The fallout from the $2 billion derivatives loss in Orange County, Calif., has put a new focus on the sale of structured notes by government-sponsored entities such as Fannie Mae and the Federal Home Loan banks.
Interestingly, the Federal Home Loan Bank of Dallas quit selling the controversial derivatives in January. Bank president George Barclary discussed that decision.
Q.: Why do the Federal Home Loan banks issue structured notes?
BARCLAY: Structured notes enable the banks to provide attractively priced funding to our depository institution members. For about an 18-month period when interest rates were at their lowest levels, the issuance of structured notes clearly resulted in the most economical sources of funds for the Federal Home Loan banks.
Q.: Are some structured notes more risky than others?
BARCLAY: Absolutely. Keep in mind that the terms "structured notes" and "derivatives" are used generically to describe a variety of instruments with a wide range of risk characteristics. By some definitions, derivatives include anything other than a fixed-rate, simple interest bond.
Using that definition, the universe of structured notes could include everything from something like a five-year bond that's callable at six-month intervals after the first two years, to the more complicated securities such as range notes or bonds where the amount of the original principal repaid at maturity depends on changes in a totally unrelated index.
Probably about 40% of the bank system's outstanding bonds could be called "structured," if you use that term to describe anything that's not a plain-vanilla simple interest bond.
On the other hand, only about 2% of the bank system's outstanding debt is "structured," if you use the more limited definition of structured notes that others have used.
Q.: Explain how the risks of structured notes can vary.
BARCLAY: The Federal Home Loan banks typically eliminate the interest rate risk embedded in the structured notes we issue by entering into interest rate swaps, with parallel structures, to create funding at some spread below one or three month Libor, which is the index used to price a large portion of our assets. This process eliminates the market risk of these instruments from our balance sheet. We manage the credit risk involved in the swap transactions by dealing only with high-quality counterparties, and securing those arrangements with appropriate collateral agreements.
For the investor, the risks vary significantly depending on the structure. Callable bonds, for instance, embody fairly straightforward interest rate risk. Some structured notes may have coupons that are calculated from changes in indexes that have the effect of magnifying changes in market interest rates.
For example, range notes pay relatively attractive interest rates when a given interest rate index remains in a certain range, but pay no interest if the index falls out of the range.
All structured notes have been designed to address very specific investment objectives, and some of them become highly speculative when not purchased for their intended use.
Q.: When you sell a structured note, can you control who buys it?
BARCLAY: Yes and no. The Federal Home Loan banks don't sell our structured debt directly to investors. A group of underwriters, mostly primary dealers and other major Wall Street investment firms, sell our newly issued bonds to investors.
We require a commitment from those underwriters to sell the bonds only to suitable investors, and in addition often stipulate large minimum denominations that should preclude small investors from purchasing the bonds and should serve as an indication of complexity for institutional investors.
Once a bond has been resold in the secondary market, however, a dealer that wasn't a party to the original underwriting agreement becomes responsible for disclosure and ensuring the suitability of an investor.
At that point, our initial controls are not in effect and we don't know to whom the investment might be sold.
Q.: Why did the Dallas Home Loan Bank stop issuing structured notes?
BARCLAY: Several things going on at about the same time led us to suspend our issuance of structured notes last January, and to limit the kinds of debt we would issue. First, our funding need happened to be minimal at that time, so we weren't issuing many bonds of any kind. Second, as the pricing advantage of structured notes began to decrease, we began to see more complex, and potentially more risky, structures being developed in an effort to maintain the previous pricing advantage.
Also, I was beginning to sense that some of these bonds that had initally been purchased by sophisticated institutional investors were finding their ways into the portfolios of less suitable investors.
This concerned me.
Q.: Has demand for structured notes been affected by big losses such as those suffered in Orange County?
BARCLAY: First, we need to understand that Orange County's losses were due more to how they leveraged their investments than what they held in their portfolio. On the basis of changes in market values alone, they would have nearly lost as much holding long-term Treasury bonds.
It appears that their problem was more a case of mismanaging their overall portfolio of investments, not just a matter of investing in structured debt.
That said, the demand for structured notes has declined steadily since the Federal Reserve began raising short-term interest rates.
For investors who were not purchasing these bonds to offset specific risks that existed in their portfolios, the purchase of certain structured notes presumably reflected their expectation that interest rates would stay low indefinitely.
As interest rates rose, these investors began to see the value of the bonds decline.
The potential problems became more apparent as investment management funds, mutual funds, money market funds, and other investors reported losses in their portfolios.
At the same time, regulatory agencies like the Securities and Exchange Commission and the Comptroller of the Currency's Office were publishing advisories about the potential risks of these kinds of investments. Demand had dried up considerably even before the Orange County problems were announced.
Q.: Are there cheaper ways for the home loan banks to raise money?
BARCLAY: Structured notes represented the lowest cost source of funds for the bank system throughout late 1992 and most of 1993.
In the current market -- with higher interest rates, a flatter yield curve, an uncertain regulatory environment, and investors more cognizant to risks inherent in structured notes -- we have recently been able to achieve equal or better funding levels by issuing more traditional bonds.