Outlook 2009: Structured products eke out growth in '08; credit fears to linger as '09 opens, observers say

By Kenneth Lim

Boston, Dec. 31 - The structured products industry got a painful reminder in 2008 about the importance of credit quality, and that issue will likely remain a top concern going into 2009, market veterans said.

Investors are likely to continue seeking principal protected products and certificates of deposit, and the industry hopes to be ready for a market recovery through an emphasis on investor education.

The first half of 2008 was starkly different from the second half, when the financial crisis fully hit. Although volumes are still higher for the year compared to 2007, the growth came in the first half of the year. Structured product sales slowed down in the last quarter.

"We were on track for another record year, and then August hit," said Advisors Asset Management vice president of structured products Brad Livingston. "We as a firm were on track for over 90% to over 100% growth at the start of the year, now it's probably 75% to 80%...We're still going to grow. We were trucking along pretty good, and all of sudden we're playing catch up."

Cautious investors were afraid of non-principal protected products, but offerings that protected capital could not be priced attractively enough, he added.

"The volatility of the markets, that caused issues with pricing, with the creation of structured products," Livingston said. "The last few months now, it's been really hard to get attractive products to the market with principal protection because the cost of protection is up."

Creditworthiness concerns

The importance of an issuer's credit quality became especially prominent in 2008 after Lehman Brothers collapsed.

"For 2008, the themes were certainly credit, credit, credit," said Advisors Asset Management's Livingston. "It seems like Lehman was driving the bus and drove us right into a brick wall."

The uncertainty in the market made it difficult to engage investors, Livingston said.

"It's hard to create attractive products when there's this fear in the market," he said. "Investors are fearful of investing, period. And brokers are fearful of fearful investors. So they're not having the conversations about making money to the market that they were six months ago.

"When the issuers are having so many problems and there are so many public problems, it just causes people to move more slowly," he added.

Jeremy Berman, managing partner of Wavecrest Asset Management, said 2008 saw a combination of events that took a toll on the industry.

"The three big events in the year were, number 1, terrible equity and commodity markets," he said. "Number 2 is a terrible credit market, which made mark to market look very bad and...the credit overlay was something that was overlooked. Number 3, the industry itself has restructured...A lot of people are rethinking the way things are done."

Berman noted that many people in the industry have lost their jobs. Citigroup Inc., Goldman Sachs Group, Inc. and Morgan Stanley were among the major banks that were reported to have laid off workers.

The layoffs are unlikely to affect the industry much, except for perhaps fewer issuers, but industry veterans feel the changes, Berman said.

"We spent a lot of our time and effort to build up the industry, and to see the business have to retrench like it has, it's very sad to see that," he said. "But all businesses, every different kind of business on Wall Street has had to do this at one point or another. Every business has its awakening moment...now we've taken 10 steps back and hopefully we'll get back."

Principal protection

Certificates of deposit and other principal-protected products had a strong showing in 2008, especially in the latter half of the year.

"Normally we have maybe a dozen CDs offered each month, maybe five to six," Livingston said. "[In October] we had upward of 20 CD issues that we brought to clients...A number of broker dealers would allow their reps to show only CDs."

"CDs are a good part of a diversified portfolio," Livingston added. "I don't think we're going to see anybody with 100% allocated to CDs, but...a good portion of that may have an FDIC insurance wrapper around it."

Structured CDs, which are insured by the Federal Deposit Insurance Corp., offer principal protection that appeal to cautious investors and could help to grow the industry, Berman said.

"I think it's actually a very good idea for the mass market," he said. "I think for more sophisticated individuals, it's not important, but for the mass market it's a very good wrapper and it gives people more confidence in the creditworthiness because of the FDIC insurance."

But principal protection may not work best under the current market conditions, Berman said.

"The problem is, again, the investors should have wanted principal protection when the S&P was at 1,500," he said. "It's a lot of human psychology. People want principal protection when they don't need it as much. When you didn't want principal protection at 1,500, why do you need it now at 850?"

Livingston also said one problem has been getting more banks to issue structured CDs.

"Other than the big investment banks, some of these Midwest and regional banks haven't come to the market as CDs," he said. "We're seeing nervousness on the part of boards of directors and their cost of funds. It hasn't made it as attractive to borrow money in a structured products arena."

"No one really has a good plan or model yet to get a lot of banks on the system," he added.

Other notable deals

Other notable deals included Deutsche Bank AG's zero-coupon principal-protection escalator notes due Sept. 16, 2013 linked to a basket of equity, currency and commodity indexes.

The notes at maturity paid the greater of the basket return and the maximum lock-in level reached by the basket on any weekly observation date. The lock-in levels are 30%, 55% and 75% above the initial basket level. Investors will receive at least par.

"That was quite an unusual structure and one that we hadn't seen in a really long time," said Suzi Hampson, an analyst with Future Value Consultants.

Just as notable were structures that seemed attractive at the start of the year but eventually fizzled out.

"The first six months of the year, so many were linked to banking stocks and finance, and quite a lot of Lehman notes," Hampson said. "Obviously at that time they were the ones that looked really interesting."

"You should have bought bear products in January," she added. "And principal-protected products. People who bought those at the beginning of the year would have outperformed a lot of things."

Constant Proportion Portfolio Insurance-based products, which dynamically rebalance the linked portfolio depending on how the underlying performs, were also popular at the start of the year but quickly fell out of favor as market volatility shot up.

"It didn't work because realized volatility was dramatically high," a buysider said.

Back to basics

Market professionals said they are focusing on the fundamentals as the new year begins.

"We're taking a back-to-the-foundation outlook," Livingston said. "We're focusing on CDs and all the things you can do with the underlying indices. I'm still amazed by how many times I speak to rooms of advisers and I hear 'I never knew about structured products before.'... Anytime you can be reminded of the importance of diversification, that's a good thing. It helped us focus on alternative asset classes."

From a buysider's standpoint, Berman also noted a move back to simplicity.

"Based on the things that I've seen, the things that I've looked at, it's really back to basics," he said. "The enhanced volatility has allowed clients to put the same kinds of trades they were putting before but at much better levels. A lot of the products, like the 3-to-1 upside notes, those are obviously more attractive in a high volatility environment."

"Instead of using these times as an opportunity to come up with some wild ideas, they're focusing on the ones that actually make sense for the investors...simplicity is going to win out," Berman added. "I think, just like anything else, when things are calmer and when revenue on the dealer side starts recovering, you'll see more innovation again. When there's no capital, many of these strategies with too many bells and whistles get knocked out first."

No early recovery

The market is not expecting an early recovery in 2009, although there is a little more optimism about the second half of the new year and beyond.

"I think this fear that we've had because of the last year, it's going to stay with people a long time," Livingston said. "We are very bullish long term. We think now is a very good time to go out on the four- to five-year bullish products. If we are not at the bottom we are very close to it. One of our reps put it great: You don't have to call the bottom as long as your investment has a bottom."

Livingston highlighted how the new administration at the White House will do in 2009, the federal bailout programs and consumer sentiment as key uncertainties entering 2009. If the new administration spends more on infrastructure, infrastructure-related indexes may do better, for example.

"Will the consumer come back? And also how is the bailout bill or the TARP, how is it going to work its way through the markets?" he said. "If we see some large finance institutions fail, that's going to affect investors...There's lots of steps you can go down."

Berman expects the woes of 2008 to persist into the first half of 2009.

"I don't think the first half of 2009 is going to be very different from 2008," he said. "Until capital markets begin to behave normally - and it's up to you to define what's normal - but until it gets back to normal I don't think clients are going to be willing to put on risky positions. We would agree that most structured products are less risky than the market, but many people don't think so."

Again, credit concerns formed the main obstacle.

"I don't think that the credit environment for banks is going to clear up soon," he said. "I think people are still jittery about bank credit. I think that's a big thing that nobody ever talked about. We never talked about the risk of our banks defaulting. It was based on the credit risk, but nobody focused on it."

"The second half of '09 should be the new beginning for structured investments," Berman added. "I think you'll start to see more buyside solutions like our firm and others [when the recovery arrives]."

Whenever the recovery arrives, Livingston believes structured products can be at the forefront.

"As long as we can keep getting issues, new issues, as long as we can provide well diversified options so that someone can invest all over the world, get invested in commodities, currencies, long-short strategies, we'll be fine," he said. "Basically economic history and investing history tells you that we're having shorter recessions. If we're in one now it's not going to be for as long as it used to be. And then the markets turn around several months before the economy does."

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