Monday, November 26, 2012

Can Non-Financial Firms Issue Structured Products?

By Tim Husson, PhD and  Tim Dulaney, PhD

The simple answer is yes.  Structured products are for regulatory purposes corporate debt--that's why they are vulnerable to the credit risk of their issuers.  In theory, any firm that can issue corporate debt could issue a structured product, and could link that structured product to any underlying asset it choose.  In practice, no non-financial firm has done so in the US (to our knowledge), as there hasn't been a compelling reason for them to do so.

But according to Vita Millers at Risk.net, that might be changing.  In fact, non-financial firms may be the future of structured products.

The reasoning is simple.  Credit risk drastically effects the value of a structured product and by holding several structured products, an investor is exposed to the credit risk of the financial sector -- which is likely correlated.  So if non-financial firms began issuing structured products, investors could diversify the risk of issuer default amongst different sectors.  So says Stephen Black, managing director of Tier One Capital:
"If say, instead of being backed by Barclays, Royal Bank of Scotland or Société Générale, a FTSE 100 note is backed by a Tesco bond, a National Grid bond or a General Electric bond, it opens up the opportunity for structured products to proliferate across a portfolio in a far more usable and safer way. Spreading that counterparty risk beyond just the financial industry mitigates the downside of having undesirably high volumes of financial debt within the portfolio, and could see the continuing expansion of what is already a fast-growing part of the industry."
However, this line of reasoning may be problematic for a number of reasons.  In our experience, few investors hold a large number of structured products and so the concentration of credit risk will likely remain large.  Also, the non-financial firms would have to manage and sell these products, which would incur fairly substantial additional costs (mostly fees to investment banks).  Finally, there is a possibility that these products could become more idiosyncratic, and thus even more difficult to compare with alternatives and therefore less transparent.  So it's unclear what the upside would be for the purported issuer or if investors would truly benefit from this possible avenue for diversification in practice.

It has also been proposed that firms may benefit from using a particular type of structured product--a call-option enhanced reverse convertible--as a way of converting debt to equity in response to a stock collapse.  While this proposal was aimed at banks, a similar argument may be relevant to non-financial firms as well, though it remains to be seen what price investors would accept for this conversion risk.

We think that it is unlikely that structured products as they currently exist will become a significant component of most firms' corporate finance options.  Their complexity and regulatory uncertainty, with little clear benefit to the issuer, makes much more sense for banks (who have that expertise) than any other institution.  But who knows, maybe one day it will be more common to see a Ford reverse convertible than a Ford convertible in reverse...

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