Jean-Eric Pacini, head of structured products sales for BNP Paribas in London

When the bear market left investors with structured products that were deeply out of the money, investment banks drafted rescue plans to win back client loyalty. Writer Philip Alexander

The turbulent 18 months that followed the fall of Lehman Brothers posed a wide range of tough questions for the structured products business, including counterparty risk and opaque product returns in a given market scenario. But the most immediate problem was simply that most investors had been buying bull market notes or options that were due to expire in the midst of a bear market - deeply out of the money.

"Almost everyone was affected, because clients tend to buy products that are long the market. Even if they had a volatility sensitivity one way or the other, the delta [market direction] was the main sensitivity," says Jean-Eric Pacini, head of structured products sales for BNP Paribas in London.

In many cases, says Emmanuel Naim, the equity manager for the cross-asset solutions group at Société Générale Corporate and Investment Banking (SGCIB), bull market products were also natural sellers of volatility. "When the market declines sharply, you tend to get a spike in volatility and that had a negative impact on the mark-to-market valuations of structured products," says Mr Naim.

Some products had coupons that only paid out as long as there was no market decline, or downside protection only to a certain floor that was broken by the precipitous fall in equity and some commodity markets. In others, such as the leveraged constant proportion portfolio insurance (CPPI) type, the instrument deleveraged and locked out of risk-taking positions if the market dropped too far. This effectively turned it into a zero-coupon bond that ensured only that investors received back what was left of their capital, with no source of excess returns.

Although most markets rallied from the second half of 2009, this was too late for products that matured earlier, or locked out permanently after the sharp declines. In European and some Asian markets, structured product volumes dropped sharply, but investment bank structuring teams sought to find ways to help their distributors provide a constructive response.

"We had to find a way to keep talking to clients, we could not simply walk away," says Mr Naim. Instead, many investment banks began looking at ways to extend or recapitalise products, while repositioning them to recoup some of the losses. Shane Edwards, global head of equity structuring at Royal Bank of Scotland in Hong Kong, says it is worth putting in the preliminary work even if there is uncertainty about whether investors will accept a restructuring proposal.

"When you launch a structured product, you have to estimate the amount you are going to raise because there are costs involved in the set-up. But in a restructuring, you are wearing a more altruistic hat, you are saying we understand people out there are in difficulties and we would like to help. It is a great opportunity to win client loyalty by helping them when they need it the most," says Mr Edwards.

Clinching the deal

For retail structured products, offering a restructuring solution is not straightforward, as distribution can be widespread through a number of private banks. Ultra-high-net-worth products are typically sold to at least 50 end-users, and pure retail products could be distributed to thousands of small investors.

"The distributors face issues with a restructuring. They need to get the private noteholders to agree to the restructuring. The probability is low and you are increasing the risk of complaints about misadvice if the new product does not perform better than the original," says Mr Pacini.

As a result, many restructurings have involved institutional investors, or discretionary managers who have the authority to make the decision on behalf of clients. Even here, agreeing a deal is not straightforward. One financial advisor recalls suggesting a CPPI restructuring to a pension fund when the product was still about 5% above the lock-out level. But trustees responded too slowly and the product had already locked out by the time they gave consent, leaving the investment bankers with less capital and fewer risk assets to work with.

Extending maturities

Despite the administrative challenges, leading structured products providers have successfully completed some significant deals. In 2009, RBS undertook the largest retail structured product restructuring in Asia, reconfiguring Malaysian notes that had been created by another bank.

"There was a little bit of money left available to recreate a product that we thought was more suitable at the time. The initial product was a very bullish one. We took the value that was left and proposed a number of things we thought would hold up better in those market conditions and were affordable with the limited capital that was left," says Mr Edwards.

This deal highlights the two further challenges that structurers face - the reduced capital that can be put to work and the high volatility that can make the cost of entering new options position prohibitively high.

"The ideal thing is not to increase the tenor or the risk characteristics of the deal, just use the residual goodwill and capital to rebuild the product. But most of the time, a deal that has three years left might need to be extended to four or five years to earn enough income to fix it. In some cases, you can ask investors to put up a few extra per cent of capital to unlock the existing capital and get into a better investment," says Mr Edwards.

He adds that this applied in particular to the first generation of CPPI products, which often featured an allocation to risk assets that was either set at 100%, or reset to zero if the valuation fell too far. In that case, extending the maturity and putting in more cash are the only solutions.

According to Mr Pacini, extending maturities was also important for capital-guaranteed products that consisted of a zero-coupon bond and bullish call options that had ended up deeply out of the money when the market fell. The new underlyings were generally chosen to create a product that is market-neutral, or stabilised to avoid excessive volatility.

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Emmanuel Naim, the equity manager for the cross-asset solutions group at Société Générale Corporate and Investment Banking (SGCIB)

Coping with high volatility

There were more alternatives available for products that featured lock-outs or barriers if the market fell too far, including more recent CPPI products that always retained a minimum risk asset allocation of about 10% to 15%, or reverse convertibles that allow the issuer to put shares to the investor in return for a high coupon. The strike levels for put options in the reverse convertible cap the upside and this pays for downside protection, but only to a certain level - for example, a 30% decline.

Where the continuous downside barrier had been breached, BNP Paribas proposed cutting the coupon to pay for making the barrier at maturity, instead of continuous. This bought time for the markets to recover and avoided triggering an early conversion at a point when investors were out of the money.

Another alternative for products linked to a basket of shares was to tinker with the downside barriers for each share to reflect their new levels in the market. So for a share that was close to hitting the barrier, that barrier could be cut further. This new protection could be paid for by raising the barrier for a share that was outperforming the market and had declined much less.

"Most people are naturally conservative once they've been locked out of a product - they agree to stay invested for another couple of years, but they do not want to risk further big swings in valuation," says Mr Edwards.

However, SGCIB found some retail and high-net-worth investors were willing to take a more aggressive approach to recovering their original capital, provided they did not need to commit more cash to the notes.

"Usually, markets take the lift down and the escalator up, so there is an asymmetry of returns when the market falls, it takes much longer to recover your initial level if you just invest straight bank into stocks. We wanted to find a solution to recover the notional value faster than the market was expected to recover," says Mr Naim.

On the basis that the high levels of volatility were likely to normalise over the remaining life of the product, SGCIB proposed funding new positions by selling volatility when it was more than 40% to pay for new call option strike levels on the equity markets that were 40% to 60% lower than the original point of entry.

"This is the classic buy-write concept, except that we present-valued the call options for all quarters until maturity rather than buying them one quarter at a time, to lower the entry price in line with the reduced capital available," says Mr Naim. The success of the product was such that it ultimately attracted new investors in addition to those who were restructuring their positions.

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