A V Rajwade: Complex structures and rating agencies

WORLD MONEY

The new structures are very complicated""last year, the US issued 250 patents for financial products.

In last week's article, I had referred to the criticism rating agencies are facing for not having foreseen the problems in the sub-prime mortgage market. As holders of the structured bonds based on sub-prime mortgage-backed securities have incurred large losses, they are questioning the rating agencies' belated reactions (downgrades started only earlier this month). Some regulators are also concerned about the matter.

Having been connected with a rating agency for about 15 years, I have a professional interest in the issue. For one thing, there are obvious commercial attractions in undertaking the rating of complex structured securities. On the other hand, there is also the fear that, given the herd mentality of participants in financial markets, any premature downgrade can become a self-fulfilling prophecy.

But this apart, new products have proliferated in credit markets in recent years. For instance, re-insurance companies are issuing the so-called catastrophe bonds whose pay-off depends on the occurrence or otherwise of a defined catastrophe, thus off-loading some of the re-insurance risk in the market. As people live longer, death bonds issued by pension funds are also becoming popular "" here again the pay-off depends on the longevity of human life. [Death bonds should, of course, not been confused with the so-called "death spiral bonds" which are popular in Japan "" these are Moving Strike Convertible Bonds (MSCBs) where the strike price falls, and the number of shares increases, as the market price of the underlying equity comes down.] Another popular category is hybrid bonds which are debt for tax purposes, but given their long maturity (50 or even 60 years), are treated as quasi-equity by rating companies and regulators. Perpetual bonds have also made their entry into the Indian market and the regulator has permitted use of long-term bonds as part of tier two capital. High yield and mezzanine bonds are also in the nature of plain vanilla products. To be sure, risks are higher: high yield ("junk") bonds are below investment grade but rank with other debt, secured or unsecured as the case may be, in the event of bankruptcy; mezzanine debt, on the other hand, has even higher coupons but ranks below other debt in priority, and just above equity. Payment in kind (PIK) bonds are also high risk, high yielding; if a coupon cannot be paid in cash, it is honoured by the issuance of another bond to the holder of the PIK bond.

The simplest variety of structured finance is of course asset- or mortgage-backed securities. Plain vanilla securitisations have been taking place in the Indian market for the past 15 years or so and the experience with the product has been quite satisfactory.

The market for complex structured products has also grown very rapidly. As in the case of currency and interest rate derivatives, it often seems to me that the driving force behind the structuring of ever more complex products is not so much investor demand or genuine risk reduction, as non-transparent pricing which permits fatter margins. The alphabetic soup of complex structured debt includes:

Collateralised Debt Obligations (CDOs). These pool together a variety of bonds including securitised debt, loans and so on. The complexity comes from the different tranches carrying different coupons and credit risks.

Synthetic CDOs are derivatives not of actual debt obligations but of credit derivatives based on debt obligations. Hybrid CDOs include both securitised paper and derivatives as the underlying.

Some CDOs also include so-called Equity Default Swaps (EDS) "" these are similar to put options on the underlying equity.

Collateralised Fund Obligations (CFOs) give the investors exposure to a pool of different hedge funds, and do not seem to be very different from fund of hedge funds.

The latest entries in complex investment instruments are the Constant Proportion Debt Obligations (CPDOs) and Constant Proportion Portfolio Insurance (CPPI) notes. The former is an instrument based on indices of credit derivatives and risky investment instruments based on high return investment strategy but with capital protection.

The stock of structured debt now aggregates $ 9 trillion (that is, more than US treasuries)! Some structures are so complex that the ability of the rating companies to analyse and rate them is increasingly questioned. A recent AAA rating for a CPDO raised eyebrows. Another corollary should be noted. Given the effort in developing newer structures, the latest trend in the US is to patent the structures: the reason is that successful new ideas get replicated very quickly, bringing down the margins. Last year the US issued almost 250 patents for financial products!

avrajwade@gmail.com