With equity markets still moving sideways and no sign of a revival in corporate profitability, the creation of structured credit products to meet specialized investor needs is one of the few business lines still booming at investment banks. JPMorgan’s structured credit business has been taking full advantage of that in recent months.
Earlier in the year it created Jeci, an instrument that gives investors a liquid way to gain diversified exposure to credit default swaps. Now it has devised Merit (Manager Enhanced Return Increasing Tailor-made), an instrument it says solves a problem that has troubled investors for some time. The market for managed portfolio instruments such as collateralized debt obligations (CDOs) gives them little flexibility in terms of structure. Deals are big and syndicated, so they rarely match particular requirements.
The structured credit basket market, by contrast, is primarily distributed through private placements and offers investors all the customization they could want in areas such as timing, structure, duration and format. But these deals have hitherto not been managed independently. Only a few have let investors make limited changes to the underlying basket themselves.
JPMorgan’s structured credit team says it has solved this dichotomy. Merit enables investors to choose almost any structure or characteristics they want – whole or partial capital protection, various levels of credit risk, zero coupon, or potential for equity upside, for example. And they can also choose to have the collateral pool managed by a specific, independent asset manager.
Managed but flexible
So the investor gets the look and feel of a managed CDO with the flexibility in timing and structure of a private placement tranche. Christian Spieler, managing director at JPMorgan, says: “Investors have been constrained by the limited range of products available in the CDO market. With a more traditional syndicated issue, the structure is determined by the arranger. Merit offers far more flexibility, since investors can choose the deal’s timing, size, format and risk-return profile. And as more asset managers become aware of the product, they will be able to choose their manager as well as their structure. Investors are in the driving seat.”
At the instrument’s heart is a bilateral advisory agreement between JPMorgan and an asset manager. The latter creates and manages a diversified basket of credit default swaps, within set constraints. Any number of deals can be executed from within this agreement and linked to the basket, within notional limits. Each deal can be structured differently: as individual tranches or as a complete capital structure, as a swap or as a note, and in any size required.
The first, and so far only, deal was designed for an investor that wanted capital protection on a CDO equity note it already owned. There were a large number of other requirements. For example, credit risk should be limited to five-and-a-half years, capital protection should be achieved through a zero-coupon mezzanine deal, and the transactions should be done within a specified time. JPMorgan structured the deal so the investor first transferred the CDO note to a special purpose vehicle, together with an amount of cash equivalent to the zero-coupon mezzanine’s initial nominal value.
The bank then entered into a swap agreement with the SPV to give it the investment-grade credit exposure that would later be managed by the external asset manager – in this case, Deutsche Asset Management. This swap was collateralized with triple-A Pfandbriefe that the SPV had bought from a third party. The buyer then invested in a Schuldschein to buy back the CDO equity note together with the synthetic exposure from the mezzanine deal. The deal ended up meeting all the investor’s needs, and left it holding a managed, capital protected CDO equity Schuldschein issued by an SPV.
Asset managers stand to benefit as well as investors and arranging banks. “There are a lot of small and medium-size asset managers who have great relationships with their clients,” says Spieler. “Many are looking for a chance to leverage these strengths in new areas to get additional fee income. With this product, they can do so without having to actually own the assets – they just maintain a list of the credits in the basket and tell us of any changes.”
