Credit downgrades no surprise for structured investors, but issuer default still tops concerns, adviser says

By Kenneth Lim

Boston, June 3 - The structured product market continues to be a vibrant sector despite credit downgrades at Lehman Brothers Holdings Inc., Merrill Lynch & Co., Inc. and Morgan Stanley earlier this week, but the risk of issuer default remains a top concern, J. Scott Miller of Blue Bell Private Wealth Management said.

"I don't think it's going to have a huge effect yet," said Miller, who is managing partner and chief investment officer of the Blue Bell, Pa.-based wealth management firm. "I think the huge effect would come if there were further concerns in the whole financial system."

Standard & Poor's cut its credit ratings for the three banks on Monday, citing weakness in the investment banking business and the potential for write-offs. Morgan Stanley's credit rating was cut to A+ from AA-, while Merrill Lynch and Lehman saw their ratings lowered to A from A+.

Miller said Blue Bell has not been affected by the downgrades. The firm does not own any Lehman products right now and has been reducing its exposure to Merrill Lynch and Morgan Stanley, he said.

"We don't own Lehman and we haven't for some time," Miller said. "We had expected the downgrades and obviously it's concerning, but we have been moving away from Merrill and Morgan Stanley anyway and continue to diversify our prospects. We have been moving our money to other investment banks to spread out our risks."

In fact, the broad structured product market continues to see positive trends, Miller said. The bulk of structured products being issued remain those that are tied to major indexes that are well understood, so investors are not as apprehensive about investing, he explained.

"I think the fact that these are tied to known indices ... they're much better to pitch for the investment banks than for the CDOs," Miller said. "I don't think it's going to have a huge effect. I think the structured products are being more and more sought after by investment advisers. ... There are a lot of people who turned their heads two to three years ago because they just didn't understand them, but now they're beginning to ask for more information."

Some structures are also doing better than others, Miller said.

"There are certain structures that seem to work at different times, and right now because of what's going on, what you're seeing are more absolute barrier type notes," he said. "To me that seems to be what retail investors are interested in right now."

But Miller stressed that the risk of issuer default is nevertheless a major concern for the industry.

"The credit quality of issuers continues to be my No. 1 concern when it comes to structured products," he said.

"What we're doing differently, again, is doing our best to lessen our exposure to any one bank," he said. "We haven't done any Lehman ... I can't imagine us doing anything right now with them. We don't have hard and fast caps, but yes, we are watching our percentages."

The current uncertainty about issuers' credit quality could continue to play out over the rest of the year, he said.

The three banks that were just downgraded will have to issue products with terms that are more favorable to investors, for one.

"I think there's no doubt it's going to cost them more," Miller said.

The three banks may also begin to work more closely with third-party issuers.

"Lehman is a special situation," he said. "I would be surprised if some of their issuance prices haven't been greatly reduced already since the Bear Stearns collapse. What you're going to see is a lot of third-party guarantors. Merrill Lynch has been doing a lot of this. I think you're going to see the same thing from Morgan Stanley. Many of the companies that are involved in the retail part of the business, they are going to have to do this."

There could also be some mergers down the road, he speculated.

"I think it's going to take a couple more quarters to work out," Miller said. "It wouldn't be shocking to see a Morgan Stanley or Merrill Lynch even be combined with another bank in the future. I'm thinking that's going to happen to Lehman, I wouldn't be surprised if they merged with a bigger bank."

"When I look at Merrill and I look at Morgan Stanley, I'm not so concerned about them, simply because they have so many other subsidiaries in other businesses," Miller said. "Whereas Lehman is so closely tied to the investment banking business."

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