SEC Shines Light on Derivatives-Backed Notes: Credit Markets
(To be sent this column daily, click SALT CMW. For credit- market columns, click on TOP CM.)
Feb. 26 (Bloomberg) -- Lenders from JPMorgan Chase & Co. to Bank of America Corp. that sold $51 billion of securities backed by equity derivatives the past two years are being pushed by regulators to disclose that the banks valued the debt as much as 10 percent less than customers paid.
Banks are being given 10 days to tell the U.S. Securities and Exchange Commission whether they will comply with rules intended to increase transparency in the structured-notes market, the SEC said in a letter sent to some banks this month. Goldman Sachs Group Inc., Bank of America, and Royal Bank of Canada began disclosures as early as May on securities sold at prices that were typically 2 to 4 cents on the dollar more than where the banks valued them, data compiled by Bloomberg show.
Regulators are increasing oversight of equity-linked note sales that have soared 39 percent the past two years as investors buy them as an alternative to traditional bonds with record-low yields. The securities generally are sold to individuals who lack pricing models employed by banks to value the securities, which use derivatives to boost yields.
“These are complex and opaque products, and the more sunshine and disclosure, the better,” said Jacob Zamansky, a lawyer at Zamansky & Associates in New York representing investors in lawsuits over structured notes. “It’s important that the SEC focus on the disclosure of structured product because they’re exploding in sales to ordinary retail investors.”
U.S. investors bought $25.6 billion of securities last year that use derivatives to pay yields tied to stock returns, up from $23.1 billion in 2011 and $18.4 billion in 2010, Bloomberg data show.
The five-page letter sent to banks Feb. 21 doesn’t set a date for when all structured-note issuers must include market valuations in offering documents. The SEC will require banks to provide a “narrative disclosure” of how it valued the securities.
They also will be required to explain why the value they place on the note may be higher than the price at which an investor could sell the security on secondary markets immediately after being issued, according to the letter.
Regulators “believe that investors should be able to understand the difference between the issuer’s valuation and the original issue price that they are paying for the structured note,” the SEC said in the letter, signed by Amy Starr, head of the agency’s capital markets trends office in Washington.
Elsewhere in credit markets, Caterpillar Inc. and PepsiCo Inc. led dollar-denominated bond sales of at least $10.5 billion. GreensLedge Capital Markets LLC and Cantor Fitzgerald LP were said to have raised a $525.5 million collateralized loan obligation for Highland Capital Management LP. Moody’s Investors Service said it won’t assign its top ratings to certain residential mortgage-bond deals with issuer-friendly terms, signaling a potentially tougher stance than competitors.
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rose 3.6 basis points to a mid-price of 90.2 basis points, according to prices compiled by Bloomberg. The measure, trading at a three- week high, has risen in three of the past four trading sessions.
The Markit iTraxx Europe Index tied to 125 companies with investment-grade ratings climbed six basis points to 119, the highest since Dec. 10, at 9:50 a.m. in London. The index jumped amid investor concern that deadlock in Italy’s elections will roil markets.
Credit swaps typically rise as investor confidence deteriorates and fall as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Bonds of Fairfield, Connecticut-based General Electric Co. were the most actively traded dollar-denominated corporate securities by dealers yesterday, accounting for 3.4 percent of the volume of trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Caterpillar, the world’s largest maker of construction equipment, issued $1.1 billion of bonds yesterday, and Purchase, New York-based PepsiCo sold $2.5 billion of debt, according to people familiar with the transactions.
At least eight companies offered bonds of benchmark size, typically at least $500 million, after sales slumped this month to $87.3 billion following $170.9 billion in January, the busiest start to a year on record, Bloomberg data show.
Highland’s CLO, the first for the Dallas-based firm since 2008, includes a $190.8 million AAA slice paying a coupon of 87 basis points more than the London interbank offered rate and a $115.8 million piece paying 125 basis points more than the benchmark, according to a person with knowledge of the deal, who asked not to be identified because the terms are private. Libor is a rate banks say they can borrow in dollars from each other.
Acis Capital, a unit of Highland, will manage the loans in the fund that was originally being marketed at $416 million, the person said. CLOs are a type of collateralized debt obligation that pool high-yield, high-risk loans and slice them into securities of varying risk and return.
Home-loan securities without government backing probably will be able to get rankings only as high as Moody’s Aa tier if “significant” limits are placed on when and how repurchases can be forced of mortgages that fail to match their stated quality, New York-based ratings firm said yesterday in a report.
Ratings companies, after fueling the U.S. mortgage-credit bubble that caused a global financial crisis, are now confronting lenders and bond sponsors such as Credit Suisse Group AG and JPMorgan that seek safer contracts for themselves. Moody’s competitors have said investors may get enough protection with weaker so-called representations and warranties if the deals have bigger loss buffers or offsetting features, such as upfront third-party reviews of all loans.
In emerging markets, relative yields widened 7 basis points to 293 basis points, or 2.93 percentage points, according to JPMorgan’s EMBI Global index. The index has widened from 265.8 at year-end.
Goldman Sachs started disclosing its valuations for equity- linked structured notes it sells in May. Charlotte, North Carolina-based Bank of America, the biggest issuer of the notes last year, followed in October, and Toronto-based RBC began this month, data compiled by Bloomberg show.
“We decided to do this because we think it’s good for clients to have more transparency of the approximate cost of these products,” Michael Dweck, a managing director in the private investor products group for the Americas at Goldman Sachs in New York, said in an e-mail.
Most of the notes issued by the lenders had an estimated value between 96 and 98 cents on the dollar, the data show.
The lowest estimate was 89.6 cents on the dollar for 10- year securities tied to the Russell 2000 Index that Goldman Sachs issued on Oct. 26. The $4.51 million offering yields 10 percent a year if the benchmark doesn’t fall below 80 percent of its value on the day it was sold, according to a prospectus filed with the SEC. The coupon falls based on the number of days below that level. Investors can lose their principal if the index falls more than 50 percent, and all capital is at risk.
Goldman Sachs also issued the note with the highest estimated value, a three-month note linked to the Tokyo Stock Price Index that the bank sold on Sept. 28 and valued at 99.7 cents on the dollar, Bloomberg data show.
Florence Harmon, a spokeswoman for the SEC, declined to comment on the agency’s letter, as did Keith Styrcula, chairman of the Structured Products Association, an industry group, and Elizabeth Seymour, a spokeswoman for JPMorgan.
Matt Card, a spokesman for Bank of America, and Elisa Barsotti and Sanam Heidary, of RBC, didn’t return e-mails and telephone messages seeking comment.
Banks have already been disclosing distribution fees and hedging costs on offering documents. Issuers will not be able to include most of those fees in their estimation of the notes’ values, according to the SEC letter.
Structured notes are bonds bundled with derivatives to create customized bets. Banks may value the notes using so- called internal funding rates which are the bank’s own estimation of its own creditworthiness and can differ from the secondary market, the SEC said in the letter.
The value estimates probably won’t stop investors from buying the notes, said Tom Balcom, founder of 1650 Wealth Management, a Lauderdale-by-the-Sea, Florida, investment adviser with a third of its $50 million in assets in structured notes.
“A structured note is not something to be bought and sold like a stock or a bond,” he said.
The SEC asked issuers in April how they value their notes and how they create secondary markets for the illiquid securities. In a Jan. 15 letter, the agency denied a Freedom of Information Act request by Bloomberg News for records related to the matter, saying it’s review was “still pending.”
Law firm Morrison & Foerster LLP said in a bulletin on its website that the SEC would require banks to include a calculation of the bond part of a note and a description of how the banks valued the derivative part.
Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
--With assistance from Sarika Gangar, Kristen Haunss and Jody Shenn in New York. Editors: Shannon D. Harrington, Alan Goldstein