Structured Notes: A Flawed Investment Product?

Structured notes may soon be the “next investment bubble” on Wall Street, according to some analysts. The products, which are packaged as derivatives mixed with bonds, often lack transparency, evoking comparisons to investment disasters like auction-rate securities and collateral debt obligations.

As reported Aug. 9 by Bloomberg, investment firms are employing the same “loophole” that allowed over-the-counter sales of collateralized debt obligations and auction-rate securities to pitch illiquid structured notes to investors in search of high yields.

The problem is that the value of illiquid structured notes relies, in part, on interest rate bets. Moreover, the derivative portion of the structured note can be highly complex, and the price of the security itself also generally includes a hefty – and undisclosed – fee.

“The trouble is that the firms originating these ersatz securities, as with the case of auction-rate municipal securities, have no obligation to make markets in these OTC structured assets or even show clients a low-ball bid,” said Christopher Whalen, managing director of Institutional Risk Analytics, in the Bloomberg article.

“Even as the big banks make a public show for the media of implementing the new Dodd-Frank law with respect to limits on own account trading and spinning off private equity investments, these same firms are busily creating the next investment bubble on Wall Street – this time focused on structured assets based upon corporate debt, Treasury bonds or nothing at all – that is, pure derivatives,” Whalen added.

In just one year’s time, sales of structured notes have increased more than 70%.