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Structured Product Collateralisation

Joshua Wynn, Lowes Financial Management

With the launch of Société Générale’s new tranche this month, Josh looks into the working of structured product counterparty collateralisation, and the logic behind it.

Would you rather invest £100,000 with one bank or spread the money across three? In scenario one, if Bank A defaults, that could mean a total loss of your investment; in scenario two, banks B, C and D would need to all be in default for total capital loss. This is the basic theory behind collateralised structured products. Keep in mind, though, that theories are always simpler than real life.

In the event of a bank being unable to meet its liabilities, and without a government bailout or other rescue plan, the insolvency process begins. Banks will have made plenty of loans to other institutions, and these will be recalled immediately; after that comes the liquidation of the counterparty’s assets, prioritising the repayment of creditors and at the front of that queue are those who have made a secured loan (that is, the debt is backed by designated assets other than cash, such as property). These fellows rank ahead of most other creditors and shareholders.

Preordaining a pool of assets to secure investors’ money against in case of default is the principle, but then comes a further development: the debt is secured against assets of the institution manufacturing the product,but put at significant risk by reference to other institutions’ credit quality. The collateral still comes from the issuing bank, but it is no longer at risk from said issuer defaulting; rather, the risk is diversified across different (often stronger) parties. For example, Investec’s UK Gilt-backed plans have taken on UK Government credit risk – so minimal that Treasury-issued gilts are taken to be the risk-free benchmark – to form the greater part of the contingency. Société Générale recently released a new range of plans, the collateralisation of which took on the credit risk of three major banks: HSBC, Lloyds and Barclays. Outside the index-linked terms of the plan, only if all three banks suffered credit events would all investors’ capital be potentially lost.

The pool of collateral assets is held by an independent custodian who monitors and maintains its value. In the past, Investec has employed Deutsche Bank to hold the plan collateral on their UK Gilt-backed plans, just as Société Générale have enlisted Bank of New York Mellon. This ensures that the pool is entirely out of the issuer’s hands until the related plans mature and is usually maintained at market value of the plan itself, which could be more or less than the value of investors’ original capital. Should the issuer become insolvent, the collateral assets would be sold at their current value, with the proceeds returned to investors.

Collateralisation does not impact on the performance of plans, although often the terms offered can vary in line with the variation in credit risk to investors’ capital. However, the index-linked terms are not affected; if at the end of the term the index falls beneath the barrier level of an investment plan – say, 60% – then investors’ capital will be reduced as such.

We have preferred two plans out of Société Générale’s latest issue, so you could call this a topical piece. Both plans offer what we consider a good reward in return for the risk to investors, and whilst their collateralisation feature was by no means a deciding factor for us, it is certainly one worth consideration and discussion.