What Happens to MLCDs If Interest Rates Rise?

Feature Article - Autumn 2011 | By Andrew Singer

WITH INTEREST RATES so low, bank investors have struggled to get some ‘pop’ for their invested dollar. Old standbys like certificates of deposit and fixed annuities don’t really make it.

Jack Cramer, Cramer + Associates

‘One of the hotter products’

MLCDs, in fact, are “one of the hotter products in banks now,” observes Jack Cramer, president of Cramer + Associates (Boulder, CO). Eighteen months ago bankers told Cramer that they would never offer market-linked CDs; now they are picking up the phone to discuss how they can sell them, he says.

“We’ve seen some good trending,” adds Richard J. Koll, managing director, Essex National Securities (ENSI) (Napa, CA). Sales of MLCDs have picked up as fixed annuity sales have dropped, “although it is not a one-to-one correlation. But among rate shoppers, in particular, it has been an alternative to the fixed annuity.”

Richard J. Koll, Essex National Securities

The low interest rate environment accounts for only “part of the appeal” of MLCDs, argues Lewis B. Carlisle, managing director, CD Funding Group, LLC (Cincinnati). What’s really happened is the creation of a “new category in asset allocation,” somewhere between stocks and bonds. “It’s a new way of thinking of asset allocation, one that has already occurred in Europe” where structured products like MLCDs have long been popular. “We feel that will continue in the future.”

If interest rates rise, consumers may go back to traditional CDs, but they will still invest in MLCDs, suggests Sean Gordon, managing director and head of third-party distribution for the Americas at Barclays Capital (New York), another big issuer of MLCDs. “They might complement each other,” says Gordon. Customers could do a bit of each.

The product has been strong, ‘and it will continue to be strong...We’ve seen a monumental change in banks and among investors in the last two to three years.’ — Michael T. Sherzan, Bankers Financial Services

A rate rise “could be a good thing,” continues Gordon. Barclays and others might be able to manufacture a five-year CD linked to the S&P 500, for instance, something that is expensive to build in the current rate environment. (Barclays’ main MLCD is linked to a basket of 10 stocks. Investors get a minimum of 50 basis points each year—regardless of how the basket performs. But a link to an index like the S&P 500 would obviously offer investors more diversification.)

If interest rates rise, it could actually be “beneficial” for MLCDs, agrees Kerbel. It will allow manufacturers to create shorter-dated MLCDs. Most now mature after six or seven years. Higher rates could make five- or four-year maturities, say, more common, says Kerbel.

The possibility of market-linked CDs ‘surpassing fixed annuities [in banks] within the next five years’ is real. – Fred Nicholas, McKendrySnow

If rates rise, banks can adjust—by offering a higher cap on rates, for instance, adds Carlisle. There will always be clients seeking something between equities and fixed-income instruments, he stresses.

Fred Nicholas, McKendrySnow

Barclays Capital saw its third-party MLCD bank business increase on the order of 300 percent to 400 percent over the past year, Gordon told us. He projects continued growth over the next year, particularly in the wake of Europe’s debt woes, which have shaken investors. The FDIC insurance attached to the MLCD product looks even better under such circumstances.

Barclays Capital saw its third-party MLCD bank business increase on the order of 300 percent to 400 percent over the past year.

At Louisiana’s IberiaBank (assets: $11.5 billion), MLCDs have been the fastest growing product within Iberia Financial Services, LLC, the bank’s investments unit, says Vance A. Richard, vice president and program manager. It’s helped the sale of other investment products. “Referrals [from branch bankers] are up across the board,” says Richard, whose bank, with the help of CD Funding, developed its own MLCD.

Michael T. Sherzan, Bankers Financial Services LLC

Overall, “We’ve seen a monumental change in banks and among investors in the last two to three years,” says Sherzan.

Eighteen months ago the “mantra was managed money,” but that is seen as increasingly difficult to do, adds Cramer. So now they [banks] want new products to get client to “tip toe back into the market.” That’s where the MLCDs have helped.

Obstacles remain

Still, if growth is to continue, most agree, certain obstacles must be overcome. “Ignorance,” for one, says Sherzan. “If everything you know about automobiles was based on what you read in newspapers, would you ever get in a car?” It’s similar here. There just isn’t a lot of personal experience yet.

Yes, in 2011 there was growing awareness about MLCDs within banks, but “a lot of people didn’t know, and many still don’t know that they exist,” says HSBC’s Kerbel, including bank brokers and bank clients.

“Education is key,” says Gordon. “It is by far the most important ingredient.” It will take more time to make reps comfortable with the product and able to explain it to customers. “One has to take the time to make sure people understand that this is not a traditional CD.” The FDIC insurance applies to the principal alone, a point that needs to be emphasized, for example.

There is increasingly a realization that there is a ‘new world order in the marketplace.’ — Jack Cramer, Cramer + Associates

“Training is key,” agrees Koll. Only registered reps can sell MLCDs in the ENSI system (even though a securities license is not required) and they must undergo training and pass a test. Reps are schooled in teaching clients how to read brokerage statements, for example. They must understand “the cost of the hedge,” the impact of market fluctuations, and be able to explain all that to the client. They also need training on the coupon calculation. “This is the term sheet. This is the final term sheet.” And so on.

There’s the risk of a zero coupon, notes IberiaBank’s Richard. There’s an early withdrawal penalty. So the sales rep has to “make sure that money won’t be needed for five years.”

Iberia has 15 senior financial advisors and 14 junior financial advisors. All have Series 7 licenses. Again, it’s a “house rule” at Iberia that sellers of MLCDs must have securities licenses, mainly because of the penalties for early redemption.

MLCDs have many more moving parts than fixed annuities, notes McKendrySnow’s Nicholas. MLCDs are linked to different indexes. The advisor has to understand how those indexes relate to the CD and be able to explain that to the client.

Does Nicholas foresee the sale of the product by platform bankers?given that it doesn’t require an insurance or securities license? No. Most of these products will reside within brokerage accounts. and they will be sold by Series 6 and Series 7-licensed advisors, says Nicholas.

Sherzan disagrees. The product can be sold directly by customer service representatives (CSRs), provided they have sufficient training. The product is “no more complex than fixed annuities, and less complex than index annuities,” says Sherzan.

At CD Funding’s client banks, the great majority of sales are by financial advisors. The financial advisor has the expertise to have a full investment discussion with the client and make sure that such a sale is appropriate, says Carlisle. The B/D platform is already experienced in issuing monthly statements, generating 1099s, valuing instruments at a certain point in time, and so on.

Is the 3 percent to 3.5 percent sales commission rate (compared with 5 percent or so for fixed annuities) a stumbling block to the sale of MLCDs? “No,” answers Nicholas. “Advisors see the world has changed. They know they have to provide a value proposition.” They also realize that they can sell more of the product.

“We do not have that problem,” agrees CD Funding’s Carlisle. The FAs are quick to understand the appeal of the product, and the FDIC backing. Moreover, in the current rate environment, “they will sell two to three times as many” MLCDs as annuities. “It’s an easier sale and it will generate more revenues.”

Proprietary versus third-party CDs

A big question is whether an institution will offer its own CD or that of a third party issuer— banks like HSBC, Barclays, Wells Fargo, and JPMorganChase, among others, manufacture MLCDs.

Some ENSI bank clients sell proprietary MLCDs—others sell third-party CDs. Does it make a difference?

It does, according to Koll. “The multiplier is three to five times.” If a bank is selling $2 million in third party MLCDs, it might do $6 million to $10 million if it is using a proprietary CD—“because it is branded to the bank,” says Koll.

There are “natural synergies,” agrees Iberia’s Richard. (Iberia is a client of both ENSI and CD Funding.) The investments unit works closely with the retail bank. Money comes back to the bank at the end of the month. It generates non-interest income. “And there is no disintermediation—which is huge,” says Richard.

‘Among rate shoppers, in particular, it has been an alternative to the fixed annuity.’ — Rich Koll, ENSI

Has it improved the brokerage unit’s relationship with the retail bank? “Absolutely,” answers Richard. “It’s further integrated us into the retail side of the bank.”

Others caution, however, that developing a proprietary CD is more difficult than it seems. It takes capital, technology, and talent, says Cramer, who works with McKendrySnow, which distributes MLCDs manufactured by HSBC and Barclays.

Has it improved the brokerage unit’s relationship with the retail bank? ‘Absolutely. It’s further integrated us into the retail side of the bank.’ — Vance Richard, IberiaBank

Vance Richard, IberiaBank

“I’ve never understood why a credit union would want to send money to a bank, or why a bank would want to send money to another bank,” i.e., sell a third-party market-linked CD.

How big can it get?

Assuming growth continues, could MLCDs eventually approach the success of fixed annuities in banks? “I think it’s possible. The genie is out of the bottle,” says Barclays’ Gordon. Moreover, MLCDs can be traded in the secondary markets, unlike annuities. This means MLCDs have more liquidity.

“It seems clear that adding MLCDs to the sales mix significantly increases the revenues generated by a bank investment program,” says Kehrer-LIMRA’s Stathis. “While the sale of MLCDs may eat into indexed annuity sales, the good news seems to be that this impact is limited, and more importantly MLCDs are bringing new investors to the table.”

It will be interesting to see how creative suppliers will eventually get with the product, says Cramer. He can envision CDs built around a collection of indices—10 different indices from around the world, say—and not just equities. It could include Asian stock market and commodities indexes, for instance.

Kerbel doesn’t see major innovations in the MLCD product while interest rates remain low, though. Right now the focus is on “consistency, keeping the product simple,” and raising awareness. Innovation is predicated on interest rates rising, he suggests.

What about the wealth management (WM) space? As the market grows, CD Funding is seeing more demand from fee-based clients, says Carlisle. One institutional money manager, for instance, was worried about his exposure to gold, particularly with the recent price run-up. He sold out his gold position and invested instead in an MLCD linked to the price of gold. This offered downside protection, but still enabled him to gain if the price of gold continued to rise. More of that sort of thing might be in the offing.

The product represents a ‘new category in asset allocation,’ says Carlisle, somewhere between stocks and bonds.

“It’s already there,” Cramer says. WM clients are better educated than in the retail space (from an investment products standpoint). Indeed, the WM space is already making the transition to market-linked notes.

But could MLCDs surpass annuities? “That’s a long way off,” answers Cramer. The infrastructure that supports annuities in banks—wholesalers, for instance—is so much larger. “That doesn’t mean there won’t be a lot of growth.”

A few bank B/Ds are already doing double-digit share in MLCDs (i.e., as a percentage of overall unit revenues). “I can see that as more prevalent.” It isn’t too fanciful to see MLCD share rising from 4 percent to 10 percent over the next few years, suggests Cramer.

To say MLCDs might rival the success of fixed annuities, however, is “a bold statement,” says Koll. “I don’t know if it will be as big as or replace fixed annuities.” But the share of program revenues can get to 10 percent or 15 percent in the next couple of years, says Koll, who admits this is a pure “guestimate.”

“It can be as big as fixed annuities [for banks], and can probably get larger,” says Sherzan. After all, the product can be sold to institutional investors, and can also be used within fee-based advisor accounts.

“It’s like where the insurance industry was in the early 1990s with indexed annuities,” says Sherzan. It took them 15 years to get that product down. Maybe banks will need half that time to master MLCDs, says Sherzan. “Look at Europe and Asia—they are so far advanced in terms of acceptance” of the product compared with the United States, he notes.

Nicholas sees market-linked CDs in banks “surpassing fixed annuities within the next five years,” assuming no further financial crises.

The potential for bank investment programs is large, concurs IberianBank’s Richard. “It could be as big as fixed annuities.”

The vast majority of the 8,500 commercial banks in this country are still not issuing their own MLCDs, adds Carlisle, and even among banks with more than $10 billion in balance-sheet assets—the 100 or so largest—only 25 percent have done so. “So we still see significant growth over the next year.”

“We are convinced that this is the way that banks will have to talk to clients in the future.” These types of products are relevant for every bank in the country—large and small—in Carlisle’s view.

There is increasingly a realization that there is a “new world order in the marketplace,” says Cramer, in the minds of both clients and advisors. We’ve experienced a “lost decade” in the investing sphere—people made no money in equities—and selling managed money products is increasingly seen as a long-term process. People are shaken, too, by market volatility—the 4 percent daily ups and downs in the stock market.

“Once they [banks] realize the change in psyche, things open up,” says Cramer. It has created a different kind of client and a different type of advisor.

Andrew Singer is editor-in-chief and publisher of Bank Insurance & Securities Marketing magazine. He can be reached at asinger@bisanet.org