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Tuesday, March 18, 2008

Why Retail Structured Products Depend on Iceland's Economy

Question: When are bonds issued by stricken Icelandic banks valued virtually the same as identical instruments issued by Royal Bank of Scotland?

Answer:  When they are valued for the purposes of comforting retail and private client stockbroker investors in structured products, of course. Derivative based retail structured products (you know the type, give me 100 and I will give you 100 +/- "some market performance" in 5 years) have been with us for well over a decade. Until now, all of them have done exactly what they said on the tin. But as well as the payoff profile, investors now have to ponder a different issue: regardless of the product's entitlement under the terms, will the issuer be solvent when this entitlement comes due? Is appropriate credit risk priced into these instruments? My example du jour is a Close Asset Management product: Japanese Accelerated Return Fund II (JAC.L). Beneath this exhilarating name hides a payoff profile which is essentially a 180 pence maximum less a 5x geared put spread on the Nikkei expiring in 2012. All well and good; the Nikkei's performance since launch may be poor, but at least investors know how the linkage works. Where it gets interesting is that the 180 pence maximum is secured on a pool of bonds. Two of these bonds, or 33% of the gross assets of the investment, are issued by the Icelandic banks Glitnir and Kaupthing (who? who indeed). Yet the formal valuations of the bonds at 31 Dec 2007 implied these Icelandic behemoths have virtually the same credit risk as, for example, Royal Bank of Scotland. Amazingly there was also no mention of the continuing deterioration in the credit quality of these issuers in the results announcement of 29 Feb, surely the perfect opportunity to alert investors in the trust. No doubt the manager got a friendly mark from their dealer to back up the valuations; they are not that stupid. But it is another thing entirely to recommend that the directors of the fund sign off that the accounts give a true and fair valuation of the assets. The secondary market price is also not yet close to reflecting the credit risk. Investors may be indifferent to the risk, but perhaps that's because the manager's NAVs are accepted in good faith. The UK has had its fair share of retail financial disasters - split capital trusts, precipice bonds, endowment policies - you name it. By and large, they are a function of the structure of financial advice provision in the country, but that's another post topic. If one of these banks fail, Close will be hoping to avoid being added to that list courtesy of the Icelandic government pulling a Northern Rock stunt out of the hat. **EDIT 20 Mar** With Glitnir going on S & P negative watch for a downgrade from A-minus today, and the CDSs jumping to over 850 bps in sympathy, we may get to find out sooner rather than later.    http://crookery.blogspot.com/

Þessir Close menn segja á heimasíðu sinni að þeir reki meðal annars vogunarsjóð og þetta um stærð sína:

Close Brothers Group plc is an independent investment banking group which was founded in the City of London in 1878 and is listed on the London Stock Exchange. The Group employs over 2,500 staff and manages assets of £8.9bn*.

http://www.closeinvestments.co.uk/Home/AboutClose/tabid/89/Default.aspx

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