SG downgrade throws shadow over structured products

The €4.9 billion loss at Société Générale (SG), blamed by the bank on a single rogue trader, has drawn attention to counterparty credit risk within the structured products industry.

In particular, distributors claim a downgrade of SG by Moody’s Investors Service and Fitch Ratings, and the reputational damage incurred by the firm, could have a knock-on effect on its structured products business.

The losses were revealed on January 24 and were quickly followed by rating actions from Fitch and Moody’s, which downgraded SG from AA to AA– and Aa1 to Aa2, respectively. Standard & Poor’s, meanwhile, placed the bank’s AA rating on credit watch, with negative implications.

A downgrade would, all things being equal, make it more expensive for a company to raise funds in the wholesale markets, potentially making it more difficult for a bank to source cheap short-term funding – an important facet of the structured products business. However, rival dealers point out SG has a sizeable retail deposit base on which to draw, meaning the downgrade is unlikely to hurt the bank from a cost-of-funding perspective.

“I don’t think SG’s structured products business will be very hurt by these downgrades,” said a structuring head at a rival bank. “In terms of the costs of funding structured products, downgrades do not have a significant impact, as the bank is getting funding from many sources, including retail deposits. In some respects the business might even be helped, as new structured products will be cheaper.”

A downgrade means a higher discount rate would be used to price any zero-coupon bond issued by the arranging bank, meaning less of the investor’s cash would be needed to buy the bond, leaving more for the option component. However, there would probably be a negative mark-to-market impact on existing structured products arranged by SG.

“Zero-coupon bonds are going to decrease in value and the mark-to-market of the product will be affected negatively, which will be a problem for traders in the secondary market,” said Benoit Barthelet, who manages a fund of hedge funds and deals structured products at asset manager Lazard Frères Gestion in Paris.

More important is the issue of counterparty credit risk. Following the US subprime mortgage crisis, the perceived financial strength of a bank has become increasingly important. Hefty writedowns by investment banks in the US and Europe have caused some private banks and retail distributors to question the assumption that dealers will always be there to provide secondary market prices for products they sell.

“An issuer with high funding costs might show terms that at first glance seem attractive. However, clients are increasingly aware of the fact that a guarantee is only worth as much as the institution that guarantees it. The right product for a client is a balance between the credit quality of the issuer and the proposed product terms,” said Friso Postma, vice-president, third-party distribution, Benelux, at ABN Amro in Amsterdam.

At least one private bank has decided to no longer deal with arrangers rated below AA. Others say distributors will be more cautious. “In the case of equity-type products, a lower rating can make the product look more attractive to investors but, for fixed-income and credit investors, rating stability and a good reputation tend to be more important,” added Postma.

The reputational damage caused by the loss, combined with the downgrades, could cause distributors to think twice about selling a product labelled with SG’s brand, at least in the short term, say some. “The problem of trust is more important than the rating. If you think a bank is not able to control the amount of risk its traders are taking, that’s more concerning than the rating this bank has been given by the agencies,” said one distributor.

That might also be the case for dealers. SG was a major market-maker in the equity derivatives market and, while rival banks say it is too early to draw conclusions, the downgrade might cause some to be more wary when dealing with SG.

“The downgrade is going to draw more scrutiny. People will be more cautious about doing business with them,” said the head of structuring at the rival bank.

So far, SG claims there has been little effect on its client business, both in terms of new business and redemptions. “We were afraid of people asking for redemption or selling their structured products, but we received at least 200 messages [on January 24] from clients saying ‘don’t worry, we will continue to deal with you’,” said Christophe Mianné, head of global equities and derivatives at Société Générale Corporate and Investment Banking.

Some distributors, too, told Risk they will not be put off by recent events and will continue to distribute SG-branded products. “I’m not concerned about distributing SG’s products to my clients, so long as I explain to them the risks involved, which personally I think are rather low,” said one. “Its reputation will be damaged for the next few months, but it will disappear with time, as people tend to forget rather quickly.”

See also: A question of funding
SG gives details of fraud, but questions remain
€4.9 billion fraud at Société Générale