Derivatives VII --- Structured Products

Structured financial products are repacked products so that something are wrapped under a coat. What are the “something”? Gold and Junk, depending on what you’re looking at. If you can’t see through the coat, which one of the goals of setting up structured products, then everyone is happy. The bank is happy because they have successfully wrap up dead asset and sell. The customer is also happy because he thinks he gets a good deal.

Inverse floaters, arrears resets, currency linked bonds and others are the underlying of many structured products. Again, the aim is to find investors who want to take risk to get higher return. They become even more complicated because every dealer has their own names on the essentially same product. Every dealer can issue their own products, which are quite similar to others. So the key of the game is to stay ahead of the competition. You can’t protect your IP.

Because there are many structured products are packed together, one problem is to separate different pools of assets and derivatives that underlay each individual transaction within the issuer. Lawyers device a system of mortgages, charges and non-recourse agreement to create separate pools of assets for each product. The non-recourse agreement says that the investor agrees to limit any claim against the issuer to the identified assets and derivatives. In other words, the issuer is immune to lawsuits. An implication of CDS is that after the bank gets rid of the risk, the bank can benefit greatly in the company’s failure. But more than this simple idea, CDS has complicated regulations by ISDA (international swap and derivatives association)

After CDS took off, CBO, collateralized bond obligation --- the predecessor of CDO, collateralized debt obligation was invented by Michael Milliken. CBOs were used to repackage junk bonds. Regulations required insurance companies holding junk bonds to provide lots of reserves against the investment. To get around the rule, insurance companies repackaged high yield assets into CBOs and transferred the riskier parts to their holding companies (which didn’t have to hold reserves). Now the companies are attached to high risk bonds in other forms (may not be recognized by the companies).

Banks also sell accumulated loans in SPV (special purpose vehicle) to distribute mortgage loan risk. SPV pays the bank in the form of loan they purchased. This is called MBS (mortgage backed securities). The bank continues to collect payment and the payments are passed to SPV to pay interest and principle on the MBS. Mortgage owners don’t realize these structures at all. Other variants to this format exist.