Saturday, October 2, 2010

Is it News or an Advert?

Dr. Hilton with What Appears to Be Schroedinger's Cat

The National ran this rather remarkable piece yesterday, which sounds to my ears suspiciously like a transcription of marketing literature from Barclays.  

Not really news.  More like product placement in a movie.  Or outright touting.   Sorry, TN, but when you publish transparent advertizing like this, the natural question is:  Are your "news" columns for sale?  Or is this perhaps part of your transition to a new website and your staff are creating filler to see how it looks on the new "page"?

There's no real analysis of the product in the article.

Let's try and fill in that gap.

Before we start a very important caveat:  without seeing the marketing materials, I don't know the underlying structure.  

So what follows is a bit of speculation (note that word), hopefully informed based on structures I've seen before.  To hammer the point home:  this article does not necessarily provide a description of the underlying elements of Barclay's product but shows how such a product might be constructed.

Clearly this is no standard commercial banking fixed deposit product.  In the current market one doesn't get a 9% return on deposits.  And note right up front, it's not a promised return of 9%.  But a return up to 9%!  There is a difference.

Bankers are not very good on selecting earning assets (that's why a select group of distinguished banks, including those from The Developed West hold a disproportionate share of Dubai World debt) but they are generally fairly good at pricing deposits.  They usually are very careful to set the rate on deposits less than the rate they expect to earn on assets. (Note the word "expect".)

Compounding the earnings issue (what the banks will have to use to pay the depositors) is that the tenors are relatively short.  And it's a general rule that the shorter the tenor on a deposit instrument the lower the rate.  More risky assets (equity, etc) have of course higher returns.  One has to ask oneself just how high a return is needed to give the investor a high rate on his deposit/investment.  We'll look at that a bit later.

So how does a bank structure the transaction so it can make a tempting offer like this?

To be clear what follows is based on structures I'm familiar with - which are multi-year tenor instruments.

First, in order to "guarantee" the principal, the bank "buys" a zero coupon bond with a portion of the proceeds of the deposit.  This theory is that this "guarantees" the depositor his principal back at the end of the term.   At maturity the redemption value of the zero coupon equals the original principal.  If the bank or the investor wants a higher return, the amount of the zero can be reduced so that the depositor has this "guarantee" for some percentage less than 100% of his original principal, e.g. 90%, 85%, etc.

Sometimes when investors or depositors hear about the zero coupon, they think they have a guarantee of the return of principal.  Generally, they don't because the bank buys a "zero" coupon bond from itself.  So the depositor has a promise from the bank to pay him back secured by the bank's creditworthiness  In effect the exact same promise he gets if he places a conventional deposit.   In either case if the bank is in financial difficulty, it won't be able to pay back a straight deposit or a bond.

How could a depositor/investor get a real guarantee on his money?  Two steps.
  1. The bank would buy a zero coupon government bond issued by the US, UK, UAE, or Indian governments, thus "guaranteeing" that at maturity the receipt of the face amount of the bond in  US$, Sterling, AED or Rupees respectively.  I'm assuming that each of these sovereigns would "print" enough money to satisfy its obligations if that would be required.
  2. The bank would legally pledge these government bonds as collateral for the investment/deposit.  If they're not pledged, they are part of the estate of the issuer (the bank) in bankruptcy.  And the depositor/investor is an unsecured creditor of the bank.
Sometimes the transactions will be described as "guaranteed".  That occurs when a subsidiary of the bank issues the investment certificate or the deposit.  Then the parent guarantees its subsidiary's payment.  Again stripping away the form, the substance is that the same as if the depositor had placed a deposit with the parent (the bank).  There is no third party guarantee.  It is "all in the family" as I often like to say here at SAM.

Sometimes a minimum interest rate is "guaranteed".  This can be achieved very simply, by taking some of the remainder of the deposit after the zero is bought and putting it aside.  Say the bank wants to promise 1% interest.  It deducts $1,00 from the US$9.09 or the US$2.91 and puts it in a deposit.

The remainder of the principal of the deposit (what's left after the "zero" coupon security is bought and any minimum interest guarantee reserve funded) is then used to "punt" in the investments - equities, commodities,  options and derivatives, etc..  

Often with leverage where the bank lends additional funds secured by the additional assets purchased.  Generally with a mechanism to unwind leverage if volatility in the underlying instruments increases.  The bank will tout this as a "protective feature" to limit risk.  And it does.  However, volatility is a measure of the change of the value of an asset - whether the values are increasing or decreasing.  So some of the upside is given away.  But a fair trade to limit downside risk, I think.

Now to some numerical analysis.
 
With interest rates so low and the tenor so short, clearly a large part of the initial principal of the deposit would have to be used to purchase the zero coupon.

The remaining principal is likely to be very small.

Let's look at a simple example for a one year tenor.  Assume that interest rates are 10% (clearly they are not now.  This is our standard Panglossian best case.)  If they were, a zero maturing for $100 one year from now would cost US$90.91.   At 3% one year rates, the bond would cost US$97.09.  

This means that with the 10% scenario the bank would have US$9.10 of the investors' funds to punt with.  And US$2.91 at a 3% level of interest rates (closer to today's level).  As you notice, I am assuming there is no promised minimum interest.  And I'm assuming there are no upfront fees or ongoing operating expenses.  All of these would serve to make the economics even more difficult.

To get the 9% return on the total principal (i.e.,  US$9 in our example of the US$100 deposit), the bank would have to earn - without any leverage on the remainder (after buying the zero):
  1. Roughly 100% if the remainder were US$9.09.  (Our highly unlikely 10% market rate scenario)
  2. Roughly 309% if the remainder were US$2.91.  (Our still optimistic 3% market rate scenario).
Neither of these seem realistic returns for current market conditions.  And one might even consider that  if achieving these rates during the last bout of irrational exuberance was difficult, it might be even more so now.

Add some leverage and the required returns still remain very high.  

With total leverage of 3 times:
  1. In the first case the required one year return is 33%.
  2. In the second case, the required return is 103%.
With leverage, the lender always collects his principal and interest first.    If asset values decline, and trigger the leverage control, the lender will sell the additional assets and repay the loans (principal plus interest).  If the proceeds aren't enough to repay the loans, then he'll take money from the US$9.09 or US$2.91 "remainder" to cover any shortfall on principal and interest.  So employing leverage can cause an erosion of the "remainder" under certain market decline scenarios.

If the investing scheme breaks even, then the investor will get the market rate on his or her deposit.  The US$9..09 or US$2.91 in our two examples.  In effect the one year rates.

Up to 9% sounds great.  Getting it will be a little more difficult than reading a glossly brochure.  

To be very clear, am I saying it's impossible that this scheme could earn 9%?  No.  Rather that the probability of earning 9% is rather low.  Better I suppose than the odds of Paris Hilton winning the Nobel in Physics. But who knows what she's doing right now?

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