Getting on the Other Side of the Housing Bubble

August 05, 2005

New structured products to track inverse to housing sector index. PHLX looks beyond the options marketplace and broadly licenses its sectors indexes for structured notes.

The Philadelphia Stock Exchange (PHLX) inked a broad-ranging deal with a variety of investment banks on August 4 to develop structured products based on its successful suite of sector indexes.  The move takes PHLX beyond its main focus on options and into the rarefied air of specialized financial products, where investment banks develop unique financial offerings targeted primarily at the ultra-rich and at hedge fund clients. 

Six investment banks signed on to participate in the new PHLX program, which provides a platform for licensing all of its sector indexes: ABN Amro, Goldman Sachs, Merrill Lynch, Morgan Stanley, the Royal Bank of Canada and UBS.  Already, more than $250 million has been benchmarked against the sector bogies.

"Oftentimes, there is a need to put together a trading or hedging product that can't be done in the regular options market," explained Dan Carrigan, vice president of new products at PHLX.  "If a high net worth individual is more likely to buy a structured product than an option, we want to make sure that we help extend that opportunity."

So what exactly is a structure product?  Essentially, it's a product that offers specialized hybrid exposure to the financial markets, often (but not always) providing some sort of capital guarantee - a promise that the investor won't lose money.  An example will make things clearer. 

In May, Merrill Lynch offered investors the opportunity to purchase structured notes offering inverse exposure to the PHLX Housing Sector Index (HGX).   These kinds of notes have been particularly popular of late, probably due to investors looking to protect themselves from a bursting of housing bubble: As the HGX declines, the value of the notes goes up.

It is, of course, more complicated than that. In this case, Merrill Lynch requires the investors to tie up their money in the product for five years - no one can redeem their notes in the interim. In exchange, Merrrill guarantees that investors will receive at least 97 percent of their money back at the end of the five-year period …  even if the index doubles in the meantime (remember, these are bearish notes).  If the housing bubble bursts and the index tumbles, however, investors will do even better - they'll get their money back AND enjoy the added returns given by the falling market.

Sounds pretty nice, no?  Essentially, investors get negative exposure to the HGX with very little risk (three percent).  Merrill Lynch makes money - and can afford to offer the capital guarantee - because it pays no interest on the money in the interim. The investments are essentially interest free loans for Merrill Lynch.

A similar product from ABN Amro launched earlier this year for European investors offered the inverse proposition, with slightly better terms: 100 percent of invested capital was "guaranteed," and investors would benefit from any upside in the index. 

Expect to see more deals and more notes roll out soon.

"There's been quite a bit of interest in the housing sector," said Carrigan.  "But also in the Bank index and the SOX (semicondtor index)."


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