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.

The Virtues of Open Architecture

Monopolies have long been a thorn in the side of consumers. High prices for a low quality of product or service are a common evil that monopolies engender. From telephone to oil companies, the regulator has broken them one by one over time in order to give the consumer more choices and spur the competition. It has become easy for consumers to compare the prices of every type of product or service, be it credit cards, insurance or flat-screen TVs. While few if any monopolies remain, other forms of captive-client models have emerged. In the private banking industry, a client becomes captive the day he deposits his monies at a bank and entrusts it to his account manager. From that point onwards, the client is usually bombarded with advice to buy this fund or that structured product. Not surprisingly a majority if not all of the proposed investments are in-house products. While in-house products are not fundamentally bad, the account manager often has an interest or been told to recommend the products of his employer in order to maximize the benefits for the bank. In the fund industry this is less of a problem because most of the funds have a similar cost structure and one has a priori no more chances to outperform than another. Hence, an investor might as well purchase the funds of the depositary bank he has chosen, unless their track record is really awful. It is different with structured products, because they often include complex options that every bank prices differently at any given point in time. Most banks also include fees in their products, the level of which may vary considerably. Other banking-related costs, like documentation, funding or trading costs may increase the level of price difference from one bank to another. The difference in pricing may become so great that some banks may not even be able to issue a particular product. This is where the concept of open architecture becomes essential. Let's illustrate this with some examples. In the first one, we ask three banks to construct a capital guaranteed product on the S&P500. In the second one, we require the price of a short term Capped Bonus Certificate on a stock paying a high dividend (E.On, a German utility company with a dividend yield of 8.8%, payable in May). The three banks have a similar rating (ranging between single A to A+ according to S&P's). The two products in detail: 1. Capital guarantee on S&P500 index
  • Currency: quanto EUR
  • Maturity: 1 year
  • Capital guarantee level: 94% of current spot
  • Cap Level: 115% of current spot
  • Strike price: 100% of current spot
  • Issue and reoffer price: 100%
  • Participation:
  1. Bank A: 56%
  2. Bank B: 66%
  3. Bank C: 82%
2. Capped Bonus Certificate on E.On
  • Currency: EUR
  • Maturity: 4 months
  • Barrier Level: 78% of spot
  • Cap Level: 110% of spot
  • Issue and reoffer price: 100%
  • Bonus Level:
  1. Bank A: can't do
  2. Bank B: 107% of spot
  3. Bank C: 104% of spot
The above examples show a huge difference in pricing. The performance of the products will vary accordingly. It is known that banks operating in true open architecture will deliver better products on average than those recommending internal products only. While in theory all the banks should operate according to the "best execution" principle, practice shows it is still an advantage to compare prices with various institutes. Some wealthy individuals have reacted to the client-captive kind of advice by splitting their fortunes across three to six banks, also in order to diversify the bank counterparty risk. Thus, the same demand may be addressed to all banks, but only the one with the best pricing will get the deal. The investor may also chose to allocate a mandate to discretionary manage his or her money. In such a case, if the mandate is identical at each bank, one can assess the yearly performance of the portfolio, with the worst bank being eliminated and the funds it managed transferred to the best one. The virtue of open architecture will eventually be reflected in the performance of the portfolio.

Better be a bank robber than a banker

If the IRS would be the Capitol of Panem, then bankers, especially those in Switzerland, would be the folk populating District 12. As a banker, you usually do what your employer tells you to. You live by a set of rules some legal guy told you was right. As he's the expert, you assume he's right. Legal documentation of your government say so as well. So, as in any corporation, you try to maximize the value you bring to that bank. You do your job, then comes along another government, a big one, with much power who says, "what you did may be right for you, but not for us." More than a bit unsettled, your bosses, your government suddenly say "stop doing what you've been doing until now." So you do. But it's not enough. The big government asks for compensation, and little by little, push comes to shove. You're stunned when

Who needs structured products?

The ideal portfolio structure It has ever been difficult to find out how the ideal structure of the portfolio of an investor, be he of private or institutional nature, should look like. Very few investors actually know about the shape of the expected return distribution they really prefer. Many sophisticated questionnaires aim to determine the risk / return profile of the investor. However, these two values are not sufficient to give a complete representation. A risk / return profile typically assumes that with higher risk, an investor may expect a higher return, but also that the losses could be higher. Hence, the classical categorization of investors assumes a normal distribution of returns. But what if, for example, an investor would like to keep the chance of higher returns while limiting his risk? Such return distributions with classic investments like equities or bonds are extremely rare, and yet investors often ask for it. Advisers are often quite helpless in such situations.

Three strategies The following describes a simplified method that allows an investor to implement his desired return distribution in a portfolio context by using the appropriate investment instruments. The investor is confronted with the choice of three strategies: 1. "Cut losses and let profits run" 2. "Buy low, sell high" 3. "Buy and hold" These familiar slogans, all hinting at wise yet nebulous strategies, can in truth be very accurately differentiated. In Strategy 1, the investor takes frequent small losses but may book occasional large profits. People who choose this strategy are dependent on safety and do not want to (or cannot) suffer large losses. In Strategy 2, the investor takes a lot of small gains, but accepts the occasional large loss. This strategy is the most active of the three, where timing plays an important role and which is often counter-cyclical. In Strategy 3, the investor is willing to take the fluctuations of the market into account, as he is persuaded that the underlying asset will generate a good return over the long run. This is the most passive of all 3 strategies. If an investor can opt for one of the three strategies, then an important step in the choice about investment vehicles to select for the portfolio will already be made. Only the 3rd strategy ("buy and hold") can be implemented with the traditional portfolio consisting of equities and bonds. In fact, it is the only one where the return prospects are normally distributed. The other two strategies have asymmetrical (non-normal) return distributions. To understand the concept, the so-called "higher central moments” of a return distribution must be introduced. These are namely the skewness (or skew, 3rd moment) and kurtosis (or height / pointiness, 4th moment) of the distribution. These designations are not very common among investors, but can be readily explained by way of example. Let us return to the investor, who would like no risk, but leave the door open to the chance of high returns. In principle, he wishes for nothing else than to replace negative return occurrences with zero and leave positive return occurrences as is. In a return distribution, replacing all negative values by a single one creates a peak at that level, and raises the kurtosis: the distribution becomes taller, pointier. At the same time the distribution loses its symmetry: since all the negative points disappear and the positive points stay, the return distribution becomes right-skewed (on a graph, the right tail of the distribution is longer than the left). In all logic it will cost something to reduce or even eliminate the possibilities of a negative return on investment. If it were free, everybody would do it. How much it costs is uncertain and depends on market conditions. So what would be a good description of this investor’s strategy? Well, the return distribution fits the first strategy, "cut losses and let profits run". The slogan description is probably better understood by the average investor than if the talk is about higher central moments of a return distribution. To round up the picture, the 2nd Strategy, "buy low, sell high" is identified by a left-skewed, high kurtosis distribution. Matching instruments Now it’s time to determine the selection of products that fit the chosen strategy. Here, structured products can be useful. Not coincidentally, structured products have been categorized in three major categories: capital guarantee, yield optimization and participation. Capital guaranteed products can’t be redeemed below their capital guarantee levels (unless the issuer goes bankrupt). All cases of negative returns are replaced by the level of capital guarantee (this sounds familiar). In theory, the cost of converting the negative returns to the capital protection level reduces the average return on the investment. As long as the product has unlimited upside potential, the chance for high positive returns remains open. Hence, capital guaranteed products have generally right-skewed medium-high kurtosis return distributions. In the case of yield optimization products, all returns that would be above a certain cap (e.g. a coupon) are replaced by the level of that cap. Negative returns are possible. To compensate for this increased risk, the investor receives a premium, which can be compared to a sold insurance premium. It therefore stands in contrast to the capital guaranteed product in which protection is bought. Yield optimization products have left-skewed return distributions with (sometimes very) high kurtosis. Participation Products have similar return distributions as their underlying assets. Both "tails" (extreme negative or positive returns) remain open. Despite minor distortions at certain points of the return distribution (such as at the barrier level of a bonus certificate), participation products return distributions can be considered as more or less normal. Conclusion The question "Who needs a structured products?” can now be answered as follows. The first strategy, "Cut losses and let winners run", can be implemented through capital guaranteed products. For the second strategy, "Buy low, sell high", yield optimization products can be considered. Ultimately, the third strategy, "buy and hold", is best achieved by means of classical instruments such as equities and bonds, but also through participation products. Of course, this is all very high level and a portfolio must be defined with more detail, but the foundations of the portfolio structure have been laid. Everyone who can identify his chosen strategy with one of the 3 slogans has also found out which product category is suitable for him. Andreas Blümke (Original text written by the author in German for B2B Magazine)

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