Risky Finance 17 May 2007

The session of the Greek parliament on 3rd May was an especially stormy one. A few days earlier, the minister for employment had been forced to resign, and the socialist opposition smelled blood. Why, clamoured the socialist MPs, had the finance ministry hired JP Morgan to package loans linked to military procurement in the form of structured notes?

JP Morgan had placed the notes in February with a London hedge fund, North Asset Management. There’s nothing untoward about this—the arrangers of loans often package them with exotic features to make them attractive to specialist investors, thus cheapening funding costs for the issuer. But North decided the notes weren’t attractive enough hang on to, and sold them. Nothing untoward about that either. However, after passing through a chain of intermediaries, the notes ended up in the hands of Greek public sector pension funds, which paid vastly over the odds for their investments.

Now a backlash is underway—against the hapless minister, board members of the pension funds, Athens-based brokerages. Greek trade unions are calling for the UK’s FSA to investigate. Even JP Morgan is offering to unwind the transaction at cost value in what sources familiar with the situation say is a goodwill gesture. Other banks whose structured products were sold to Greek pension funds have made similar offers.

The row epitomises the tensions that can emerge when domestically-focused institutions interact with the complex products and sophisticated players of the international capital markets. It’s easy to characterise it as a predator-prey relationship that inevitably converts naive stakeholder funds into the bonuses of wealthy bankers.

Yet, over years of covering such stories, I have developed a shred of sympathy for the investment bankers. They compete fiercely with one another to offer services to institutional clients—structuring, hedging, takeover advice, financing and so on. Careers, and bonus payments, depend on the banks’ ability to deliver these services honestly and effectively.

True, structured derivative products can be opaque and risky. But are bankers wholly to blame if major institutions such as Greek public sector pension funds – with some €50 billion between them—have such poor supervision and governance that they cannot spare a tiny fraction of their time and wealth to verify the price or performance of a structured note?

Insurance companies and pension funds may complain with some justification that external pressures ranging from accounting and regulatory reform to tougher conditions in traditional asset classes are forcing them into unfamiliar markets. Whether it is a derivatives hedge to reduce regulatory capital, or a new form of collateralised debt obligation (CDO) that squeezes extra returns out of overheated credit markets, the moving parts can be dizzyingly unfamiliar.

But before joining the hue and cry over structured product mispricing, people should remember what exactly they are buying. Traditionally, insurance companies and pension funds paid consultants and fund managers handsome fees to make decisions on their behalf. A structured product or derivative may seem quite different: a tailored security with a required return and risk profile.

However, behind the facade lies something very similar to traditional consulting and fund management. The price of a structured product includes two things: the cost of advice needed to sell it, and the trading costs required to manufacture the risks and returns promised to the customer.

There is no mystery or deception about this. Long ago in 1973, Fischer Black, Myron Scholes and Robert Merton worked out that the price of an option—once considered a form of security—was no more than the cost of dynamically replicating it using underlying assets. Rather than patenting this idea, they published it.

Financial products have grown in complexity since then, but so has the amount of information about them. Institutional investors have no excuse not to learn about the mechanisms and costs of the structured products they are buying.

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