Structured products mean different things to different people. Generally we might consider them to have helped power the inexorable rise of the financial services sector in recent decades, of great service to the public good.
Individually, however, many of us will have had experience at some point or another of structures with outcomes far from good. The truth probably lies somewhere in between. Getting to the heart of the structure itself is often the problem, and this can undermine confidence and lead to losses.
Legal, tax and financial engineering has enabled a revolution in the investment industry since de-regulation in the 1980s. Insurance bonds, special purpose companies, unitisation, personal equity plans (Peps), wraps, self-invested personal pensions (Sipps), Isas, real estate investment trusts, venture capital trusts, enterprise investment schemes, exchange-traded funds (ETFs), credit default swaps (CDS), contracts for difference (CFDs), derivatives – they have all been at the forefront of industry innovation and sophistication.
But there are some elements of ‘structure’ that warrant closer scrutiny. At the risk of being simplistic, a distinction can be usefully drawn between two main groups of structured products: those which facilitate access, ownership and transfer and are broadly legal and tax-driven in design; and those which package and tailor investment risk and return profiles. The first group involves a focus of legal and accounting expertise, and generally should serve long-term solutions or capital sums of sufficient scale over which the costs can be amortised economically. The beneficiaries should be expected to continue to benefit from such structures over the full term, even though their personal circumstances may change in the meantime.
The second group involves a focus on financial engineering more than the legal or tax basis of the structure. Whether guarantees, enhanced returns, embedded derivatives, leverage, opaqueness, or sheer complexity are involved, living with these kinds of structure for the full term can become uncomfortable. Investment markets and appetites for risk tend to shift around a fair bit for most investors. There comes a point in every cycle where investors look more closely at the risks of a structure and are less interested in the returns that attracted them in the first place. It is at this moment that the real risks and value of a structure can be a challenge to define, liquidity diminishes, and losses are realised.
While all boats rise on the flow of the economic tide, the need to understand the fundamental or intrinsic value of assets becomes much keener when it starts to ebb away – something akin to Warren Buffett’s homely ‘swimming trunks’ analogy.
The easier you can get at that, the better, but any elements of structure and complexity make it harder. Consider the opaqueness of value (risk) in crises of the past: mortgage banks and securitisations (savings and loans banks, 1980s); emerging market loans (1980s), structured return caps, floors, collars, ranges, knock-outs and knock-ins (1990s); split capital trusts (1990s); special purpose vehicles and the whole panoply of off balance sheet financing vehicles that led us into the vortex of our own Great World Debt crisis of 2007. This recent one has been given many rather euphemistic names – ‘the credit crisis’, ‘subprime crisis’, ‘sovereign debt crisis’, and ‘Great Recession’ – but apparently it has consistently been ‘unprecedented’ in its nature. And yet so many features have been seen before, and probably will be again – Lord Mervyn King’s new book will likely feature on many a reading list this summer.