Lehman holders find few answers; BofA to be top structured agent with Merrill deal, but layoffs a concern

By Kenneth Lim

Boston, Sept. 15 - The structured product market saw a mixed bag from the bankruptcy filing of Lehman Brothers Holdings Inc. and from Merrill Lynch & Co. Inc.'s planned acquisition by Bank of America Corp.

Lehman's plan to file a Chapter 11 bankruptcy petition generally left investors concerned and without any answers about how much they would be able to recover from their Lehman-issued products. Observers said the bank's collapse drove home the point that an issuer's credit risk should not be taken lightly.

The Merrill-Bank of America deal was greeted with more optimism about what it could imply in terms of the credit quality of Merrill-issued products, although industry insiders worried about the impact that the deal would have in terms of layoffs.

Monday maelstrom

The structured product market came back Monday to startling news that Lehman Brothers was planning to file a Chapter 11 bankruptcy petition and Merrill Lynch - the most prolific structured product issuer so far this year by dollar amount - would be bought by Bank of America.

Lehman said none of the bank's broker-dealer subsidiaries or other subsidiaries of the holding company will be included in the filing, but structured products by the bank are generally offered through the holding company.

Merrill Lynch's takeover by Bank of America would take place through an all-stock exchange. Bank of America will exchange 0.8595 shares of its common stock for each Merrill common share, originally valuing the deal at about $50 billion.

The two pieces of news were the latest in a tumultuous month for the financial markets, Structured Products Association chairman Keith Styrcula said.

"Everybody is reeling from these," Styrcula said. "First we had the Freddie Mac and Fannie Mae bailout, and that was followed by another one-two punch with Merrill and Lehman. These were all just hypotheticals that the lawyers used to use...but now they've all come true."

Lehman leaves more questions than answers

The Lehman move left investors worried about the fate of their Lehman paper, but their concerns found little answers Monday.

"We'll gladly comment on how this will affect the products that we distribute, but the problem is right now nobody knows what's going to happen," said Brad Livingston, Advisor's Asset Management's vice president of structured products.

"What we're telling our clients right now is be, very clear on what structure you have, whether you have a CD, in which case we tell you not to worry, or whether you have a note, in which case you want to know if it's a senior note or a subordinated note, if it's backed by any collateral."

The chief concerns were what would happen to Lehman-issued notes in a default, whether structured products can be included in payouts, and whether the debt is backed by any collateral, he said. But with more questions than answers, investors and brokers are mostly sitting on their investments and waiting to see what happens.

"That's all you can do right now," Livingston said.

When AAM learned about the Lehman plans, it quickly had its teams contact its clients - mostly investment advisors and brokers - early Monday, Livingston said.

"We've done a great job this morning, our teams were really busy calling our clients and explaining to them what happened," he said. "We only deal with brokers and advisors, so we don't have that many people to deal with, but they [AAM's clients] may be getting a lot of calls from clients."

Senior debt quoted in 30s

In the distressed debt market, traders told Prospect News that Lehman's senior debt - the regular corporate notes with not structure - were quoted in the 34 to 36 range, while its subordinated debt moved to the 4 to 6 context. Sources called the bonds down at least 30 points on the day.

"Any senior bond, and any sub bond are, for the most part, interchangeable," one trader noted, saying all the company's senior debt was trading at essentially the same level, and likewise for its subordinated debt.

'Too soon to know'

Styrcula echoed the view that uncertainty was the dominant sentiment.

"It's too soon to know how it's going to shake out," he said. "We don't know if there are some private equity firms waiting to step in and buy it on the cheap. We don't know if some China bank or Indonesian bank or Dubai will step in... Investors in Lehman paper are just kind of holding their positions right now."

The fact that the subsidiaries will not be included in the bankruptcy filing may not be much consolation, Styrcula added.

"The subsidiaries will be under pressure also," he said.

The Structured Products Association will address the issue in its coming fall conference on Oct. 2, Styrcula said.

"We'll have a better sense of how things shape up, and we're going to have a topic for that for our conference," he said.

Spotlight on issuer risk

The Lehman collapse struck home a cautionary message that the credit quality of a structured product issuer should not be taken lightly, observers said.

"It confirms some critics' views that credit risk in structured products is very real ... we've entered uncharted territory, this is the biggest financial failing in 18 years...these are extraordinary times with jaw-dropping impact," Styrcula said.

Investment advisor Scott Miller Sr. of Blue Bell Private Wealth Management said the risk lesson will be the key takeaway from the Lehman collapse.

"One thing that's going to come out that's very important is investors have to understand that you do have credit quality risk with structured products," he said.

"The credit risk of the underlying structured product is every bit as important as the portfolio of structured products," Miller added. "So while I'm not overly concerned about our management of structured products, because I think we have a lot of downside protection, I think it's very important to manage the underlying credit risk."

The bankruptcy filing was not a total surprise, but it came suddenly enough to be significant for the market, he said.

"Lehman is rather negative news, obviously, especially for people who own their structured products, and I do know people out there who had substantial exposure to Lehman," he said.

Blue Bell does not have any exposure to Lehman - Miller said his firm had made it a point to buy structured products only from companies with solid credit ratings.

"From that standpoint, that gives me great comfort," he said.

Bank of America will be top issuer

Bank of America's takeover of Merrill Lynch will boost the acquirer's standing in the structured products league tables.

Merrill Lynch is currently the top underwriter of U.S. structured products with about $7.6 billion worth of products year-to-date, based on preliminary data compiled by Prospect News. Bank of America, which has just under $1 billion year-to-date, is currently in the 11th spot. Merrill Lynch was also the top agent in 2007.

Miller saw the combination of the two banks as a positive move for the industry.

"I think the Merrill Lynch news is actually favorable news for the industry and for structured products," he said. "We want to make sure that all the banks out there are capitalized...I think it's good because the backing of Bank of America along with the credit of Merrill Lynch, to me, makes them that much stronger."

But an industry veteran saw the merger of the two banks as a mixed bag.

"Ultimately you can look at that and say, if the JPMorgan and Bear Stearns combination was successful...you can see how that's helped their revenue stream," the veteran said. "But the argument is that you're taking Bank of America and combining it with the guys over at Merrill Lynch. You're going to have massive redundancy."

"In terms of their brokers, they have at least 7,000 in New York alone," the veteran said. "You're going to have an amazing distribution channel."

But a marriage of the Bank of America and Merrill Lynch structured products teams would be intriguing, the veteran said.

"What's interesting for me is Merrill Lynch is super innovative and aggressive, and Bank of America is very conservative," the veteran said.

Structured products marches along

The Monday news may have sent many players and investors in the structured product market scratching their heads trying to figure out the impact of all the news, but the industry in general continues to be robust, Livingston said.

"Actually, what we've seen is more interest simply because of the FDIC insurance, so a lot of interest in CDs," he said.

There has also been an uptick in interest in products that have low or negative correlations with the major stock markets, Livingston said.

"Long-short products, commodities, currency," he said. "We're seeing more interest in those, and we think those are great stories right now."

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