Q&A: counterparty risk - Spot the differentiation

The credit quality of product issuers has become a prime concern following the downfall of US investment bank Bear Stearns. Sophia Morrell asks seven industry players - issuing banks, an index provider, a distributor, a risk analysis and pricing company and a lawyer - about how counterparty risk is affecting business in the US

Structured Products: How sensitive are investors to an issuer's credit rating? Do they distinguish between the credit quality of different institutions?

Anna Pinedo, partner, Morrison and Foerster: Investors are particularly sensitive to all of the headlines about write-downs at the large financial institutions and the ratings downgrades or ratings warnings that have followed. Investors anticipate that there will be additional write-downs by large financial institutions and, as a consequence, additional ratings actions. Investors have also been observing that all of the financial institutions have been seeking to raise funds in order to maintain their regulatory capital ratios or otherwise maintain adequate liquidity.

Scott Mitchell, executive director, structured investments, JP Morgan: Sophisticated investors in the high-net-worth and institutional space have become ultra-sensitive to credit risk in structured products, and have started to adjust product terms using issuers' credit default swap (CDS) levels. Investors in the retail space are now starting to differentiate based on credit quality as well. This is not surprising given that risk reduction (through principal protection or buffers) is the primary goal for most retail investors purchasing structured products.

In both segments we are seeing the beginnings of a flight to quality, which should be a boom for certificate of deposit (CD) issuers (due to the attractiveness of Federal Deposit Insurance Corp insurance) and also to Registered Note issuers, which are perceived to be of the highest credit quality. Investors are also starting to differentiate between well-capitalised issuers and those issuing through subsidiaries that are not explicitly guaranteed by a well-capitalised parent company.

SP: How prominent is counterparty risk in the minds of investors and distributors when selecting or constructing products, compared with attractive terms or specific underlyings?

Steve Braverman, President, Harris myCFO: Since clients understand that they are investing in the obligation of the issuer to deliver contracted performance, this has been a very important issue. While it is clear that certain institutions have areas of expertise and strengths that might help introduce innovative and compellingly priced products, clients are finely tuned to the ideal of not only return on capital but also return of capital. As such, issuer risk is being discussed directly at the investor level.

David Armstrong, managing director, equity derivatives, Americas, Societe Generale: Distributors tend to be sensitive to the headline risk of their institution. The bankruptcy of an issuer can have a terrible impact on distributors' reputation, as they are responsible for conducting due diligence on the issuer on behalf of its clients.

On top of reputation risk, the failure of an institution would leave the distributor liable. When they choose an issuer, its credit rating will certainly function as an important part of their decision process.

Srikant Dash, head of global research and design, Standard & Poor's: Investors prefer to take a broader view. Market reputation, product innovation, brand awareness, existing relationships and credit quality are important considerations, with the latter becoming more important due to news flows.

SP: How are people protecting themselves against counterparty risk - are they putting together baskets of issuers, and are distribution platforms looking more towards open architecture? Are they buying CDS on the issuer as a means of hedging themselves?

Rohan Douglas, founder and CEO, Quantifi (credit risk and pricing software provider): Counterparty risk permeates the financial markets and the development of the credit default swap (CDS) market along with a better understanding of counterparty risk have led to fundamentally new ways of actively measuring and managing this risk.

Historically, counterparty risk has been managed using static measures such as outstanding notional, fundamental credit research on the counterparty, or structuring deals in a way to minimise this risk. More recently, the most sophisticated banks have led the way towards dynamically measuring counterparty exposure and actively managing this exposure using CDSs. The infrastructure required to do this is extensive and complex but the techniques and models are becoming more widely available and there is no reason why techniques for measuring counterparty risk cannot be integrated with industry best-practice market risk management.

Scott Mitchell, JP Morgan: At this point, we have not seen distributors purchasing insurance on particular issuers to hedge against credit risk.

There have been two general approaches taken by distributors: portfolio limits for each issuer based on their overall credit quality, and credit adjusting pricing levels on a product-by-product basis. Issuers who take this approach also tend to perform top-level due diligence on each provider on their platform. In situations where clients have a large allocation to structured products, leading providers now offer third-party issuers to help diversify credit risk.

Anna Pinedo: Although there is a lot of discussion about open architecture, most wholesale banks still principally market their own structured products.

Steve Braverman: We have discussed the opportunity that clients have to consider CDS and other hedges as a way to mitigate exposures, but these conversations have been more from the perspective of quantifying issuer risk rather than insuring against it. Seeing that structured products are a helpful, but not critical, component of our well-diversified investment mandates, if a client is so uncomfortable with issuer risk that they feel the need to hedge it away, we will likely find another alternative to deliver the desired exposure.

SP: Given that banks with a lower credit rating might be able to offer more attractive terms, are investors and distributors willing to consider the lower rated banks to get the higher coupons?

David Armstrong: Not especially. It really depends on the investor's risk/return appetite. Some of them will favour returns over risk and others will favour the opposite. However, we think that many investors look beyond the level of coupon offered by an issuer.

Investors tend to be very sensitive to the quality of services associated with the product they buy, including the ability to provide an active secondary market, to send detailed reporting or to explain the valuation of a specific product, all of which may not be obvious given the sophistication of certain payoffs.

Mike Clark, head of structured retail products Americas, Credit Suisse: We did see a lot of this type of shopping for terms prior to April, but I would say this is much less prevalent now. Accounts do seem to understand that credit matters.

Scott Mitchell: This was certainly the case in late 2007, but recently it has become much less common. Risk reduction (through principal protection or buffers) is the primary motivation for most retail structured investment purchases, so going out further along the credit spectrum has become less and less desirable.

SP: Is Bear Stearns viewed as an isolated incident or is it perceived as a situation that could repeat itself with another bank? How concerned are investors about the negative headlines on Lehman Brothers, Merrill Lynch and Morgan Stanley?

Rohan Douglas: While the fall of Bear Stearns seemed rather sudden, the problems faced by the bank are not unique, especially in the present market environment. There are other investment banks that are contending with excess leverage on their balance sheet on similar mortgage-related assets like those held by Bear Stearns.

It is not the first time that investors have made a run for a bank and it's unlikely that it will be an isolated incident, especially given the length and breadth of this current credit crisis.

Banks are clearly under a lot of scrutiny, especially since it is hard for investors to get a handle on how they are marking to market some of the assets on their balance sheet. This lack of transparency has clearly spooked investors, impacting the stock price and investor sentiment.

Anna Pinedo: Although there are elements that investors, especially institutional ones, recognise as being very particular to Bear, generally they are concerned about another large financial institution or investment bank facing serious liquidity issues. Recent headlines have focused attention on the possible liquidity issues being faced by Lehman Brothers, for example. Investors no longer believe that any investment bank is immune from the kind of issues that led to Bear Stearns' problem.

Steve Braverman: News moves so quickly these days, and the pace at which the Bear Stearns scenario unfolded was unsettling for clients. Most people are still inclined to follow the headlines and feel that 'another shoe has to drop eventually'. Investors are definitely tuned into the differences between those organisations that they perceive to be overleveraged and/or trading focused institutions versus those that seem to have more stable, diversified businesses.

SP: What has been the impact of Bear's troubles - how has it affected the way structured products are viewed? Given that all products were later guaranteed by JP Morgan, yet shareholders lost 97% of cash, could it even have a positive effect on the market?

Mike Clark: It has had a positive impact in the sense that clients do take into account that there is a linkage between terms offered on a structured product and the credit of the underlying.

Rohan Douglas: The Fed's intervention that led to the JP Morgan takeover of Bear Stearns certainly went a long way to ensure counterparty risks were mitigated and succeeded in averting a full-blown banking crisis. Although the Bear Stearns stockholders were clearly the biggest casualty of this situation, the domino effect of the counterparty credit risks associated with the meltdown could have had far greater consequences for the US banking system and the economy as a whole.

As banks try to cope with the losses, the issuance of most structured credit instruments has slowed down dramatically and in some cases come to a grinding halt, and might subsequently take a while to fully recover.

David Armstrong: The current financial crisis has affected structured products in much the same way as it has other financial instruments. The losses seen in the market emphasised once more the importance of dealing with banks that operate under a diversified business model. Questions regarding the strength of a group are crucial. Investors now realise that differences in the spreads of creditors first reflect their business model and then their credit rating, among other factors.

Srikant Dash: In general, most retail structured product trades, such as certificates, warrants, index-linked notes and reverse convertibles, are based on very liquid, exchange-listed underlyings and are collateralised by the actual holdings. Investors therefore find such products more transparent and appealing than synthetic exposure or exposure to less-liquid markets. One of the issues that has come to the fore following recent events is the increasing importance of liquidity and tradability. In some ways, credit risk and liquidity are related because securities that are traded over the counter or have tight liquidity become difficult to liquidate if there are credit concerns. So we see risk managers in issuing banks impose tighter requirements on the liquidity of underlying benchmarks before approving index-linked products.

Anna Pinedo: Investors tend to view some institutions as too large or interconnected to fail, or think regulators will not allow an investment bank or other large financial institution in the US to go under because the ripple effects on the rest of the US financial system would be too costly. This attitude has affected how investors perceive structured products and other debt securities issued by large financial institutions.

Overall in the US, we are seeing a backlash against financial engineering, overly complex financial products, innovative financial products and derivatives. Many commentators and mainstream newspapers and other media outlets blame the complexity of financial products for the credit crisis. Similarly, many have said that financial innovation and derivatives are to blame for the credit crisis. We witnessed a similar phenomenon in the US after the Enron scandals.

The popular press, legislators and others were eager to have someone or something to blame for the financial woes and it became easy to blame financial engineering. As a consequence of this kind of reporting and these knee-jerk reactions, structured products, which the mainstream business press still regard as overly complex, are likely to suffer.