Securities Lending Update July 2011

Transcription

1 Message From Colin McKechnie The second quarter of 2011 was very active as the U.S. government continued to struggle with the debt ceiling and the economic crisis in Europe came to a head. In our latest issue we take a look at how recent events and market conditions are affecting the securities lending environment. In our regional focus we highlight the Australian cash market and discuss some of the challenges the region has seen in the second quarter of Colin McKechnie, Global Head, Financing & Markets Products Next our regulatory focus offers insights into the recent legislation passed in Washington and in Europe. We also outline our predictions for the effects new legislation will have on the securities lending market in the coming months. Finally our desk updates provide a full view of the second quarter events for equities, fixed income and the investment desk. With each update we also provide an outlook with our predictions for the next quarter We hope you enjoy this issue of the securities lending update and we encourage any feedback you may have. As the financial landscape continues to evolve, we look forward to helping your business succeed. If you would like more information, please contact your relationship manager. Page 1

2 Regulatory Focus As we enter the second half of 2011, the various governments and regulators continue to write regulation with the goal of managing risk and enhancing transparency for securities lending programs. As lenders and borrowers return to the market, they face potential new legislation and a change in supply and demand side dynamics, resulting in less predictability for lenders. In addition, beneficial owners, although not directly impacted, are indirectly feeling the effects of regulatory change. Below are a few of the key regulations J.P. Morgan has been actively following and the impacts we foresee to the industry as a result of their implementation. The European Commission on Short Selling discussions continued between the European Parliament, Council and Commission to try and produce an agreement on rules governing short selling in Europe. Disagreement remains on uncovered short selling of shares, bonds and CDS, plus the powers to be given to ESMA (European Securities and Markets Authority) to monitor and control short selling, versus those of individual member states. Further meetings are not expected until September. Dodd-Frank Of the major regulation impacting the industry, Dodd- Frank has been at the forefront. Consultations around rule makings regarding Securities Lending are still taking place, but below are a few specific titles of Dodd-Frank we have been monitoring closely. Title IX, which focuses on increased transparency for both lenders and borrowers, has yet to be fully established. J.P. Morgan has been an active player in the industry task force, speaking to the SEC about the initiative and helping regulators understand what the current transparency standards are in the market and how changes to standards affect the industry. J.P. Morgan has also been actively involved in Title II discussions that focus on the Orderly Liquidation Authority (OLA). As part of a larger industry group, J.P. Morgan spoke with the FDIC about the OLA clarification issues and specific business impact questions. Finally, J.P. Morgan has been closely following Title VII, which details legislation around the clearing of derivatives and rules of remaining OTC derivatives. Title VII could potentially increase demand for highgrade collateral to post at exchanges, again affecting the supply and demand side dynamics of the industry. Basel III While the implementation and impact of Basel III are still a number of years away, many firms are already operating under Basel II/III guidelines, which have yet to be formalized. The overall impact of Basel III is still being assessed but additional capital constraints on borrowers may impact the demand side of the Securities Lending business. FATCA and U.S. Tax Changes Foreign Account Tax Compliance Act (FATCA) takes effect January 1, As a result, major changes have been announced in the U.S. market relating to the tax treatment of U.S. source income. The goal of the legislation is to require non-u.s. financial institutions and non- U.S. entities owned by U.S. persons to provide information identifying U.S. persons invested in non-u.s. bank and security accounts to the IRS. As J.P. Morgan s accounts are all correctly documented, and because of the manner in which J.P. Morgan conducts its U.S. lending (i.e., on loan tracker ) there should be no impact as a result of these changes; however we continue to monitor developments until the regulations are finalized. UCITS IV & V The implications of UCITS IV and V are still being assessed as we await developments to see how legislations will affect the funds landscape and therefore the investment strategies of lenders. It is possible that the legislation could result in a consolidation of funds through UCITS mergers and changes in Investment Management companies. Page 2

3 Regional Focus: Australia Q2 Cash Collateral Reinvestment Market Update The second quarter was both rewarding and challenging for the Australian cash market. For most of the quarter, cash returns averaged on or around the 90-day Bank Bill Swap rate, while weighted average duration remained around the 30- day range (obviously well below 90 days). Most of the value J.P. Morgan has extracted from the market has been in bank Term Deposits. However, we have reached a point where the market is no longer paying a premium for deposits because domestic banks are in a strong balance sheet position, having completed a significant balance sheet restructure away from short term debt (refer to chart 1) and towards domestic deposit (sic Term Deposits) Chart 1. 1) Fully Funded - having completed the restructure banks find themselves fully funded (Chart 2) and are no longer seeking/rewarding term deposits at the same levels. 2) Credit Growth - the market appetite for credit has declined significantly (Chart 3), and demand from banks to borrow cash has declined in tandem. Chart 2. Chart 3. the curve has flattened considerably for the coming months. While it has not started to show in the market forecasts as yet, some participants are now talking about a possible rate cut rather than rate rise. In June, Moody s placed a total of 12 banks on negative watch for various reasons. The impacted banks and the reasoning for Moody s negative watch are detailed below. 1) Greek Exposure - BNP Paribas SA, Societe Generale SA and Credit Agricole SA. In light of their holdings of Greek public and private debt and any inconsistencies between their ratings now- and potential impact of a Greek default. It looks as though a possible sovereign default will have wide-reaching impact across the global banking system and that the rating agencies have looked to be more proactive than they have been in the past in identifying the exposed entities sooner rather than later. This sea change from short term debt to domestic deposits has been driven by regulatory changes (Basel III and APRA liquidity guidance), which J.P. Morgan has extracted significant value from. However, the tide is changing for a couple of reasons. In April the futures market was pricing in a rate rise for June/July, this has since been pushed out. The turning point was April s loss of 22,100 jobs, resulting in an unexpected downside to the market. Since then the front part of 2) Government Backing - Royal Bank of Scotland, Bank of America, Citibank and Wells Fargo. Moody s explained these banks could not continue to rely on government backing and therefore they were reviewing their credit standing on the basis that government support would be withdrawn. 3) Japan (Tsunami Impact) Bank of Tokyo Mitzubishi, Mizuho and Sumitomo With the fall out from the Page 3

4 March 11 Tsunami yet to be fully quantified, Moody s has moved early based on the latest GDP impacts. Action Taken: Generally speaking, client guidelines* for AUD cash do not permit J.P. Morgan to purchase any security while on negative watch. Therefore, for all Banks currently on negative watch below are actions the firm will be taking: 1) J.P. Morgan has not repurchased any of the assets that were rolling overnight (on a ay to day basis) and in effect maturing everyday 2) With the names that had a longer maturity and still may not have matured to-date J.P. Morgan has not sold these and they are still held in cash portfolio as permitted in the cash guidelines. However, we will not be buying back into these assets upon maturity if they are still on negative watch at this point in time. results in deposits being placed with alternative approved Banks, (e.g., UOB) not previously used as they did not offer as attractive rates. The end result of the decrease in term deposit rates and the reduction of investment options is that spreads have dropped some 4 basis points in June and we expect overall spreads to decrease a further 2 to 3 basis points. Conversely, we have added some duration to the book as banks are looking to move away from overnight funding to longer term funding options to meet the APRA liquidity requirements. Finally, we are also looking at supranationals and other options to provide further diversification. *The only exception to the above being any names that are A1+ rated, where the cash guidelines permit J.P. Morgan to continue buying these names. Impact: Due to the market events described above J.P. Morgan has seen: 1) Term Deposit rates decrease (particularly overnight rates) as domestic banks are fully funded and no longer need to pay-up to attract deposits. 2) A reduction of investment options due to Moody s negative watch. This reduction Page 4

5 Desk Updates Equities The second quarter was very volatile for equities as the European debt crisis continued to cause concern among investors. Markets rallied on positive news such as the Portuguese bailout in April and the Greek parliament approving austerity measures at the end of June. However, between these periods of optimism, negative news and uncertainty led to a risk off scenario, with investors moving into safe havens such as Government bonds and cash. In addition to Europe there were other concerns adding to the uncertainty, including the U.S. debt ceiling stand-off, continued unrest in North Africa and the Middle East, inflation in emerging market countries, concern about the strength of the global economic recovery, and the end of U.S. QE2 in June. The second quarter was a bad quarter for hedge funds as uncertainty and market volatility led to a difficult trading environment. A sharp rise in correlation between asset classes, made it difficult for stock pickers and for investors to hedge positions. Funds were therefore lacking in conviction and direction, and on the short side, even where a fund had a negative view, they were reluctant to take the risk of expressing that opinion by going short. Demand to borrow continued to be focused on directional plays and capital raising arbitrage (e.g., rights and convertible bond issuance). Sectors driving lending revenue included financial, alternative energy, retail and technology. The second quarter was the peak of the European dividend trading period for the year. Performance was mixed due to changes in borrower demand and tax rules. Out of the major markets, France and Sweden traded higher, while others, such as Italy and Switzerland were lower, and Germany and Finland were flat to In general, dividend payments were up and several companies that didn t pay a dividend in 2010 started paying again this year. In Europe, capital raising by financials as they sought to strengthen balance sheets ahead of European wide stress tests and future Basel III rule changes, was a big driver of borrowing demand. There was also directional demand for financial shares in the European periphery countries off the back of the debt crisis, especially the small to mid cap stocks. The alternative energy sector was also in demand by short sellers as the industry faced the headwinds of reduced Government subsidies and increased competition from Asia. In Asia Pacific, the technology sector (especially semi conductors), auto, property, construction, and consumer sectors were all in demand. Hong Kong became very active as investors took a negative view on the back of slowing Chinese growth, credit tightening and accounting/corporate governance concerns with certain Chinese companies. Korean and Taiwanese balances were also strong, with the semi conductor space being of particular interest. U.S. equities experienced an increase in short selling activity, with IPO stocks attracting particular demand, along with U.S. listed Chinese stocks, again off the back of corporate governance and accounting concerns. Other revenue generating sectors included retail and alternative energy. Fed Funds traded at low levels, with reinvestment opportunities constrained due to a lack of collateral. This led to the U.S. equity general collateral (GC) rate being set at zero and even trading negative at times. At the end of the quarter the Russell rebalance caused a lot of volatility in the lending market as clients sold out of securities leaving the index and bought those that were entering On the regulatory front, discussions continued between the European Parliament, Council and Commission to try and produce an agreement on rules governing short selling in Europe. Disagreement remains on uncovered short selling of shares, bonds and CDS, plus the powers to be given to European Securities and Markets Authority (ESMA) to monitor and control short selling, versus those of individual member states. Further meetings are not expected until September. Page 5

6 Going Forward: We expect continued volatility in the markets as the EU attempts to deal with the debt crisis. Until we have some form of a resolution on the debt crisis and the other uncertainties facing the market, hedge funds will be reluctant to take risk, and short selling will be subdued. It is anticipated that cash will be king over the summer, with investors remaining on the sidelines. On a positive note, we do expect continued capital raising activity from European financials, creating lending opportunities, and we hope the recent pick up in activity in Hong Kong and the U.S. will continue. Borrowers will continue to focus on collateral optimization, with the trend to non-cash collateral, especially equities, continuing. Page 6

7 Desk Update Fixed Income Beginning on April 1, Fed Funds, repo rates and other short-term rates decreased because of the new Federal Deposit Insurance Corp (FDIC) assessment fee. The FDIC adjusted the calculations of U.S. banks deposit insurance fees to include all liabilities rather than just domestic deposits, which includes excess reserves. Prior to April 1, U.S. Banks could borrow in the Fed Funds or repo market at a level below 25bp and invest this with the Federal Reserve at 25bp (interest on reserves) and lock in the spread. Since these liabilities were not insured, no FDIC assessment was involved. For some time now, there have been banking entities that have taken advantage of the spread between repo and the interest on excess reserves (IOER). Banking entities would engage in repos with cash providers and pay a rebate rate of 10-15bp and then take the cash and leave it on deposit with the Federal Reserve Bank to earn the IOER of.25bp for a spread of 10-15bp. The U.S. debt ceiling debate is likely to attract most of the focus of the U.S. markets as it nears the August 2 deadline. While there will be numerous headlines and political debates in the time leading up to this date, market participants widely expect the debt ceiling to be raised and for Treasury to continue to honor all of its debt service obligations. Bond markets in the U.S. have in fact rallied to yearly low yields as investors seek the safety of Treasury securities because of weak global economic data and ongoing sovereign debt issues in Europe. The two-year note auction at the end of June had the lowest yield on record for the two year note at.395%. In terms of Treasury coupon issuance, benchmark sizes have remained unchanged on the year while the paydown in Treasury bills that began in late April has continued. The reduction in bills outstanding is only one of the factors that have helped to keep repo rates low. The paydown in bills is expected to continue into the middle of July. 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. As a result, the desk secured term commitments from dealers as early as possible. This quarterend rates were sharply lower as more cash and less Treasury supply kept rates anchored. Fed Funds opened at a record low 0.02% and Treasury general collateral traded as low as a negative rebate rate as Treasury supply dwindled. The spread between Treasuries, Agencies and Agency MBS widened as Treasury general collateral traded in a range of 0.05% to negative 0.25% and MBS traded in a range of 0.30% to 0.12%. The majority of borrowers were not involved as reducing balance sheet usage remains 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. The Federal Reserve completed $600 billion in Treasury purchases on June 30 as part of the asset purchase program called QE2. The Fed will continue with the reinvestment of principal payments from agency debt and agency MBS at least into mid-july of this year a program that had been announced by the FOMC on Augst 10, Many market participants believe that the Federal Reserve will begin to exit its accomodative monetary policy stance beginning with the cessation of these reinvestments. In fact, Federal Reserve Chairman Ben Bernanke has stated on numeorus occasions that the end of reinvestments would signal a shift to a less accomodative policy stance. Following this, market participants anticipate the Federal Reserve will begin to drain the record amounts of excess reserves through the use of the Term Deposit Facility (TDF) and large-scale Reverse Repos (RRP). While Repos and Reverse Repos have been previously used in the past as a way for the Federal Reserve System to achieve its monetary policy Page 7

8 objectives, the TDF is a relatively new policy tool that was introduced in March Next, the Fed will likely raise the Federal Funds rate, with J.P. Morgan currently projecting the first Federal Funds rate hike in the first quarter of Finally, the Federal Reserve could conduct outright sales of its GSE Agency and MBS holdings to bring its balance sheet back to historical norms. Agencies / MBS As the first half of the year comes to a tumultuous end, agency and agency mortgagebacked collateral continues to trade above treasury collateral, as was the case at the beginning of the year. Agency collateral traded 1 to 4bp above treasury collateral while mortgage backed collateral traded 2 to 5bp above treasury collateral. The world economic situation with several countries debt being downgraded has made the reinvest climate a bit precarious at best. The strategy for lending of the asset classes has been difficult to guage and requires restructuring of positions on the open general collateral book almost daily. Balance sheet considerations have become a larger concern for dealers, which challenges month-end and quarter-end positioning. This makes the partnership with our reinvestment desk more important than ever. Towards the end of the quarter, liquidity risk has been alleviated by transacting term loans of general collateral assets especially in the agency and agency mortgage classes. In an effort to further reduce fails and support liquidity, The Treasury Markets Practices Group (TMPG), at its April 29 meeting, proposed fails charge recommendations for agency and agency mortgage backed securities which are effective February 1, Securities subject to this charge would include agencies issued by Fannie Mae, Freddie Mac and Federal Home Loan and mortgage backed securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. The agency fail charge would be similar to those charges for fails on treasury securities which is a fails charge equal to the greater of 0 percent and (3 percent minus the fed funds target rate). Mortgage backed securities fails charge has been modified slightly and will consists of a fails charge equal to the greater of 0 percent and (2 percent minus the fed funds target rate). Corporate Bonds Corporate bond balances increased over 15% in the second quarter. Issuance was down during the quarter as concerns increased around the sovereign debt crisis in Greece. June was the slowest month for new issuance thus far in Despite lower new issuance and heightened economic and geopolitical concerns, daily activity was very brisk. Brokers were actively locating and borrowing securities up until the end of the quarter. However, the daily volumes remained high, but duration short. Specials continue to be rerated to rebates closer to general collateral levels. Market participants continued to quickly cover trades and aggressively manage risk positions. Financials (banks and consumer finance companies) remain the sector most in demand. We anticipate balances to drift lower through the summer months on a lighter new issue calendar and on continued concerns about sovereign debt and the global economy. International Balances and volumes continued to grow, as had been the pattern in 2010 and the first quarter of The main drivers were European sovereign specials, a spread between core and peripheral European sovereign issuers and significantly higher volume in the corporate bond book. Borrowing demand for European government bonds remained generally high throughout the quarter. Shorts in peripheral European countries meant that specific issues continued to trade at negative rebates in the repo market. However volumes decreased in Greece, Portugal and Ireland. A continued flight to quality to core Europe meant that the highest quality collateral was in constant demand leading to increased specials in Germany, especially during May. Overnight general collateral rates continued to be volatile with EONIA setting between 0.531% and 1.549% during the quarter. Volatility was especially pronounced Page 8

9 during June. A freeze in the interbank market because of the political crisis in Greece led to rates spiking by 65bps over three days. Greece will get a vital loan instalment by July 15, saving it from an impending default, while work continues on a second bailout for the struggling country. The Greek parliament responded to EU and IMF demands by passing 28.4 billion euros in budget cuts and tax hikes, and a 50-billion-euro privatization program, despite rioting in the streets of Athens. Greece is now expected to receive 12 billion euros from the euro zone and IMF after finance ministers approved the fifth tranche of aid from last year's 110-billion-euro financial rescue package. However, a final decision on the new aid plan has been left until the involvement of banks and other private creditors has been resolved. As expected, the ECB raised rates at the April meeting to 1.25% - the first hike in 3 years. On July 7, President Trichet confirmed that the ECB would again raise rates 25 bps to 1.5% and indicated a further hike is likely this year. U.K. Gilt supply remained abundant with virtually all issues trading as general collateral across all maturities. However, demand to borrow under 10 year maturities meant that most remained fully lent throughout the period. The Bank of England left their benchmark rate on hold at 0.50% while their asset purchase program remained at 200bn as the majority of the MPC warned that tightening policy now could dampen consumer spending and hamper the recovery. Activity in the credit markets remained high and intrinsic value remained strong but the average spread was affected week to week by the volatile overnight cash rates in EUR and, to a lesser extent, in USD. The majority of corporate issues trading significantly special were high yield bonds with borrowing demand usually caused by illiquidity. Going Forward Looking ahead, the end of QE2 should bring about higher rebate rates, as more Treasury supply is available to the market. Once the debt ceiling issue is resolved there will be an additional upside risk to rates. A debt ceiling increase would likely be followed by a resumption of The Supplementary Financing Program (SFP), which would help to alleviate the shortage of Treasury bills. Presently the SFP has been suspended at $5 billion from its prior level of $200 billion, which will help to push average Treasury rebate rates above the Federal Funds opening level. Page 9