By Yaser Anwar, CSC of Equity Investment Ideas
Professor Moorad Choudhry is one of the industry experts when it comes to structured products, and has worked over 18 years in investment banking including experience at ABN Amro Bank NV and JPMorgan Chase Bank.
He has written the following books: (1) The Bond and Money Markets: Strategy, Trading, Analysis, Butterworth-Heinemann 2001 (2) Handbook of European Fixed Income Securities (editor, with Frank Fabozzi), John Wiley 2004 (3) Analyzing and Interpreting the Yield Curve , John Wiley 2003 (4) Structured Credit Products, John Wiley 2004 (5) The Repo Handbook , Butterworth Heinemann 2002 (6) Capital Market Instruments: Analysis and Valuation , 2nd Edition, Palgrave MacMillan 2005 and (7) The Credit Default Swap Basis, Bloomberg Press 2006. For more of his excellent writings, please visit this link
Moorad talked to me in his capacity as Visiting Professor at the Department of Economics, London Metropolitan University. He is also a Visiting Research Fellow at the ICMA Centre, University of Reading and a Senior Fellow at the Department of Mathematical Trading and Finance, Cass Business School.
Structured Products: Market Developments, Insider Trading, Institutional Investor Usage, Market Risks & Liquidity, M&A activity, Credit Derivative Trading Strategies & more.
Y: Moorad, thank you for joining us for this interview
Y: Could you tell us a little about what structured products are and how you got involved in them?
M: That’s a big question. Hal Davis (the Editor of the Journal of Structured Finance) conducted an exercise into just this question that included a survey of market participants, and there was a wide range of responses, as you might expect. Some people include instruments such as credit-linked notes and some people don’t. My personal opinion, I would say that within the context of the financial markets structured products or structured finance refers to any product that is not plain vanilla. Of course, what may have seen “structured” 20 years ago may now be viewed as the plainest of plain vanilla, for example a conventional interest-rate swap. My definition would cover, among other things, hybrid bonds, derivatives that are a bit more involved than a vanilla swap and bonds that are issued out of a securitisation transaction. I don’t think it’s important to tie down one all-encompassing definition, only that anyone involved in structured finance knows exactly what it is they are involved with!
How did I get involved with them? Just as a result of working in the banking industry…which also triggered an interest in the subject academically.
Y: Why do you think corporate treasurers, or other investors, buy such complicated products? If they don’t need them to hedge risks, and they’re too complex to safely diversify their portfolios, do the products simply make people feel more financially sophisticated? Is the push coming from the dealer side?
M: I wouldn’t say that such market participants don’t necessarily need them to hedge their risks….although I would posit that many of their risks can be met using vanilla products. Even in the wholesale markets, it might be surprising to some – given the focus of so much of the academic and practitioner literature – to see just how much of banks’ and other financial institutions’ hedging requirements can be met using vanilla derivative products.
One would hope that no user buys any financial instrument simply to feel sophisticated! As for the last point, well certainly it is incumbent on any bank salesperson to ensure that their customers know exactly what sort of transaction they are entering into and that it is indeed the right product for them – simple business ethics dictates that. I wouldn’t like to comment if the push is coming from the dealer side, although it does appear to me that some products aimed at customers have been designed first and then marketed later. But the financial markets can also boast many types of products and transactions that have benefited both sides of the deal – the much vaunted “win-win” scenario in investment banking – and that is something all concerned should be happy about.
Y: What has been the most significant development in the credit markets in recent years? And, what major developments do you expect from the market in the future?
M: It depends what you mean by “recent”! [Laughs]. Certainly the development of credit derivatives was a major development and what we can observe happening right now is a sea-change transformation in the credit markets with regard to the interaction between cash and synthetic (derivative) products, mirroring what was observed in interest-rate markets a generation ago. After the introduction of interest-rate swaps and exchange-traded futures, we saw how, after these products started being widely used, that the market experienced a transformation whose end-result can be described as “the tail wagging the dog”. The derivative market – because of its inherent transparency and liquidity – began to be viewed as the pricing source and benchmark, with a consequent improvement in market efficiency – both cash and synthetic – for all users. This is a good thing, and this experience is being repeated now in credit markets.
For the future – well as they say the world is one’s oyster! It looks like iTraxx is being viewed as a credit market benchmark (in Europe) so that should help to draw in more users, such as smaller banks and corporates. Within structured finance, we should expect to see the application of synthetic securitisation technology to more types of asset classes, as well as an expansion of asset types in the cash arena. And more and more investors will start using the synthetic market as the key indicator for use when assessing relative value in the cash market – the tail wagging the dog, so to speak.
Y: Looking forward, what areas of the market do you think are most vulnerable, given that there is so much money sloshing around & record number of cash on corporate balance sheets?
M: I find your choice of words interesting [smiles]. At the macro level, the global economy is actually in relatively good shape and has been from about 2003 onwards, recent tremors in the equity markets not withstanding. In this sort of scenario the prime risk when you get to this situation is that, in the ongoing search for yield, investors (which includes banking institutions here) lose sight of risk, or rather, the most appropriate risk/reward profile suitable for their needs. In a healthy economy corporate spreads tighten as companies perform better, and this means investors go further out along the credit curve as they search for enhanced yield – at which point some of them take their eye off the ball. It remains important to maintain due diligence when there is a lot of cash “sloshing around”, as you put it, and this means being wary of higher spreads that are available but where the accompanying risk is possibly not worth taking on.
For example, when spreads tighten investors start to look at lower-rated tranched securities such as CDO and SIV mezzanine notes, which in itself is not necessarily a bad thing, just as long as the buyer is fully aware of the risk exposure being bought into, and understands issues such as correlation sensitivity.
Y: With the increase of syndicated loans being used by companies to finance major acquisitions or re-finance debt, they have been passing on more info and financial projections to their lenders.
At times, these lenders are Hedge Funds who can take positions depending on that material info (sort of like a bulge bracket firm, where the proverbial Chinese wall exists amongst bankers, researchers and traders). Do you think there should be some sort of restriction as to who finances a company depending on their financial interest in the company?
M: That’s an interesting question. I think we have to assume, unless we have proof otherwise, that Chinese Walls where they are in place in a firm are effective and do their job and there is no need to worry on that front. But to restrict what sort of entity can advance funding (beyond the existing banking regulation)? On first thought I would have thought not…that would be over-regulation and restrictive for many borrowers.
Y: As credit derivatives become increasingly complex, do you worry about the stress on transaction documentation, delays in confirming trades and the back-office burden placed on Wall Street firms? This is a trillion-dollar problem.
M: Not personally, no [smiles]. If I was a regulator I might. Both the Fed and the FSA have mentioned this as a potential problem, and certainly it does make sense for banks and other user institutions to put in place the resources necessary to tackle this problem.
Y: What is your view on the recent talks about insider trading activity in CD markets- In the past few deals- increased activity in a particular company’s CD’s has been a precursor to a buyout deal- what do you think?
M: I am afraid I am not up-to-date with this issue and so could not possibly comment.
Y: You’re one of the world’s experts in the field of structured products. What do you think are the big issues now in terms of market liquidity & risks?
M: You are far too kind, I am not sure I would label myself in that way [laughs]. With regard to structured finance, it seems to me that the lowering of entry barriers has enabled more and more banks to offer the same product range, with the consequent lowering of costs for end-users – this is a good thing. Market liquidity is a very important issue, and we have seen in correction or default-type situations such as 9/11 and the Ford/GM downgrades how liquidity didn’t dry up, in both the cash money markets and the CDS market. Given that overall liquidity and transparency is even higher now, it wouldn’t appear that we have any real foreseeable worries with regard to liquidity, barring a catastrophe situation. Also, the introduction of the Eurex credit futures contract this month means that users will have an exchange-traded product to fall back on – at least in Europe anyway – should that be necessary.
Y: It used to be a strategy reserved for the super wealthy and professional investors but now small investors are powering money into complex investments called, structured products. Nearly $49 billion worth of structured products issued just last year. Up more than 50% from a year earlier. Do investors really understand the risks and rewards associated with structured products?
M: That’s a good question. I don’t know if retail investors really do understand the risks and rewards associated with structured products, although one hopes that they do. When it comes to my own money I’m actually a bit conservative when deciding where it should be placed, so from a personal point of view I’d always be a bit wary of any situation where structured products are being marketed to retail personal investors.
Follow-up: Recently the SEC increased the limit for individual investors looking to participate in HFs. What are your thoughts on restrictions against "retail-ization" of structured products, due to their inherent sophistication?
M: As I say above, in general I would be wary of it. Of course, “retail” is a very large sector and includes certain high net worth individuals who might have several tens of millions to invest – provided they receive satisfactory and adequate advice then certain hybrid and structured products may very well be appropriate for them, as they might be for specific other classes of retail investor.
Y: Recently Securities and Futures Commission (SFC) engaged the Social Sciences Research Centre of the University of Hong Kong (SSRC) to conduct a Structured Product Investor Survey. Did you know only around one-tenth of investors, and these are "sophisticated investors", recalled having read and fully understood the offering documents. Doesn’t that worry you?
M: I wasn’t aware of that statistic but if it’s true, while it doesn’t worry me personally, I think it’s a shocking state of affairs. Anyone looking to invest in a structured finance note should always read and understand the offering docs, and if necessary obtain professional advice on the contract from (for example) a capital markets lawyer.
Y: With the recent arrival of a new form of cash settlement, the contract can boast ever improving efficiency as a mechanism for transferring generic credit risk. But when a very specific hedge is needed the contract needs to be modified and new versions of the CDS are emerging to dealwith this need. What do you think are some of the advantages and disadvantages of the on-going standardization of the CDS?
M: Anything that adds to the ability to hedge specific risk, and adds usefulness for any market participant, is a good thing. That is the beauty of the plain vanilla CDS – its inherent simplicity, which makes it very handy for a number of applications, and the fact that it can be modified or adapted to suit other requirements.
Y: The third major sector of the credit derivatives market (after CDS and index products) is CDOs and other basket products. What is fuelling the growth of standard and bespoke tranche products?
M: Several inter-related factors, I dare say. Such products are an efficient way to affect risk transfer, and the application of securitisation technology means that one can parcel out bits of risk to where the demand lies. Some of these products – such as synthetic balance sheet CLOs – really are a kind of win-win transaction (up to a point – we won’t mention defaults just now!) because both issuer and investor are having their requirements met. Essentially these products are very flexible and reasonably straightforward to bring to the market – one of the main reasons behind their popularity.
Y: Could you give us an overview of some of the credit derivative trading strategies, such as: curve plays, tranches and leveraged strategies (CPPIs and CPDOs)?
M: This is really more of an academic than a practical field of interest for me, so I don’t think I’m the best person to comment. But one topic worth discussing is the negative basis trade (echoing the basis trades in the interest-rate markets of a generation ago) where one buys the cash and buys CDS protection – this is an increasingly popular strategy. Actually the more people are aware of it the better, because having an awareness of the cash-synthetic basis assists in understanding relative value in the cash market. This is a good thing.
Y: Tell us a little about your upcoming book ‘Bank Asset & Liability Management: Strategy, Trading, Analysis’.
M: It’s actually my last ever book, for the moment anyway, as I am taking a break from book writing for a while! It’s basically a reference text that brings together all the various strands that are essential to the ALM discipline in banking. So it covers basic groundwork like cash management, liquidity risk and gap, as well as more specialised topics such as securitisation, balance sheet management, synthetic funding vehicles and so on, there are also chapters on Basel I and II.
One of the reviewers for the book – a gentleman currently with Abu Dhabi Commercial Bank – wrote “Every bank should have a copy of this book” in his endorsement – which I feel is possibly overly fulsome in its praise but was still very nice to read!
Y: Finally, how can someone learn more about credit products and get a job in the industry?
M: Well certainly the credit market is well served in the academic literature, I hesitate to mention my own books as I’d rather someone else recommended them, but anyone who wishes to learn about this field should make an initial investment in one or two of these books. Of course another very good way is to take a postgrad course in the subject, institutions such as ICMA which offer these specialist degrees.
I hesitate to give careers advice as it isn’t my field, but obviously as strong as academic background as possible is essential if you are trying for an entry-level position, in a quantitative subject or a subject with a strong element of quant work. That plus any work experience such as internships during your student years. If you are past that stage, I would have thought the pages of the FT and such like and also talking to one or two recruitment consultants. Sometimes a job at the institution you desire – even if it isn’t first choice – is a good foot in the door for an internal move to your preferred position later.
Y: Mr. Choudhry thanks for spending time with us, good luck with future endeavors.
M: My pleasure, you’re welcome. And thank you for the kind words.
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