Autocallables Part IV: Issuers’ Day-1 Value Mischief
By Craig McCann and Mike Yan
Earlier this week we posted about the $122 billion in autocallable structured products sold in the past 4 years, mostly issued by UBS, Goldman Sachs, JP Morgan, Citigroup and Morgan Stanley. You can read that post here.
We illustrated features of autocallables with reference to the five notes linked to the stock price of Lucid issued by Credit Suisse and Citigroup in a post available here and pointed out a particularly poorly timed issuance by Citigroup linked to Silicon Valley Bank stock in a post available here.
In this post, we explain how some issuers overstate a key disclosure required by the Securities and Exchange Commission to be prominently displayed in the 424b filing for every structured product. Some issuers (Goldman Sachs and Morgan Stanley for examples) appear to adhere to the word and spirit of the SEC's guidance by using yields on their straight debt to estimate the Day-1 value of structured notes. Other issuers (Citigroup, Toronto Dominion and HSBC for examples) use internal funding rates but disclose qualitatively at least that if they had used secondary market yields their estimated Day-1 values would be lower.
On the other hand, UBS, Credit Suisse and Bank of Montreal appear to flout SEC guidance and instead provide meaningless Day - 1 values based on arbitrarily low discount rates and without any discussion of the impact of using these lower discount rates on the estimated values they place on 424bs.
UBS, Credit Suisse and Bank of Montreal issued $43.1 billion of autocallable structured notes, and billions more in other types of structured notes with inadequate disclosures. Moreover, investors in Credit Suisse's autocallables which physically settle have lost at least $100 million.
Introduction
Since 2013, the SEC has required issuers to include an estimated value of structured products in the pricing supplement describing the terms of the security being offered. At the time, the SEC provided guidance to issuers in a February 21, 2013 letter from the Division of Corporation Finance. See for example, the Corp Fin letter sent to UBS available here.
The SEC’s intent to provide investors with the “market value” as well as the “purchase price” of the notes seems clear and is certainly laudable. Unfortunately, some issuers have taken extraordinary liberties in their calculations of Day-1 value such that, at best, the values reported in the 424bs should be viewed as an upper bound on the true value of the note.
The option components have to be valued by reference to observable option prices (and implied volatilities and correlations). The bond component on the other hand can be valued using yields on the issuers' straight debt which would including compensation for credit and liquidity risk. Using these "credit spreads" would result in a true FMV to the extent the structured notes are as liquid as the issuer’s debt trading in secondary markets.
The SEC also allows the issuers to value the bond component using its internal funding rate. Some issuers appear to interpret “internal funding rate” to mean whatever the issuer wants to pay on the notes being issued, not at the rate the issuer allocates capital internally or the rate at which it values the outstanding notes as a liability in its accounting.
To get a rough idea of the range of discretion: Suppose Citigroup has 2-year bonds trading a yield to maturity of 5%. This 5% includes Citigroup' yield spread and would be a sensible discount rate to apply to the structured note to estimate a FMV ignoring the difference in liquidity between Citigroup’s traded debt and the nontraded structured note. Suppose, given a note's parameters and the 5% discount rate derived from the yield on Citigroup’s traded 2-year bonds, the estimated value of the newly issued note is $930.
If instead, Citigroup instead discounts at 4% because that is the 2-year Treasury yield (also Citigroup’s yield less its yield spread) the estimated value will be about 2% higher or $948.
Some issuers seem to discount the structured notes future payments at whatever rate the issuer wants to pay to investors on the notes given it may have other costs which it is not supposed to include in the note’s valuation. Continuing with our example, suppose the issuer structures the note to pay investors only 2.5% so that the issuer can incur additional selling commissions, hedging costs and legal fees entailed in issuing the structured product and still pay less all-in that if the issuer had issued straight debt. Now, a very aggressive interpretation of the SEC’s 2013 guidance would allow the issuer to value the notes using a 2.5% discount rate and our example note would be valued at $976.
All of which is to say, the Day-1 values posted on 424bs sometimes look like our $930, $948 or $976 examples and so are an upper bound on the FMV. In our example, the FMV is $930.
Moreover, the SEC told issuers to inform investors of the impact of using something other than the yield on the issuers’ traded debt or other similar debt. As we demonstrate below, when issuers use internal funding rates rather than discount rates which include credit spreads, they use nonsensical language which fails to address the SEC's disclosure requirements.
The issuers offering a Day-1 value based on any discount rate substantially less than the yield on their traded debt, could and should report the value using discount rates which include their credit spreads so investors can see the impact of using the lower internal funding rates.
Goldman Sachs $60,000,000 Autocallable Nasdaq-100 Index?-Linked Notes due 2026
Goldman Sachs meets the spirit of the SEC’s disclosure rule in the 424bs we recently reviewed. For example, its September 29, 2022 424b reads in part:
Estimated Value of Your Notes
The estimated value of your notes at the time the terms of your notes are set on the trade date (as determined by reference to pricing models used by Goldman Sachs & Co. LLC (GS&Co.) and taking into account our credit spreads) is equal to approximately $948 per $1,000 face amount, which is less than the original issue price. The value of your notes at any time will reflect many factors and cannot be predicted; however, the price (not including GS&Co.’s customary bid and ask spreads) at which GS&Co. would initially buy or sell notes (if it makes a market, which it is not obligated to do) and the value that GS&Co. will initially use for account statements and otherwise is equal to approximately the estimated value of your notes at the time of pricing, plus an additional amount (initially equal to $52 per $1,000 face amount).
Emphasis added.
Thus, Goldman Sachs is using the yield on its debt to value the notes at $948. It also discloses that the first few months it will add enough to the value of the notes when reporting a value of the notes on account statements so that investors won’t notice a loss due to the difference between the $1,000 purchase cost and the $948 fair market value.
Morgan Stanley’s Contingent Income Auto-Callable Securities due August 15, 2024
Like Goldman Sachs, Morgan Stanley uses a discount rate which incorporates its credit spread when valuing these notes at $933. The 424b for this note at page 3 reads:
What goes into the estimated value on the pricing date?
In valuing the securities on the pricing date, we take into account that the securities comprise both a debt component and a performance-based component linked to the underlying stocks. The estimated value of the securities is determined using our own pricing and valuation models, market inputs and assumptions relating to the underlying stocks, instruments based on the underlying stocks, volatility and other factors including current and expected interest rates, as well as an interest rate related to our secondary market credit spread, which is the implied interest rate at which our conventional fixed rate debt trades in the secondary market.
[Emphasis added]
Citigroup’s Autocallable Barrier Securities Linked to the S&P 500? Index Due July 1, 2027
While Goldman Sachs and Morgan Stanley meet the spirit of the SEC's guidance, Citigroup does not. It uses an internal funding rate rather than the yield on its traded debt when valuing this note at $964.20. This is implausibly high since the net proceeds to Citigroup is only $970. Citigroup’s 424b reads at PS-9.
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Valuation of the Securities
CGMI calculated the estimated value of the securities set forth on the cover page of this pricing supplement based on proprietary pricing models. CGMI’s proprietary pricing models generated an estimated value for the securities by estimating the value of a hypothetical package of financial instruments that would replicate the payout on the securities, which consists of a fixed-income bond (the “bond component”) and one or more derivative instruments underlying the economic terms of the securities (the “derivative component”). CGMI calculated the estimated value of the bond component using a discount rate based on our internal funding rate. CGMI calculated the estimated value of the derivative component based on a proprietary derivative-pricing model, which generated a theoretical price for the instruments that constitute the derivative component based on various inputs, including the factors described under “Summary Risk Factors—The value of the securities prior to maturity will fluctuate based on many unpredictable factors” in this pricing supplement, but not including our or Citigroup Inc.’s creditworthiness. These inputs may be market-observable or may be based on assumptions made by CGMI in its discretionary judgment.
For a period of approximately three months following issuance of the securities, the price, if any, at which CGMI would be willing to buy the securities from investors, and the value that will be indicated for the securities on any brokerage account statements prepared by CGMI or its affiliates (which value CGMI may also publish through one or more financial information vendors), will reflect a temporary upward adjustment from the price or value that would otherwise be determined. This temporary upward adjustment represents a portion of the hedging profit expected to be realized by CGMI or its affiliates over the term of the securities. The amount of this temporary upward adjustment will decline to zero on a straight-line basis over the three-month temporary adjustment period. However, CGMI is not obligated to buy the securities from investors at any time. See “Summary Risk Factors—The securities will not be listed on any securities exchange and you may not be able to sell them prior to maturity.”
The same 424b at page PS-6 at least offers a qualitatively correct statement about the impact of using an internal funding rate which is lower than market yields to value the structured note.
The estimated value of the securities would be lower if it were calculated based on our secondary market rate. The estimated value of the securities included in this pricing supplement is calculated based on our internal funding rate, which is the rate at which we are willing to borrow funds through the issuance of the securities. Our internal funding rate is generally lower than our secondary market rate, which is the rate that CGMI will use in determining the value of the securities for purposes of any purchases of the securities from you in the secondary market. If the estimated value included in this pricing supplement were based on our secondary market rate, rather than our internal funding rate, it would likely be lower. We determine our internal funding rate based on factors such as the costs associated with the securities, which are generally higher than the costs associated with conventional debt securities, and our liquidity needs and preferences. Our internal funding rate is not an interest rate that is payable on the securities.
Emphasis added.
The SEC instructed issuers to make substantially this Citigroup disclosure in the event the issuer uses an internal funding rate which does not incorporate credit spreads. Page 2 of the SEC's 2013 instructions to issuers including the following instruction.
If the internal funding rate is used we believe that you should include appropriate disclosure to describe how the use of an internal funding rate, rather than the secondary market credit spreads, impacts the user's valuation of the structured note.
Credit Suisse’s $1,142,000 Contingent Coupon Autocallable Yield Notes with Upper Threshold Feature due November 7, 2024 Linked to the Performance of Four Underlyings
Like Citigroup, Credit Suisse discloses it uses its internal funding rate to value newly issued structured products. Credit Suisse’s 424b for this autocallable, it valued at $959, includes at page 14:
? THE ESTIMATED VALUE OF THE SECURITIES ON THE TRADE DATE IS LESS THAN THE PRICE TO PUBLIC — The initial estimated value of your securities on the Trade Date (as determined by reference to our pricing models and our internal funding rate) is less than the original Price to Public. The Price to Public of the securities includes any discounts or commissions as well as transaction costs such as expenses incurred to create, document and market the securities and the cost of hedging our risks as issuer of the securities through one or more of our affiliates (which includes a projected profit). These costs will be effectively borne by you as an investor in the securities. These amounts will be retained by Credit Suisse or our affiliates in connection with our structuring and offering of the securities (except to the extent discounts or commissions are reallowed to other broker-dealers or any costs are paid to third parties).
? EFFECT OF INTEREST RATE USED IN STRUCTURING THE SECURITIES — The internal funding rate we use in structuring notes such as these securities is typically lower than the interest rate that is reflected in the yield on our conventional debt securities of similar maturity in the secondary market (our “secondary market credit spreads”). If on the Trade Date our internal funding rate is lower than our secondary market credit spreads, we expect that the economic terms of the securities will generally be less favorable to you than they would have been if our secondary market credit spread had been used in structuring the securities. We will also use our internal funding rate to determine the price of the securities if we post a bid to repurchase your securities in secondary market transactions. See “—Secondary Market Prices” below.
[Emphasis added.]
Remarkably, Citigroup's and Credit Suisse’s statements could allow for the use of an arbitrarily low discount rate. The worse Citigroup and Credit Suisse structure the note from the investor’s perspective, the lower the expected yield the note’s structure implies. The lower the expected yield, the lower the discount rate the issuer feels justified in using and the higher their reported Day-1 value. That is, under Credit Suisse’ apparent interpretation of the SEC’s guidance it could report a $959 value whether the true FMV was $959, $929 or even $899 because the lower the true FMV, the lower the yield will pay investors over the life of the note.
At least Citigroup was clear that using a market yield which reflected its credit spreads would lower the estimated Day-1 value compared to the value reported on the first page of the 424b.
Credit Suisse's language isn't even close to what the SEC requires. The SEC told issuers to tell investors what the impact on the Day - 1 values would be of using market yields instead of internal funding rates. Instead of providing Citigroup's qualitatively correct disclosure, preferably quantified, Credit Suisse offered this meaningless word salad.
If on the Trade Date our internal funding rate is lower than our secondary market credit spreads, we expect that the economic terms of the securities will generally be less favorable to you than they would have been if our secondary market credit spread had been used in structuring the securities.
UBS AG $301,000.00 Securities Linked to the common stock of D.R. Horton, Inc. due on December 27, 2024
UBS's standard language is similar to Credit Suisse's language and does not state that using its secondary market yields instead of its internal funding rates to value the notes would result in a lower Day-1 value.
The issue price you pay for the Securities exceeds their estimated initial value - The issue price you pay for the Securities exceeds their estimated initial value as of the trade date due to the inclusion in the issue price of the underwriting discount, hedging costs, issuance costs and projected profits. As of the close of the relevant markets on the trade date, we determined the estimated initial value of the Securities by reference to our internal pricing models and it is set forth in this final terms supplement. The pricing models used to determine the estimated initial value of the Securities incorporate certain variables, including the price, volatility and expected dividends on the underlying asset, prevailing interest rates, the term of the Securities and our internal funding rate. Our internal funding rate is typically lower than the rate we would pay to issue conventional fixed or floating rate debt securities of a similar term. The underwriting discount, hedging costs, issuance costs, projected profits and the difference in rates will reduce the economic value of the Securities to you. Due to these factors, the estimated initial value of the Securities as of the trade date is less than the issue price you pay for the Securities.
Emphasis added.
Autocallable Barrier Notes with Contingent Coupons due March 28, 2024 Linked to the Least Performing of the shares of VanEck Vectors? Gold Miners ETF and the shares of VanEck Vectors? Junior Gold Miners ETF
Bank of Montreal at page 8 of the 424b uses language similar to Credit Suisse's language.
The terms of the notes were not determined by reference to the credit spreads for our conventional fixed-rate debt. — To determine the terms of the notes, we used an internal funding rate that represents a discount from the credit spreads for our conventional fixed-rate debt. As a result, the terms of the notes are less favorable to you than if we had used a higher funding rate.
Better disclosure would read something like:
The terms of the notes were not determined by reference to the credit spreads for our conventional fixed-rate debt. — To determine the terms of the notes, we used an internal funding rate that represents a discount from the credit spreads for our conventional fixed-rate debt. As a result, the estimated value of the notes would be lower if we had used a higher rate which reflected our credit spreads.
Of course, issuers should value structured products using the yields on their straight debt. Using an internal funding rate, especially a rate that can be whatever the issue structures the note to pay investors, allows for extraordinary mischief.
Issuers can and do lower the discount rate to whatever they want and call it an internal funding rate. By lowering the discount rate arbitrarily, issuers like UBS, Credit Suisse and Bank of Montreal can push Day-1 values arbitrarily close to the “proceeds to issuer” amount and thereby include in the Day-1 values costs and profits the SEC explicitly told them not to include in Day-1 values.
This mischief could be somewhat offset if UBS, Credit Suisse and Bank of Montreal told investors the Day-1 value is not a fair market value based on its secondary market yields as does Citigroup, Toronto Dominion and HSBC.
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11 个月Good point -- these structured notes look much less attractive when you remember you're taking bank credit risk which pays a good rate normally