Issuers change their tune on structured note disclosures

Open to disclosure


Going by their prospectuses, the target investor for issuers of structured notes in the US used to be a pretty special individual – someone with the language skills of Samuel Johnson, the maths expertise of Bernhard Riemann and the physics nous of Robert Oppenheimer.

“Firms that were disclosing anything about pricing were doing it in a way that was virtually impenetrable. You had to have an otherworldly grasp of the English language, physics and maths to get anything that approximated an understanding,” says a senior New York-based structured products expert at a US bank.

Things are a bit better today, but while the industry is now willing to poke fun at its old disclosure practices, it did not walk away from them voluntarily – it took a 2012 crackdown by the Securities and Exchange Commission’s (SEC) office of capital market trends, headed by Amy Starr, which initially drew fierce protests from dealers. The SEC’s most specific demand in the letter it sent that April was for issuers to start disclosing the difference between the public offering price of the structured note – that is, the price the investor pays for it – and the issuer’s estimate of its fair value. In effect, the regulator was asking the industry to show how much profit it was making on the sale, a requirement that was finalised in February 2013 and showed up in prospectuses from the middle of last year.

Nine months down the line, issuers say their early concerns have proved unfounded – if anything, the new disclosures have been helpful.

“Commercially, a year ago there was some uncertainty about the whole thing, but I think it’s been a positive. There were some challenges involved in working out the clearest language and getting the procedures in place, but I haven’t seen any adverse impact on the business,” says Kevin Woodruff, global product head of structured notes at Morgan Stanley in New York.

You truly had to have an otherworldly understanding of the English language, physics and math to get anything that approximated an understanding

Others claim they were never that worried. “I never really understood the passion around it except that perhaps people were concerned about the client reaction to what they were disclosing,” says the senior New York-based structured products source. “I felt anyone who wasn’t comfortable with it would push back. And they did. When people don’t want to disclose something like profit margin, it’s probably not because it’s super-competitive, conservative and reasonable.”

But while attitudes and practices have changed, the new regime has its blind spots, one of them being comparability, which can be undermined for some products by the very different funding costs and assumptions baked into dealers’ valuations.

The price investors pay for a structured note depends on four components: the bond, its embedded options, the distribution fees and the bank’s profit. The bond is valued by taking the principal amount of the structured note and any coupon payments, then adding a haircut charged by the bank’s internal treasury.

This haircut rate – and the methods used to pick it – was left up to the bank as long as it could explain the reasoning. “The SEC ended up giving the industry a bit of flexibility there, and the way I read their final letter is ‘Look, we’re not going to tell you what funding rate to use, but – whatever you do – try to explain it to people’. That’s their approach to life in general,” says another structured note specialist at a second US bank in New York.

The rate used affects the final fair value of the note, and some issuers are now checking with other market participants to ensure they are not an outlier. “Do you use your internal funding rate? Do you use your external credit default swap price for your company? Do you use your company’s bond price? Do you have sufficient points on the curve? Different companies approach it differently. We have been discussing with other market participants to make sure we have something that is consistent with the developing market practice,” says Olivier Daguet, head of engineering for the Americas in the cross-asset solutions team at Societe Generale Corporate & Investment Banking in New York.

It’s not hard to see why. Morgan Stanley’s Woodruff says that for a simple product such as a reverse convertible with less than one-year maturity, there will be pretty much no difference between banks. For maturities between three and five years, he says there may be a quarter of a percentage point difference. But for longer-dated and more complex products, the differences can be big.

“If you’re talking about a 20-year product with complexity – say a hybrid product where some inputs are not readily observable – and differing funding assumptions, you could probably see a couple of percentage points of difference in the current environment,” he says. If funding spreads were as dispersed as they were in 2012, it could make more of a difference, and investors could be expected to gravitate to the product with the higher fair value, he adds – one of the fears raised by banks following the SEC’s original letter.

As an example of the new information being put in front of investors, a January 2014 prospectus from BAML for an S&P 500 accelerated return note, issued at $10 per unit, states the fair value is $9.80, and that it costs the bank $0.075 per unit to hedge its exposure. The prospectus also says that, of the 20-cent difference, up to half can be due to the internal funding costs it pays to its treasury, which charges around 0.5% below what it would pay for a conventional debt security.

So far, there is little evidence that investors are gravitating towards products with a higher fair value, issuers say – instead, they are picking and choosing based on how their own aims match up with those of the product. “I think they’re making the investment based on the quality of the investment and the objects. If you think about it, when you’re selling someone an S&P 500-linked note, they’re making their decision based on the underlying and the economics of the trade,” says a New York-based structured products source.

In fact, some of the new disclosure requirements may have proved more helpful to issuers than investors. One dealer says the SEC’s push played a role in finally convincing its treasury to publicly disclose its internal funding rate – something it had previously avoided doing because it did not want to be limited to a particular range.

“It would have been very difficult to get treasury to agree to this. Frankly, it was difficult to get treasury to agree to this even with the SEC pushing for it. Without the pressure from the SEC, it would have been extraordinarily difficult to get this disclosed,” says the New York-based US bank source.

Another upside, he says, is that the disclosures help demystify the pricing process, meaning people feel less like banks are taking them for a ride. “Investors never thought we were doing this for free, but I think they appreciate the fact we’re now very concrete about demonstrating how much we’re making,” he says.

So far, the SEC seems to like what it sees. Speaking at a conference organised by Risk’s sister publication Structured Products in December, Starr said she was generally pleased with the new disclosures, but said her office is now starting to scrutinise prospectuses for exchange-traded notes (ETNs).

“Can someone look at [an ETN] and say, ‘I can figure out what I’m entitled to get’, or is it a formula that you need a high-level maths degree to figure out? What are the costs and fees, and are they taken into account when you’re doing a valuation?” she said.


What was the industry scared of?

In time-honoured fashion, banks responded to the Securities and Exchange Commission (SEC) push for new disclosures with a list of complaints and concerns. The fair value of the notes had limited relevance to investors, some said, and calculating it would be practically challenging. Others argued the disclosures would be misleading because issuers have different valuation approaches and would use institution-specific inputs, including their funding spreads.

“Given the different assumptions, forces and factors that underlie this divergence, we do not believe that one can in a comprehensive and accurate manner ascertain, and therefore, quantify and disclose such differences for any given note,” said Barclays in its April 2012 comment letter.

Deutsche Bank said in its own letter: “We are concerned that retail investors will place too much reliance on any disclosed estimate of fair value, when their investment decision should instead be based on the economic terms of the structured note.”

Clarity arrived in February 2013, when the SEC released guidance on what to include in the disclosures. To many banks’ dismay, the regulator dug in its heels, refusing to back away from the requirement to publish the fair value of the structured notes on the front page of the prospectus.

The SEC also refused, in most circumstances, to allow hedging costs to be included in the fair value of the instrument – something banks pushed hard for, arguing it would otherwise inflate the apparent profit margin. An exception was provided under three conditions – banks would need to bid out the pricing of the embedded derivative to a third party; not use any internal pricing model to value the embedded derivative for any reason; and disclose that the issuer is entering into a derivatives transaction with a third party.

Banks, however, say these requirements are impossible to meet, as the major players nearly always use internal models to value options contained in their structured products. “As a big dealer, I have to value the embedded derivative using internal pricing models. I feel like our controllers won’t be too happy if I say ‘Aw shucks, I don’t know how much this thing is worth’,” says one New York-based structured products specialist at a US bank.

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