The complexity of a simple concept
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Collateralised products have proliferated as investors seek to safeguard their assets. But the paradox lies in their varying levels of complexity and risk, so the need for caution is paramount.
The advent of collateralised products - in the structured products market, at least - is a relatively recent innovation. An advent due in no small part to the FSA’s guidelines that should have no more than 10% exposure to a single counterparty within their portfolio. Collateralisation, while a relatively simple concept is still one which requires a full and proper explanation.
Collateralisation is the use of real assets to back a product - you can think of it as being similar to the way a home is used as security for a mortgage. In the event a counterparty is unable to meet its obligations and return investors’ capital, the collateral can be used to compensate investors.
However, just because a product is collateralised, it does not mean that risk is completely removed. This new method of constructing products may have a sound and strong rationale, but it can be complex, and there are important nuances in the ways collateralised portfolios are built.
A counterparty to a structured product is the financial institution that promises to repay capital and to provide the return. It is the quality of this promise that helps to determine the reward profile. Theoretically, the riskier the institution, the better the reward on offer should be, which is in line with the relationship between the risks and the rewards of most investment products. This is why the credit ratings of counterparties are such a vital ingredient in structured products and require just as much due diligence in their assessment as do the product pay-offs.(Trends continues below)
Post Lehman the importance of choosing counterparties became clearer. Today, counterparty disclosure and explanation of credit ratings is normal. It is the same focus on counterparties that has led to the advent of collateralised products. A by-product of this has been the creation of structured funds, which are ready-collateralised.
The FSA’s guidance has led some structured providers to diversify the counterparty exposure they offer or else suffer from reduced demand. Meanwhile, the 25% rule - a guideline that no more than 25% of a retail investors’ portfolio be invested in structures - hampers take-up of structured products in general.
On the most basic level, a collateralised structured product works like any other structure - the issuing bank issues a security on which the investment is based. Next, a pool of assets equal in value is assembled. If after three months the value of the product has risen say, 10%, then more collateral will be placed. If the investment’s value stays still, but the value of the collateral rises, some of the collateral is returned.
To manage this process, providers appoint an independent custodian. Should the provider fail to meet its obligations, the custodian will liquidate the collateral and repay the investors, whereas under normal circumstances the product would mature and the collateral would be returned to the provider.
The important bit is the make-up of the pool of collateral, how often it is valued and how a default in the pool would be dealt with. Importantly, this may differ depending on whether it is a fund or a structured product. The European Union’s Ucits III funds directive features quite clear guidelines as to what is appropriate collateral, including where it is invested, under what circumstances it must be replaced and what type of asset and credit rating is required. Structured products, on the other hand, have far greater flexibility in determining collateral, and the decision is essentially up to the provider, although this should be transparent.
To perform due diligence on collateralised products, it is not just a matter of seeing what the pool contains. For instance, what happens if something goes wrong with the collateral assets? Take an example of an uninsured house with a mortgage. If the house is the collateral backing the loan, what happens if the house burns down, or is only partially burnt? Now imagine the same scenario, but one in which the house is insured. It can be helpful to keep this analogy in mind when analysing collateral-backed investment products.
”This new method of constructing products may have a sound and strong rationale, but it can be complex”
Another aspect advisers should examine is the difference between collateralised and diversified products. While such products are often compared, the key difference is that rather than reducing risk by providing collateral, diversified products aim to reduce risk by spreading it across several institutions to mitigate the impact of a default. Should a default occur, assets are generally not replaced and a loss would be realised. The difference with a collateralised product is that any assets that default would be replaced by the provider.
Just as a structured product backed by lower quality counterparties can offer potentially superior returns, those backed by weaker collateral may do the same. There are several interpretations of collateralisation, but the Ucits III rules for funds provide a good benchmark. If the collateralisation offered within a product differs from the Ucits III standard, then there are some key questions to be asked as part of an investor’s due diligence. Here are some examples:
- What is the creditworthiness of the principal counterparty?
- What is the quality of underlying assets used as collateral?
- Are the assets sufficiently diversified and uncorrelated to the principal counterparty?
- Is the collateral held independently and ring-fenced from the counterparty?
- Is the collateral dynamically managed on a regular basis to ensure that it covers the value of the investment?
- Is investors’ capital unaffected if an underlying asset used for collateral defaults during the life of the plan?
- What is the mechanism for the payment of collateral and how long will this take?
If the worst-case scenario is realised, and collateral is required to effect a payment to investors, how long would it take for the collateral assets to be liquidated, and how long for investors to receive the payment they are owed?
The innovations of collateralised and diversified products are a positive step, but they require scrutiny. Just as a structured product backed by lower-quality counterparties can offer superior returns, those backed by weaker collateral will do the same. Knowing what you are buying, therefore, remains paramount.
Richard Henry is a director of investor solutions at Barclays Wealth.
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