated Treasuries (remaining maturities of 3-years and less) and purchase an equivalent amount of Treasuries with maturities remaining 6-years to 30-years. Purchases will be most heavily concentrated in the 6-year to 10-year sector but would also involve a significant amount of buying in the long end of the curve. The program is designed to put downward pressure on longer-term interest rates and ease broader financial conditions. The FOMC will continue to regularly review the size and composition of its securities holdings and has stated that it is prepared to adjust those holdings as appropriate.

To help support the mortgage market, the Fed also announced its plans to reinvest Agency and Agency MBS principal payments into the Agency MBS market. The FOMC statement also noted that “inflation appears to have moderated” and that “there are significant downside risks to the economic outlook, including strains in global financial markets.”

The U.S. Treasury closed its books on fiscal year 2011 on September 30, a year that produced the third largest deficit on record. J.P. Morgan estimates that the fiscal year 2011 budget deficit will total $1.275 trillion (8.4% of GDP or 1.5% lower than the deficit in fiscal year 2010). Looking ahead, Treasury said in the quarterly funding documents released in August, that given its current forecasts, it “expects to modestly decrease note and bond issuance in the coming months.” However, it also said that the magnitude of the declines would depend on the fiscal outlook. According to J.P. Morgan’s strategists, Treasury has historically refrained from cutting issue sizes when there is a possibility of higher deficits in order to retain flexibility and to avoid changing issuance too frequently. J.P. Morgan currently is forecasting a fiscal year 2012 budget deficit of $1.2 trillion – this would likely reduce the need to cut coupon sizes.

Corporates

Corporate bond balances grew slightly over the third quarter despite significant market volatility. Spreads on Corporate bonds began to widen in late July and early August during the debt ceiling crisis and continued to widen as the European debt crisis returned to the forefront. Daily borrowing volumes remained heavy, and although balances increased during the quarter, loans being returned daily remained very high. During July and August, broker-dealers were focused on risk reduction. Originally, that focus led to increased loan activity to close out failing trades. However, as market volatility persisted, traders reduced risk positions by closing out trades on both the short and long sides. New issuance of Corporate bonds moderated as anticipated in July and August. However, in September, concerns about a double dip recession led to less supply. Through three weeks of September, only $51 billion high-grade Corporate bonds had been issued, after $45 billion was issued in both July and August. Concerns of a weakening global economy and on-going concerns about sovereign debt could weigh on demand from broker-dealers to borrow Corporate bonds, leading to lower on-loan balances.

International

Balances and volumes in the international fixed income lending book increased further, following the strong growth we saw throughout the first half of 2011. The same drivers remained – European sovereign specials, a spread between core and peripheral European sovereign issuers and significantly higher volume in the Corporate bond book, especially financials. However, the period was particularly volatile from a risk perspective as both the European sovereign debt crisis and U.S. political dysfunction in addressing the debt ceiling caused a global sell-off in equities and, simultaneously, flight-to-quality investing.

Borrowing demand for European government bonds remained high throughout the quarter. A continued flight to quality for core Europe meant that the highest quality GC was in constant demand – leading to increased specials, particularly in Germany, once supply disappeared from the overnight market. Shorts in peripheral European countries meant that specific issues continued to trade at negative rebates in the repo market, though volumes traded were much lower in Spain, Greece, Portugal and Ireland. Overnight GC rates were less volatile, due to the huge amount of excess liquidity provided by the European Central Bank’s weekly and longer term operations, though high quality GC traded at a wider spread to EONIA than the historical average.

The European Central Bank (ECB) held the euro zone interest rate at 1.5% while softening its stance on inflation. At the press conference in Frankfurt following the rate decision in September, ECB President Jean-Claude Trichet stated that threats to the euro region have worsened and inflation risks have eased, giving officials the option to take further action should the debt crisis worsen. The yield on German 10-year bunds fell to a record as some investors speculated the ECB could cut interest rates or open up more emergency credit lines for banks.

U.K. Gilt supply remained plentiful with virtually all issues trading as GC – however, demand to borrow under 10 year maturities meant that most remained fully lent throughout the period.

Activity in the Corporate bond markets remained high – intrinsic value was increased for EUR issues due to increased shorts but under pressure for U.S. dollar issues due to low overnight interest rates. The majority of corporate issues trading significantly special were financials or high-yield bonds with borrowing demand usually caused by illiquidity.