A V Rajwade: Structured financial instruments

I generally caution clients against the use of complex derivative instruments, which often do not have price transparency or an easy exit route.

Between a bank, which can call upon the services of "rocket scientists" to structure ever more complex instruments, and the corporate treasurer facing an array of sophisticated marketing teams, the playing field is hardly level.

The attractions of complex derivatives for the bank are obvious: as competition in plain vanilla instruments has shaved profit margins, structured or proprietary products are the way to improve them.

The marketing teams may also have a vested interest. Their bonus often depends on the deals they succeed in concluding. The question is whether complex products are equally beneficial for the end-user.

One has serious reservations on the subject. This apart, there are a number of cases in international financial markets of even sophisticated players suffering losses from complex derivatives.

Some of the cases that readily come to mind include Procter and Gamble, Gibson Greetings, Ashanti Goldmines and so on. After the introduction of rupee-based options in India, one has seen various structures, attractively packaged, being marketed in the rupee market.

One major problem in the rupee options market is the lack of published data of bid offer prices.

Prima facie, it seems that transaction costs are high "" and multiply when one uses a combination of options to reduce/eliminate up-front "cost".

On this point, one feels that the blame squarely lies with our corporate culture. The executive, who is quite happy to write a cheque for insurance premium to cover, say, earthquake or fire or transit risks, is not equally ready to pay for insuring the risk of adverse exchange rate movements by buying currency options.

He prefers a "zero-cost" structure confusing zero cash outflow for zero costs! In fact, "zero cost" structures involve significant transaction costs.

This unwillingness to bear cash outflows up-front, canceling an out-of-the-money forward contract at a "loss", for example, tempts some corporate treasurers to replace the forward with structures involving three or four options.

They often do not realise that the transaction margins of the multiple options are adding to the costs, rather than reducing them. The cash outflow may be zero but this is not the same as the structure being cost free.

Another common trait, even in otherwise competent executives, who claim that they are not speculating, is the belief that they have a better handle on the future than the ruling market prices.

As if complexity in the interest rate and currency derivatives was not enough, it has now made major inroads in the field of so-called structured finance, and credit derivatives based thereon.

It is in the field of collateralised debt obligations (CDOs) that increasingly complex instruments are making an entry in the international credit markets.

(The difference between asset backed securities , or ABS, and CDO is that the former is secured by one type of asset like housing loans, credit card receivables and so on, while the latter has a more diverse underlying portfolio.)

CDOs are quite complex "" in their simplest version, the credit risk on a portfolio transaction is typically divided into at least three tranches, each carrying a different level of credit risk (see World Money, October 28, 2002).

Further complexity is added when certain CDOs themselves invest in other CDOs (so-called CDO2), thus making the monitoring of risks extremely difficult.

In a recent case, the senior-most, or safest, tranche was downgraded from AAA to junk rating in a matter of less than three years! In general, AAAs have to be "earned" and are expected to be far more stable.

Such cases apart, the explosive growth of credit derivatives (outstanding amount estimated at $ 5 trillion at the end of last year) is making life difficult for rating companies in other ways as well.

One experience I had as a director of a rating company was that capital market pricing of equities/bonds often led, rather than lagged, rating changes.

The credit derivatives market seems to be reflecting the change in perception of a company's ability to meet its debts, even faster than the capital market.

Clearly, rating companies have a tough challenge on their hands in the form of credit derivatives.

In India, the Reserve Bank of India came out with draft guidelines for introduction of credit derivatives almost two years ago but nothing much seems to have happened thereafter.

In the meantime, a number of issues of asset backed securities, including mortgage backed securities ( MBS), and of a couple of plain vanilla collateralised debt obligations have taken place.

The scope for securitisation is enormous. There is an explosive growth in housing finance. Given the long-term of housing loans, they do create asset liability management problems for housing finance companies and lender banks.

Securitisation could be an answer. Again, non-performing assets also present a securitisation opportunity.

While I have not come across any multiple tranche securitisation transaction, with each tranche carrying a different rating, in India, analyses by the rating companies evidence that the securitised pools have broadly performed as anticipated at the time of issue, thus validating the methodology.

Securitised assets are also attractive to the investor as they typically yield 0.25/0.5 per cent higher than similarly rated securities.

Tailpiece: Recent surveys evidence that a number of analysts/participants in financial markets seem to be bullish both on the rupee, in terms of the exchange rate, and the stock market, because of further improvement in corporate profitability.

This seems incongruous: surely an appreciating currency is deflationary and pressures corporate profitability downwards?

Email: avrco@vsnl.com