June 2008

STRUCTURED PRODUCTS: How safe is your guarantee?

Capital guarantees are a common feature in structured products today. But with confidence in the banks that underwrite these guarantees at an all-time low, Nick Fitzpatrick asks if a default is on the horizon ... ropesnap.jpgInvestors who bought capital-guaranteed products in recent years must be feeling a little smug if their investments matured during the depths of the sub-prime crisis. These products were sometimes criticised in the buoyant markets before sub-prime because they deliberately did not pay out the full investment return; instead, they just paid a percentage of it. But this was the trade off for having the capital guaranteed in the first place, which proved a smart move in August last year when stock markets fell sharply.

Capital guarantees
Capital guarantees are a common feature of that broad array of vehicles called structured products. Structured products have become more popular in recent years. Issuance in the EU for retail investors alone was around €99.4bn in 2004 according to one estimate, and this was expected to grow significantly as institutional demand increased.

Initially rolled out to retail and wealthy investors who wanted to protect their capital, institutions have sought structured products too in order to make their portfolios less sensitive to market swings and to access investments such as hedge funds in more efficient ways.

But the guarantees that are a central feature of many of these products are only as strong as the bank underpinning them, and confidence in the banking sector is at its lowest for years. “The default rate on a single A-rated bank is higher than youwould imagine,” says John Godden of IGS, a firm that advises investors and manufacturers about structured products. “Six months ago there seemed like no chance of a bank defaulting. People said, ‘No way would that happen’.”

But Bear Sterns almost did and, according to Godden, guarantees that the bank had underwritten on certain hedge fund products could have defaulted had it not been for JPMorgan’s rescue package. It’s a cliche, but it just goes to show that there is no such thing as a guarantee when it comes to investment.

Arguably, the guarantees within structured products are at more risk now than ever. The creditworthiness of the counterparty making the guarantee needs to be carefully considered and, as a sign of the opaqueness of these products, the counterparty may not always be the bank offering the product. It may not even be a bank at all. As in the case of Bear Sterns, it could be a special purpose vehicle.

Interest rate risk
Interest rates are also making it harder to support guarantees. The simplest kind of guarantee is secured using risk-free bonds. But low interest rates could mean that more of the principal sum invested needs to be used to buy these bonds, leaving less capital to be put to work in the markets.

Robin Creswell, managing principal at Payden & Rygel who formally designed structured products at Man Group, the hedge fund, says: “The shorter the period of the guarantee, the more capital needs to be set aside to buy the bond that underpins it. With a Treasury yield of 4.5%, you would have to put about 60% of the capital aside to secure it.”

He adds: “Imagine that you invest $90 of $100 and mark to market the value of your investment every day to determine the amount of Treasury bonds needed to secure the guarantee. If interest rates are low and at some point the capital value of the investment falls below $80 or even $60, you may have to use the rest of the capital to go and buy the rest of the bonds.”

This would inevitably result in the liquidation of the investment portfolio.

“In a falling interest rate environment,” adds Creswell, “you would have to buy a larger number of bonds, and this is going against you further if the value of the investment is also falling.” However, according to Creswell, there is nothing peculiar to these sub-prime times that should make capital-guaranteed products less attractive to investors, or for fund managers and other providers to create.  “There is no reason at all not to consider a guaranteed product now. It doesn’t matter where we are in the cycle. Some are more risky than others, but there is a lot of difference between the various models out there.”

However, Godden, of IGS, says: “Structured products are different in nature but they are all grounded in the same place and have similar issues.” He points out that all structured products at some point in their convoluted contractual chains, sit on the balance sheet of a bank somewhere. Owing to the importance of bank balance sheets, structured products are now more expensive than ever because balance sheet access has tightened at a time when there is an upsurge in demand for structured products, according to Godden.

“Bank balance sheets are slightly different now to how they were a few months ago. Constraints have been put on them. Before, banks were effectively using their balance sheets to offer structured products at knockdown prices.

“But now balance sheets are a rarity and if you get access to them they cost a lot of money. Where a bank might have charged Libor + one-twelfth of 1%, now it’s Libor + five-twelfths of 1%.”

Godden says that it is specifically capital guarantees that investors are now looking for from structured products. That wasn’t always the case. “Last year, people wanted structured products in order to get leverage. But no one wants leverage now. People want guarantees.”

With increased focus around risk of default for structured products - or at least the financial institutions that issue them - it might seem that the structured product market is, temporarily at least, hindered by uncertainty. Skandia Investment Management is at least one fund manager that has decided not to launch structured products for the moment, although a specific reason was not given.

Product roll-out
Yet product development has not come to a total standstill. Since November last year, Lehman Brothers, the broker, has increased its roll out of structured products, having launched into the Icelandic, Nordic and UK retail markets in the last two years. Lehman also has a longer-established institutional business and is looking also at Eastern Europe.

Paul Adams, head of sales of UK structured retail products at Lehman Brothers, says structured products typically become more complex when moving along the spectrum from retail investors, through wealthy investors, to institutions. He points out that the amount of principal capital that is protected can vary greatly between products, usually in relation to the  income stream from the investment.

But importantly he feels that the risk of defaults on guarantees has been greatly reduced by regulatory action.“This risk of banks defaulting has been taken off the table by the action of regulators. The Fed has effectively underwritten the market by allowing access to its discount window.”

People have largely stopped trying to guess what might happen next in the sub-prime crisis. Instead, they have started to try and predict when it will officially end. Nevertheless, for those investors with some form of guarantees in their portfolios, it will be comforting to see the credit ratings of banks start to rise again. ©  2008 funds europe

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