Structured products are being presented as something of a holy grail for the financial markets. They’ve certainly been embraced by investment banks, who like the fees they earn for structuring them; by retail banks and insurance companies, who like the commissions they earn for selling them through their networks; by investors, who are looking for the type of return such products can provide in a low interest rate environment; and by credit rating agencies, which have received a major boost to their earnings by judging the creditworthiness of the products that are structured.
Just how far and fast this market can develop is a subject Risk will look into in some depth next month. But, as with any growing market, there are teething problems. And this month our cover story (on page 38) uncovers one of the more worrisome episodes to date.
At the start of this decade, the Italian retail market for capital guaranteed products was increasingly competitive, and issuers were looking for ways of cheapening the cost of the zerocoupon bond offered to investors to keep the potential equity upside high.
The answer Poste Vita came up with, together with its investment bank advisers, was to use synthetic collateralised debt obligations (CDOs) – or, more specifically, bespoke single-tranche synthetic CDOs.
These CDOs – totalling more than €2 billion under the name of Programma Dinamico – were then rated triple-A by Fitch and Moody’s. Nothing amiss there, it seems. But the rating agencies say they assigned their highest marks to these bonds on a private basis. These ratings were then used in the marketing material put out to Italian retail investors by Poste Vita, until recently unbeknownst to the agencies, they claim. The problem was compounded when some of these CDOs were restructured and downgraded – none of which was communicated to the broader market, or to those who had invested in them, because the deals were still officially privately rated.
Who’s at fault here? There’s no simple answer. The agencies now bemoan their failure to ask that the addressee of the ratings letter sign a confidentiality agreement.
But the rating agencies need to ensure that they are seen as whiter-than-white in the structured credit arena, because of the huge revenue stream the market now represents for them.
One answer would be to produce a different rating system for the private market – as is currently the case for short-term debt. Perhaps a private rating could carry a ‘P’ pre-fix. It would avoid any confusion. When all is said and done, the rating agencies must take responsibility for how their ratings are used. Such a pre-fix would show immediately if a rating was private, or if it was published by the seller without the pre-fix, show that the seller was at fault and not the agency.
Structured credit remains one of the most dynamic and competitive areas of the global financial markets, as shown by the number of banks that rate highly in Risk’s annual inter-dealer rankings, coverage of which begins on page 46.