Structured Products

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Counterparty risk?

Since the downfall of Lehman, the structured products industry has been plagued by the problem of the counterparty risk, which denotes the risk associated to the bankruptcy of the issuer an investor is exposed to when investing in a structured product. Indeed, a structured product is a security issued by a bank and as such, it ranks equal to common senior unsecured bonds of the same issuer. If the bank goes belly up, any structured product it issued will fall into the bankruptcy mass and lose most, if not all of its value. So how remote is the issuer risk on YOUR product? how can you judge this risk?Pre-Lehman, the investor's trust relied mainly on rating agencies: Moody's, S&P, Fitch and the like. They assign a degree to the issuers, the best being Aaa (or AAA), the least being D, like Default. Any issuer had to have at least a medium grade, for example single A in order to be accepted as a serious counterparty. Problem is, rating agencies tend to react too late with their adjustments: Lehman went broke with an A2 rating. The rating agencies also gave all the AAA ratings to the mortgage-backed and credit-linked notes that imploded during the big crisis. Hence, few investors now even bother to take a look at the grades the credit agencies give to other companies, and justly so. There is another, more accurate way to judge the financial strength of an issuer: its credit default spread, or CDS. The CDS is the yield spread, or difference in yield between different securities, due to different credit quality, that the market (and not a company or agency that may have other motives than the pure reflection of the risk) determines at any given moment for a determined period. The standard is 5 years. It's accurate, fast and above all, independent, because it is the market that determines it (and not a US company). Let's look at some numbers (5 year CDS as of 13th of Jan 2011):
  • BNP: 123 / Soc Gen: 165 / France: 104
  • UBS & Credit Suisse 99 / Switzerland 46
  • ING: 151 / Belgium 205 / Netherlands 58
  • Deutsche Bank 108 / Germany 59
  • Barclays 133 / HSBC 81 / UK 72
  • Unicredit: 211 / Italy 206
Just looking at the numbers tells us one thing: the CDS of the banks are pretty low in absolute terms and in some cases are damn near the CDS of the sovereign state they are based in. Take BNP and Soc Gen, for instance: both have been hammered during the PIIGS crisis, but ultimately, their CDS spreads are pretty near the one of France itself. So unless you would expect France to default on its sovereign debt, they are as secure a counterparty as can be for your product. I personally don't see France letting its major banks down, even if Mr. Sarkozy bashes them on every public meeting about the financial system. Be it as it may, in my opinion, the counterparty risk of large issuers like those mentioned above is negligible, especially if one invests in short term product maturing within, say 12 months. The reason is quite simple and can be illustrated through an example of the computer industry. Remember when Apple was nearly broke and its stock traded at a few bucks? They just had about three months of cash left before going bankrupt. Then came along Steve Jobs and we know the rest; today Apple holds about USD 50 billion in cash. You know why? Because they said: "never again". Never again short of cash. Well, the banks had the same problem in 2008, they nearly all went broke. Many had to be saved by their sovereign states. This will not happen again: now the banks hoard the cash like dragons their gold. And well they should; they do not want to experience a similar situation again. Hence my message: there will be no default of major banks like those mentioned above withing the next three years. The structured products issued by these banks are quite safe. Beyond that... who can tell.