Structured Note Rules May Fail to Resolve Confusion Over Pricing
A move to improve pricing transparency for U.S. structured notes may be undercut by the tendency for issuers to use their own models and assumptions to value the complex products.
The Securities and Exchange Commission plans to require banks to disclose an estimated initial value of their securities in offering documents and describe how they arrived at prices for the bond and derivatives components, according to a report from securities law firm Morrison & Foerster LLP last month.
Issuers can use internal funding rates or prevailing market spreads over risk-free rates for “calculating” a bond’s price and should “discuss” how the derivatives are valued, which would include the use of models or assumptions, according to the report. Differing approaches to valuation may complicate efforts for investors to compare similar products to get the best deal.
“Depending on what the rule is, there might be so much wiggle room in the valuation that it won’t be as useful,” said Frank Partnoy, a professor of law and finance at the University of San Diego who previously structured derivatives at Morgan Stanley, in a telephone interview.
In April, the regulator asked issuers how they value their notes and how they create secondary markets for the illiquid securities. It isn’t clear if the SEC has given the banks a deadline, as documents and discussions aren’t public. In a Jan. 15 letter, the agency denied a Freedom of Information Act request by Bloomberg News for records related to the matter, saying “the filing reviews are still pending.”
Structured notes are bonds packaged with derivatives, often options, that are customized for individual investors. Derivatives base their value on other assets, such as stocks or commodities, as well as the expected volatility of those assets. Banks often use proprietary models to value their own derivatives.
“If you changed your volatility assumptions for one of these options that are embedded in one of these structured products, you could get a vastly different valuation,” Tim Dulaney, senior financial economist at the Securities Litigation & Consulting Group Inc., a Virginia consulting firm, said in a telephone interview. “And whether or not their volatility assumption is appropriate is up for grabs.”
Dulaney also said that how banks estimate volatility could be “too esoteric” for note buyers to understand. “Even the simplest models you can use to value these things would fly over the head of most retail investors,” he said.
The two largest structured note issuers in the U.S. by sales last year, Bank of America Corp. and Goldman Sachs Group Inc., have begun disclosing the initial fair value of their securities. The estimates appear on the first or second page of prospectuses for the products.
Most of the notes issued by the banks had an estimated value between 96 and 98 cents on the dollar, according to data compiled by Bloomberg. The lowest price was 89.6 cents on the dollar for 10-year range accrual securities tied to the Russell 2000 Index that Goldman Sachs issued on Oct. 26. The highest value among equity-tied notes was 99.7 cents on the dollar for a three-month security linked to the Tokyo Stock Price Index, known as the Topix, sold on Sept. 28.
Tiffany Galvin, a spokeswoman for the bank, declined to comment.
The offering documents say the estimated value is lower than the issue price partly because of underwriting fees and expenses to create and market the notes. Models used to determine the initial value “are proprietary and rely in part on certain assumptions about future events, which may prove to be incorrect,” according to the prospectus. The notes’ value on the secondary market may differ “perhaps materially” from Goldman’s appraisal because another party may use a different pricing model, the bank wrote.
The notes pay annualized interest of 10 percent for days that the benchmark is at least 80 percent of its initial value. Goldman has the option to redeem the securities monthly after the first year.
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