Chapter 11

Structured Products

Timothy A. Day

Guggenheim Securities, LLC

INTRODUCTION

The term structured products is sometimes used to connote anything new and innovative in the financial markets. However, more narrowly, structured products are defined as products that are based on an underlying security (e.g., single securities or indexes such as stocks, baskets of stocks, commodities, debt issuances, or foreign currencies). Indeed, after a review of the ways in which the term has been used in the vernacular, one is tempted to loosen the definition even further: a structured product is anything that varies in any meaningful way away from some original underlying instrument. Now, this is purposely vague in order to highlight the fact that virtually anything and everything can be described as a structured product. Therefore, we begin with a conceptual discussion of structured products, including various examples of what are and what are not considered structured products and why or why not this is the case.

This chapter is intended to provide an overview of structured products and their applications with a specific focus on equities and credit. It is in the interest of brevity that we do not include summary sections on commodities or interest rate and forex structured products. Those are covered elsewhere in this book.

A Note on Derivatives

The growth in structured products occurred as an extension of the growth in the derivatives market as a whole; in fact, separating the one from the other today is impossible. The growth of both has been extraordinary. While there has been no shortage of negative press—for example, Enron's bankruptcy in 2001 and the credit crisis that began in 2007—the benefits outweigh the risks.

An early driver of the derivatives markets was the need to hedge pricing risk. An illustration is the farmer who seeks to immunize himself from mark-to-market volatility in order, say, to ensure the sale price of a crop. It was not much of a stretch to see the introduction of contracts to enable delivery to occur on behalf of another party, and the subsequent formations of exchanges and such, to promote the efficient clearing of these contracts.

Soon, there were contracts not only on corn and wheat, but also on cotton, coffee, cacao, and other commodities. Moreover, contracts spread to almost anything that could have a deliverable. This extended beyond commodities and into monetary contracts, Eurobonds, and so forth.

Now a market participant could not only manage price exposure, but could also engage in a secondary exposure to an asset class without actually engaging in the risk of holding the underlying asset. This is generally referred to as taking synthetic or derivative exposure.

The advent of derivative exposure has both widened ports of access to individual asset classes and increased the number of asset classes that are available. In short, derivatives increased liquidity in the underlying asset classes and, thereby, increased the number of market participants.

We proceed with a summary of the history of structured products and then describe the structured products’ life cycles, including roles of the various participants, and the role structured products play in systemic risk distribution.

A HISTORY

Structured products have existed in Europe for four decades and were created in response to investor demand for achieving investors’ risk-return objectives (for example, principal protection) or an issuer's risk distribution needs. Only more recently have structured products become popular as investment vehicles in the United States and Asia.

Once upon a time, the financial product lexicon consisted of a well-defined universe of products divided into segments with which we are still familiar today: equity, fixed income, foreign exchange, interest rates, and commodities, among others. However, with the advent of the age of the financial engineer, a veritable bloom of structured products arose in the financial seas. It was the financial engineer who noted that investors desired risk-return characteristics to fit a variety of investment needs or to take specific views on the performance of any of a wide variety of asset classes. In such a way, a traditional security could be combined with a derivative in order to meet specific investor demand.

As new variants on the product increased (and investment bankers began to realize fees on the creation of these products) so too did the breadth of structured products. Structured products began to move from the convertible bond space until each product area had its very own enclave of structured products. Today, structured products include a host of instruments.

As mentioned in the preceding, the building blocks for many structured products consist of a note and a derivative component. The note component may consist of either the individual security (or swap in the case of a synthetic transaction) or index of securities (or swaps). The derivative component may consist of any of a variety of various options, swaps, or, less frequently, futures, forwards, and the like. In combination, these, and the legal framework of the vehicle used for purposes of the execution of a specific trade, comprise the transaction structure.

The motivations of the various parties are key to the formulation of the structure. Each party seeks to achieve the most favorable terms possible, as constrained by the wants and needs of the other parties, especially pertaining to the economic feasibility of the overall transaction. It is this latter element that the banker for the transaction is most concerned with, and, under the banker's purview, an orchestration is performed that consists of various balancing acts to achieve the twin aims of profitability and client satisfaction.

EQUITIES

If we must pick the product that symbolizes the birth of the structured product, then we might as well start with the convertible bond. This instrument represents a departure from the cozy and staid condition that the financial products lexicon had found itself in. In a convertible bond, an investor is willing to accept a lower rate of interest in exchange for a higher possible return if the equity value increases. As this already represented a note with an embedded option to convert to equity, it was a simple extension for investment bankers to bundle in other features, such as principal protection or limited conversion rights.

With respect to equities, the note component can be considered to be either a stock or an index (i.e., a portfolio of stocks). There are a variety of regulatory issues that one must consider when dealing with stocks and indexes. These include various corporate and securities law issues—dilution, dividend, borrowing, and exchange issues—and the role of constituent documents.

Corporate and securities laws regulate the issuance and subsequent trading of individual stocks and securities. Naturally, these regimes differ according to geographic and national boundaries, as well as the specific type of stock or security under consideration. The regulatory constraints pursuant to applicable corporate and securities laws are not only important for the individual security, but come into play with the equity derivative as well. Therefore, when considering a structured product, one must consider the ways in which these laws might interact with the provisions of the law governing the entity responsible for issuing the structured note, as well as the securities laws that may be relevant to the issuance of the structured note.

Dilution is a particularly interesting issue with respect to the interplay among stock, derivative, and structured notes. Dilution occurs when the firm issues more stock, or a derivative may directly be responsible for dilution when the firm issues call options (e.g., a convertible bond issuance). Derivatives that reference the stock will be affected by this through the change in the stock price.

The dividend is a particularly vexing issue in the valuation of any equity derivative and, hence, any structured note that contains an equity derivative component. A dividend, by design, has an unknown timing and payoff profile, not to mention raising accounting and tax treatment issues.

Borrowing stock is mainly required when one undertakes a short-selling strategy. One's ability to borrow may be influenced by the overall liquidity in the market.

Exchange trading considerations must also be taken into account. The exchange rules will determine variously how a stock may or may not be traded, as well as influence the trading costs associated with specific transactions.

Last, we must consider the firm's constituent documents that govern the actions that may be undertaken with respect to a firm's stock. This will clearly impact the equity derivative as well as those that reference the stock directly. One must consider the impact of this on the structured note.

Strategies that relate to indexes are prone to all of these issues as well as various others. Indexes are constructed to resemble either existing indexes—for example, the Standard & Poor's (S&P) 500 index or the Dow Jones Industrial Average (DJIA)—and structured notes on these allow the investor to synthetically replicate exposure to the underlying index.

Various products have been created to simulate exposure to indexes such as the S&P 500 or the DJIA. This evolution began when exchange-traded funds (ETFs) were created in 1993 on the back of the birth of program trading. Structured notes referencing indexes have substantially impacted trading and liquidity in the underlying equity markets and generally are seen to have enhanced the price discovery mechanism. To be fair, the creation of indexes and the ease of trading in and out of these instruments has also led to a large amount of technical trading, which may or may not be considered a useful element in price discovery. This point is geared toward the difference between valuation and price and is the subject of a later section within this chapter.

Index creation has allowed for a far greater degree of short selling, as well as increased flexibility with respect to the ability to leverage various positions, track intraday price movements, and assist in trading strategies. These strategies may be directional or volatility based, or may be strictly of an arbitrage nature. Index strategies may also be layered onto other positions either as a partial hedge or to create new complex positions.

The purposes behind equity derivatives strategies are varied but may be generally classified along three dimensions: (1) asset allocation, (2) transaction cost management, and (3) return enhancement.

Asset allocation refers to an investment strategy that involves a manager's prediction for a market or market segment as opposed to more traditional single-stock-picking strategies. This technique has gained favor in tandem with the growth in the depth and breadth of equity derivatives and structured equity product offerings. Asset allocation allows for specific trades to be structured that, for example, make a play on the relative value of a specific stock or a basket of stocks.

Transaction costs come increasingly into play as more stocks are considered for a specific trading strategy. Thanks to various scale economies, one can reduce costs through employing index strategies.

Index strategies are also important, in that they allow the investor to take part in fractional trades; that is, the amount of an investment in a specific index may result in owning only a fraction of some shares. This partially removes an important barrier to entry: the individual stock price. This is an added benefit for liquidity in those underlying stocks, as the market maker can then act as an intermediary for small investors who may wish to partake in high-priced stocks. This further enhances liquidity in the underlying stock as well.

Returns are also more easily enhanced through the employment of index strategies. Bankers are more apt to provide leverage on a basket of securities than they are on a specific security. Additionally, management of exchange rate risk and other risks inherent in direct foreign investment may be incorporated into a product, thereby allowing for cross-border diversification strategies divorced from direct foreign exchange rate considerations.

Structured equity is also integral to equity capital management (i.e., the firm's ability to manage the capital structure). The company may do this on a variety of levels, including the management of equity price risk, in order to lower the cost of capital, manage equity positions, or manage equity risk as it pertains to mergers and acquisitions (M&A) transactions.

Since structured equity products allow for access to hard-to-access securities and separation of specific risk components (e.g., rate risk) from the market component, it should come as no surprise that structured equity is integral to many alpha-generation strategies. These are strategies that seek to maximize return to investors through generation of returns not explained by the market factor. As we will find in the following sections on other asset classes, this is a common theme in structured products and continues to serve as a prime driver for new product creation.

CREDIT

The fixed-income arena has been one of the strongest engines of growth in structured products for the past decade as a result of the burgeoning credit derivatives market. The credit derivatives market is primarily composed of total return swaps and credit default swaps. From these, in turn, a variety of products are structured to employ various strategies on—for example, the forward curve of credit spreads or the probability of various default/recovery events on credit baskets.

Total return swaps replicate the performance of a loan or bond whereby the investor takes on all the risk of the underlying assets. The bank pays all the payments (whether interest or principal) on the underlying asset while the investor makes a payment (essentially the funding cost). The investor additionally takes on all mark-to-market (MTM) risk associated with the underlying through a series of periodic payments over the life of the transaction. The bank pays the investor the MTM difference to the extent the value of the bond rises, and the investor pays the bank to the extent the value of the bond falls.

The advantages of this structure are similar to those outlined in the equity section and include the capacity to short sell, funding cost advantages, and leverage capability.

However, a total return swap differs in that it is an off-balance-sheet transaction. This, combined with the potential funding cost advantages, allows entities with lower credit ratings to gain access to the credit market without having to build out the infrastructure necessary for trading and settlement of credit securities.

Due to the lack of direct alignment of interests between the underlying borrower and the end investor, certain issues may arise surrounding confidentiality and dispute resolution in the event of default (especially in the case of loans). This is one of the many documentation issues faced when investing in these products and should be scrutinized carefully.

Credit default swaps divorce specific bonds from the process altogether in an attempt to arrive at a price for the underlying credit risk associated with debt issued at a specific point in a company's capital structure.1 The protection buyer pays a spread (premium) to the seller, who is obligated to make payments upon the event of default in an amount equal to the difference between the nominal amount and the recovery amount on, generally, the cheapest-to-deliver security in the relevant point of the capital structure.

It should be clear from the preceding that credit derivatives are a highly documentation-intensive enterprise. The International Swaps and Derivatives Association (ISDA) has standardized the documentation for these transactions. The standard is, of course, always evolving, but it is of note that the industry has weathered several defaults (e.g., Enron, WorldCom, etc.) without severe incident. This is in large part due to the counterparties involved—that is, large qualified institutional buyer (QIB) type institutions—and may vary as less sophisticated investors venture into the territory. The main elements of concern are settlement issues that constitute an event of default.

Events of default (EODs) determine under what conditions the protection seller is to pay the protection buyer. The main EODs are bankruptcy, failure to pay, obligation acceleration, repudiation or debt moratorium, and restructuring. Other EODs can be specified in the contract and may be appropriate based on the nature of the underlying referenced entity, but this can result in a substantial liquidity premium. The discussion of each of these is beyond the scope of this chapter. It is interesting to note that restructuring, in particular, is geographically variant, with specific modifications put in place to better serve the terms of European entities.

Settlement issues are of paramount importance in credit derivative transactions whether total return swaps or credit default swaps. Settlement may be specified as either cash or physical and varies from agreement to agreement. In cash settlement, valuation dates are specified to determine the price of the bond, whereas in physical settlement the actual bond is delivered. The advantage of the cash settlement process is that one need not necessarily have the bond itself in hand to conduct the required auction pursuant to the valuation process. In such ways the credit markets are made more accessible to investors.

Parallel to the equity market, there are a variety of indexes in the credit derivative universe that are used for the same purpose of enhancing liquidity in the underlying asset and enabling an overall reduction in transaction costs. There are a multitude of other specifications regarding the reference obligation, deliverable obligation, and delivery process, which are beyond the scope of this chapter.

The credit derivatives market has developed rapidly to include a number of products such as credit default swap options and various fixed recovery credit default swaps.

Credit default swap options allow the buyer of protection to enter into a credit default swap at a specific date at a specified strike price. This may allow investors to protect themselves against a corporate default only to the extent that the default risk had exceeded a certain amount by a certain date—an arrangement we might easily imagine would save one's job under certain circumstances and certainly would allow for the elimination of some worry that might otherwise remain latent.

Fixed recovery default swaps eliminate the recovery risk. These swaps are generally less liquid and therefore demand a premium that would seem to be out of line with the proper valuation of such a security. Therefore, the question arises: “Why would one enter into such a trade?” The answer has to do with the regulatory capital treatment of such debt. Credit default swaps normally are triggered when there is a default on any debt of the referenced entity, but the deliverable is generally senior, and this debt is often treated as a 20 percent risk-weighted asset. Therefore, there is the possibility to obtain exposure to subordinated debt at a capital charge less than that of purchasing the subordinated debt separately.

The credit derivatives market also includes several standardized indexes that are divided into investment-grade corporate debt, high-yield corporate debt, loans, and several subsets thereof. These indexes serve a similar purpose to that of equity indexes in terms of providing liquidity and enhancing price transparency.

There are a variety of products that result from the index technology. All major investment banks and an increasing number of other parties utilize this technology to make structured bets on when assets default relative to various market segments or the likelihood of a specified amount of loss on a portfolio. These products are very similar in concept to collateralized debt obligations and afford a dizzying array of variants.

First-to-default swaps are swaps where the seller of protection provides default protection on the first asset to default among a basket of reference entities. Here, buyers of protection can pay substantially less than they would for protection on the assets individually while protecting themselves against the first entity to default among a pool of assets. This might be particularly useful when one is concerned, say, about a small number of corporations in a specific industry sector and one wants to partially hedge the risk associated with a default event in this sector. Credit default swap protection has also been increasingly employed to hedge the credit risk inherent to other derivative instruments (e.g., interest rate swaps). This usually is an attempt to hedge out the counterparty risk inherent to the payment of any number of legs of a particular set of derivatives. To consider any swap, forward, or option position, one must take into account that both the timing and the notional amount will vary at each point in time. To write protection on such swaps, one must consider the mark-to-market of the position at the time of the default on the credit-linked notes and collateralized debt obligations.

Credit-Linked Notes and Collateralized Debt Obligations

It seems only natural at this point to discuss products that combine fixed-income securities with a derivative to enable an investor to replicate exposure to a security without the purchase of the actual securities. A credit-linked note is, essentially, functionally similar to a funded credit default swap and may be written either on a single name, or on a basket, or a portfolio of names. Interest in credit-linked notes stems from both the seller and the buyer of risk.

While most corporate debt capital is raised by debt issuance in the capital markets, lending by banks and other financial institutions remains a vital component of financial intermediation. These banks and other financial institutions, then, are fundamentally long credit risk. As credit derivatives technologies have expanded, the ability of banks (and other institutions) to measure and evaluate their credit risk on a portfolio basis has increased. Risk managers, duly noting this, have encouraged greater credit-risk portfolio management activities, such as the purchase of credit protection vis-à-vis credit-linked notes.

Meanwhile, investors are driven to purchase these notes to diversify their holdings and to put cash to work. However, they may have various regulatory or administrative issues:

• In terms of diversification, the credit-linked note market has been a boon to investors. As part of the issued bond market, corporate risk represents only a fraction of the issuance when compared to government/sovereign debt issuance.
• Investors often need to put cash to work in order to satisfy various portfolio yield targets.
• Regulations may prohibit various parties from entering into credit derivatives transactions.
• Administrative issues exist with the documentation, recording, valuation, and tax and accounting issues associated with credit derivatives.

The nature of the protection seller is the main limiting factor in the advancement of the credit derivatives market. The bank's main concern as a net issuer and holder of credit risk is that sellers of protection have certain characteristics in order to allow the bank to obtain regulatory capital relief and to increase the quality of their credit exposure to outside counterparties. This means, in practice, that not only does the seller generally need to have a credit quality higher than that of the referenced entity, but that the seller must be a bank or sovereign institution. To top it off, a bank's credit department will want to have assurances that there is a low default correlation between the seller and the reference entity.

Investor demand for access to the credit market has also been a factor in the advancement of credit-linked note technology. The credit market outside the credit-linked note market has been difficult for investors to access as a result of regulatory concerns. Examples of these regulatory concerns include determining whether investments are even allowed in the product, and dealing with the various complexities in obtaining approval to invest in these securities directly. Additionally, settlement difficulties and relatively high transaction costs have encumbered the expansion in direct corporate investment. Over the past several decades, as governments reduced their debt, investors were left with more and more free cash. Given the existence of various diversification requirements, investor demand for products that would allow access to credit markets increased.

This combination of regulatory and transactional difficulty and free cash translated into a ripe market for product development and promulgated the credit-linked note market. Bankers were able to work with existing documentation standards and utilize their balance sheets (e.g., through medium-term note programs or specially set up special purpose vehicles in the Caymans, Dutch Antilles, or other tax-advantaged jurisdictions). Advantages of setting up notes through such programs include the ability to reduce the legal complexities associated with direct investment in the underlying corporate debt and the flexibility to tailor the specific terms to the investor (as these often differed from the original issuer-driven terms).

The possibilities for tailoring debt issuance to investor needs have led to immense growth in credit-linked notes:

• The currency of the offered note may differ from that of the referenced security.
• Minimum denominations may vary. This allows investors to more easily allocate credit risk across any number of funds.
• The specified interest rate may be changed to accommodate specific investor needs whether on an absolute basis or from fixed to floating.
• Various degrees of principal protection can be realized. The note seller (protection buyer) accomplishes the issuance by combining a zero coupon bond of similar maturity (usually from the government market) with the corporate debt. The purchaser (seller of protection) does not see the specific mechanics of this, instead only seeing the resultant terms.
• Ease of investing in previously unavailable assets (foreign bonds).

Such notes may be constructed not only to replicate credit derivatives but also to replicate total return swaps or first to default notes. Another interesting application that we have not yet addressed is repackaging.

In the repackaging of an asset, the bank can achieve a true sale of an existing security into a special purpose vehicle, and then the cash flows and credit risk are recombined by entering into various credit derivatives transactions with the arranger (dealer).

Collateralized Debt Obligations

Collateralized debt obligation (CDO) is a generalized concept used to describe any form of credit-based securitization. The first types of assets that were securitized in such a manner were loans and bonds. Soon, as the advantages of these structures became clear to the sponsor banks, the banks began using them to securitize a variety of assets that were difficult for the bank on an economic level.

The first CDOs were therefore largely arranged by banks seeking to reduce their balance sheet exposures to any of a number of assets or derivatives that were often difficult to value. Additionally, the credit risk associated with the sponsor bank would also often be removed and replaced with various collateral assets. The bank could thereby benefit from the removal of credit risk from its balance sheet, and the investor could invest in specific risk divorced from the risk of the sponsor bank.

The transition from securitizing loans and bonds to pooling multitudinous assets was accomplished through the employment of the credit-linked note structure as described in the preceding section. This allowed derivatives and other assets that were difficult to securitize directly to be referenced in a CDO portfolio.

The CDO technology benefited investors greatly by allowing them not only to specify the type of asset classes in which they would like to invest, thus enabling the relative value plays and other asset allocation discussed previously, but also to specify the level of credit risk associated with those referenced asset classes. This was accomplished through the tranching of the risk.

The traditional cash flow CDO may best be thought of as a miniature bank. The CDO has both an asset component and a liability component. On the asset side, the CDO invests in any of a wide array of assets and, generally, enters into various derivative agreements to hedge out market, currency, and other risks in order to isolate the credit risk component. The CDO may then be analyzed as a company with specific asset cash flows.

In order to fund the purchase of the assets, as well as the required derivatives, the CDO then issues liabilities to investors. These liabilities are issued in credit risk slices (or tranches), the legal characterization of which ranges from equity and preference shares (at the highest risk layer) to investment-grade and high-yield debt.

While the needs of the sponsor banks were the primary motivating force behind the first CDOs to be issued, investor demand quickly increased in importance. This fundamental shift from balance sheet to arbitrage transactions changed the role of the sponsor bank from one of risk provider to that of structuring agent.

Structuring CDOs requires the matching of investor demands with the bank's ability to source risk at levels such that the associated parties to a transaction might be paid and investors left with suitable cash flow so as to warrant the investment. The main parties to a transaction range from investors, lawyers, rating agencies, and bankers to auditors and trustees.

Synthetic CDOs utilize the same technology as the CDO just described. However, instead of purchasing entire portfolios of specific assets, the CDO may purchase only a portion of the credit risk associated with a portfolio. This vastly reduces the number of securities that are required to be sold, greatly easing the ability to engage in credit risk management. Synthetic CDOs, however, do not achieve balance sheet reduction as there is no transfer of assets. They do substantially reduce funding costs associated with traditional CDOs as they do not require funding for a large portion of the transaction. This latter point, coupled with the significant reduction in required securities’ placement, significantly enhances the viability of large portfolio management techniques from the sponsor bank's perspective.

From the investor perspective, the same versatility of design associated with credit-linked notes is available. For example, one may remove prepayment risk, foreign exchange risk, the implementation of static run-off structures, and leveraged returns on asset classes. Leveraging is an especially important feature, in that investors are able to enhance returns on high-grade assets or difficult-to-access asset classes (e.g., life insurance-based products).

There are a number of features that are employed in CDO technology to divert cash flows to protect senior note holders and align the interests of a manager of the asset pool (if one exists) with that of the end investor(s).

Collateralized debt obligations have served an important function as cleanup tools in times of crisis. They help achieve a transfer or reduction of risk in order to free up a business to proceed in new business ventures. As such, they may be deemed a catalyst for change.

Pricing transparency is accomplished in this space through the construction of various tranches of risk that trade and allow investors to hedge risk on a correlation basis. Essentially each tranche represents a layer of risk. As there are fairly standardized markets in various tranches for each of the indexes, these allow the investor to individually hedge portfolio exposures at specific debt levels.

Securitizations and Structured Finance Structures

Securitizations predate CDOs in occurrence but may likewise be thought of as a subset of CDO technology. Securitizations exist to finance pools of certain assets and are specialized to the particular characteristics of their respectively referenced asset class that include but certainly are not limited to automobiles, credit cards, residential mortgages, commercial mortgages, student loans, and small business loans.

There are a number of specialty structures that have been developed as a result of the boom in CDO and securitization technologies. Of late, acronyms such as SIV (structured investment vehicle) and CDPC (credit derivative products company) have come to join the vernacular along with terms such as the now ubiquitous CDO, asset-backed security (ABS), residential mortgage-backed security (RMBS), and commercial mortgage-backed security (CMBS). SIVs and CDPCs, however, are two important classes of structured finance operating companies (SFOCs), which utilize specified sets of operating principles that are reviewed by the rating agencies in order to obtain specific ratings.

Risk Assessment

As we have seen, the tools of the financial engineer encompass almost any financial product. The objectives of the issuer and the investor work in concert to motivate an idea in the mind of the structurer, who will then employ these tools. However, the structure cannot be complete without some glue. That glue is a combination of the legal and corporate structure that is required to achieve the economic purpose of the transaction.

The corporate structure used is determined not only by the structure's purpose, but also by the legal, accounting, regulatory, and ratings requirements. These structures can range from characterizations of derivatives as notes, as we saw in the case of the credit-linked note, to specific structures designed under operating guidelines, as in the case of SFOCs.

The risks that therefore exist in a specific structure will include the risks of the underlying notes and derivatives, as well as those of the corporate structure. Many of the most important and under-analyzed risks relate to the interaction of termination provisions in the underlying derivatives and, at the corporate level, the event of default (EOD) provisions and subsequent termination or liquidation provisions.

Events of default are defined in the indenture to the transaction, this being a document between the trustee and the securities’ issuer. The EODs generally include the following standard provisions:

• Bankruptcy
• Obligation acceleration
• Obligation default
• Failure to pay
• Repudiation/moratorium
• Restructuring

There may be other provisions that require some interpretation. For example, starting in approximately 2005, ABS CDO indentures began to include EODs that were triggered based on various structural triggers, some of whose measurements were, from time to time, calculated for purposes of determining an EOD alone differently than otherwise in the transaction documentation. This meant that in certain cases a transaction would be in EOD despite the fact that no tests, as described in the usual marketing materials, were breached.

There are, however, even more concerns. As a result of the often substantial documentation in these transactions, there is the possibility for differing interpretations of the same concept and even outright contradiction between various areas of documentation. Further, the rules surrounding each party's obligations under various circumstances may be vague or may not have been well communicated by the presented marketing materials (for example, the rules surrounding early redemption or liquidation). This can lead to difficulties in pricing and substantial legal disagreements between parties.

In addition to the aforementioned risks, one must take into account the interaction of the various products employed in the construction of the structure, as well as various moral hazard issues that can arise with multiple parties to a transaction. These include the alignment of all parties’ interests—for example, the alignment of a manager's incentives to the protection of the debt holders in a CDO or the obligation of the trustee to conduct auctions that protect the note holders’ interests in a liquidation scenario.

Valuation and Hedging

An accurate assessment of the risks associated with a given security is essential to the risk management of that security, whether it be the monthly valuation, liquidity assessment, or hedge position. The assessment of risk should consider:

• A summary of all parties to a transaction.
• A breakdown of the responsibilities of each party.
• The risk drivers to the transaction.
• Structural features of the transaction.
• Tax and regulatory considerations.

The list of transaction parties is imperative to ensure that one establishes the relevant entity responsibilities. Without such a list, it is rather easy to overlook particulars that may well lead to a different view of the probability of a specific action occurring. Consider the liquidation of a special purpose entity. Here, we would need a careful construction of the rights and responsibilities of the various note holders, trustees, swap counterparties, rating agencies, and so on. A senior note holder oftentimes will have voting rights with respect to the liquidation of the transaction, but there may be other provisions that determine the extent of these rights (e.g., the consent of a swap counterparty may be required).

The risk drivers of the transaction determine the instruments used in the hedging of the transaction. Specifically, all the cash flows of a transaction must be determined in order to understand the risks of these drivers. Examples of these include:

• Which asset classes are represented?
• Are rates fixed or floating?
• Are rates linked to an index?
• What are the day-count conventions used?
• Are there funding components to the transaction?

We alluded to the structural features of the transaction previously in a brief example concerning liquidation. However, there are a number of structural features that impact the direction of cash flows to a transaction as well. As a result of this complication in cash flow, with each addition to the structure it becomes more difficult to predict cash flows under each and every scenario. More importantly, it is also difficult to determine the likelihood of each of these scenarios. Even to the extent that one becomes comfortable with the level of certainty, it is clear that due to this variability there would be costs imposed on any hedging strategy for a specific transaction.

CONCLUSION

The past several decades have seen a surge in the number and variety of structured products created to capitalize on the increased appetite for new asset classes or to allow participation in heretofore difficult-to-access asset classes. The array of products that now exist range from variations on traditional stocks to special purpose entities whose structures are motivated by desires to arbitrage market inefficiencies and generally distribute asset classes to a broader array of investors. As has been seen throughout the unfolding of the credit crisis of 2007–2010, it is now clearer than ever that an accurate assessment of risk is necessary. The risks in a given product may or may not be obvious. The only way in which one reduces the risk of omission is to conduct a thorough analysis of the various components of a given product, from the parties involved to the underlying assets referenced by the product. As investors continue to focus on novel ways to outpace the competition, it is likely that risk management requirements for structured products will increase. This may in the short run decrease product innovation. However, as the desire to improve returns continues unabated, we will no doubt see in the future new innovations in the structured product space to give those who can better assess risk the ability to create alpha-generating returns.

Note

1. By specific point in the company's capital structure, we are referring to the debt issue's standing in terms of the issuer's credit hierarchy, that is secured bank loans, senior bonds, subordinate bonds, and so on.

ABOUT THE AUTHOR

Timothy A. Day is director of the Financial Securitizations Group at Guggenheim Securities, LLC. From 2001 to 2007, he worked at UBS Securities LLC, where he focused on corporate synthetic transactions. Prior to that, he worked in CLO/CDO origination at J.P. Morgan Securities LLC. In addition, he was previously employed by Lexam Capital LLC and Capital Market Risk Advisors, Inc. Mr. Day graduated from the University of Chicago, where he specialized in economics and mathematics.