Sept. 29 (Bloomberg) -- A brochure pitching $1.84 million of notes sold by Lehman Brothers Holdings Inc. in August, a month before the firm filed for bankruptcy, promised ``100 percent principal protection.''

Buyers had ``uncapped appreciation potential'' pegged to gains in the Standard & Poor's 500 Index, the brochure said. In the worst case, they would get back their $1,000-per-note investment in three years. Only the last in a list of 15 risk factors mentioned the biggest danger: ``An investment in the notes will be subject to the credit risk of Lehman Brothers.''

Lehman's Sept. 15 bankruptcy leaves holders of the notes waiting in line with other unsecured creditors for what's left of their money. The collapse has rattled Wall Street's $114 billion structured-notes business, which Lehman, Merrill Lynch & Co., Morgan Stanley and Goldman Sachs Group Inc., all based in New York, used to raise cheaper funding as the credit crisis drove bond yields higher. About three-fifths of the $68.1 billion sold this year were bought by individual investors, according to data compiled by mtn-i, a London-based firm that tracks the market.

``Investors are going to be a lot more concerned about the credit of the issuers of these notes,'' said James Angel, an associate professor of finance at Georgetown University in Washington. Until recently, ``the buyers may have been mesmerized by the bells and the whistles,'' he said.

The market for structured notes -- constructed by Wall Street firms from a combination of bonds, stocks, commodities, currencies and derivatives -- has mostly avoided fallout from the slump in sales of mortgage-backed collateralized debt obligations and auction-market preferred securities.

Hong Kong Outcry

The $330 billion auction-rate market seized up in February, when securities firms stopped supporting the auctions. The U.S. Securities and Exchange Commission, along with state regulators in New York and Massachusetts, has since forced companies, including Citigroup Inc., Merrill and Morgan Stanley, to buy back more than $50 billion of the securities from aggrieved customers. Regulators cited claims that the investments were improperly touted as safe, cash-like investments.

A similar outcry broke out in Asia last week in the structured-notes market following Lehman's bankruptcy, the largest in history. Hong Kong's Securities and Futures Commission issued a statement saying it received 960 inquiries and 170 complaints from holders of about HK$15.6 billion ($2 billion) of structured notes arranged by or linked to Lehman.

``Many of these investors are old people relying on these investments to support their retirement,'' Albert Ho, chairman of Hong Kong's Democratic Party, said in a Sept. 23 interview.

Lehman Bankruptcy

Lehman, once the fourth-largest investment bank in the U.S., had to file for bankruptcy after its shares plummeted on concern that the firm couldn't raise enough capital to compensate for mortgage losses. Lehman had estimated debts of $613 billion as of May 31. Holders of unsecured Lehman debt may get less than 50 cents on the dollar, CreditSights Inc. analyst David Hendler said in a Sept. 23 report.

Lehman spokesman Mark Lane declined to comment. SEC spokesman Kevin Callahan said he couldn't comment on whether the agency had received complaints from investors or whether it is looking into how the securities were marketed.

``The banks and brokerage firms invent a product, and they push it until it breaks,'' said Roger Robson, founding principal of CapTrust Financial Advisors, a consulting firm in Tampa, Florida. ``Then the regulators step in and fix it. This could easily be the next product they've got to step in and fix.''

Structured notes were first sold in the U.S. in the 1980s, according to the Web site StructuredInvestments.com, maintained by Chicago-based securities firm Incapital LLC. They're sometimes marketed as ``structured equities'' or ``hybrid financial instruments'' because they combine features of debt and equity.

Mitts, Sequins

They have names like Mitts (Merrill's Market Index Target- Term Securities), Propels (Morgan Stanley's Protected Performance Equity Linked Securities) and Sequins (Citigroup's Select Equity Indexed Notes), according to StructuredInvestments.com. Lehman's offerings included Suns (Stock Upside Note Securities) and Prudents (Prudential Research Universe Diversified Equity Notes).

Total issuance of structured notes in the U.S. climbed fourfold over the past four years from $28 billion in 2003, according to mtn-i.

Structured notes are ``no longer Wall Street's best-kept secret,'' Keith Styrcula, chairman of the Structured Products Association, said in a Sept. 10 presentation at an industry conference hosted by the law firm Morrison & Foerster LLP in New York. The New York-based association has more than 2,000 members, including Citigroup, JPMorgan Chase & Co., Merrill, Morgan Stanley and Goldman, as well as European banks BNP Paribas, Barclays Plc and Deutsche Bank AG, according to its Web site.

Principal Protection

About a third of the structured notes sold last year promised full or partial principal protection, according to StructuredInvestments.com.

Corporate treasurers at Wall Street firms sold the notes in part to avoid paying bond yields that surged over the past year, said Brad Hintz, an analyst at Sanford Bernstein & Co. in New York, For example, Merrill's senior unsecured notes due in August 2017 trade at 88 cents on the dollar. That means the notes, sold a year ago with a 6.4 percent coupon, now yield 8.4 percent.

Hintz, who said he doesn't buy structured notes because of their ``opaque'' pricing, called the sales a ``perfectly reasonable thing for a corporate treasury to do.''

``The reason they're cheaper for the firms is because the average person can't take them apart,'' Hintz said.

Anna Pinedo, a partner in New York for Morrison & Foerster who represents sellers of the notes, said disclosures about the risks of structured notes are ample. ``People go into it with their eyes wide open,'' she said.

Fine Print

The Lehman brochure, e-mailed to clients in July, carried a blue banner headline -- ``Equity Structured Solutions.'' The securities being offered were called ``100 Percent Principal Protection Notes Linked to the S&P 500 Index,'' and the minimum investment was $10,000. After a table of formulas provided to compute theoretical returns was a footnote stating that Lehman had an A credit rating from S&P and an A+ from Fitch Ratings.

A list of ``selected risk factors'' started on the fourth page. The brochure said there would be ``no interest or dividend payments'' and warned that the notes ``may not appreciate.'' There were ``built-in costs'' to cover Lehman's own hedging expenses plus a profit, along with $20 per $1,000 principal amount of ``dealer incentives.'' Lehman's ``economic interests'' were ``potentially adverse'' to those of investors, and ``you must rely on your own evaluation in the merits of an investment.''

Bullet Point

The last bullet point read: ``An investment in the notes will be subject to the credit risk of Lehman Brothers Holdings Inc. and the actual and perceived creditworthiness of Lehman Brothers Holdings Inc. may affect the market value of the notes.''

Georgetown's Angel says the issue is to what extent Wall Street firms emphasized the risks that they could go bankrupt and urged investors to read the fine print. A month before the Lehman brochure was sent out, the firm announced a first-quarter loss of $2.7 billion. Over the summer, as conditions worsened, Lehman Chief Executive Officer Richard Fuld, 62, was busy trying to sell a stake in the firm to shore up its capital base. Fuld was paid $34 million for running Lehman last year.

``Until recently nobody had too many concerns about our major investment banks,'' Angel said. ``We thought these were rock-solid institutions that had been there since the dawn of time and would be there forever. Recent events have pointed out that that's not true.''

Lehman Bankruptcy

When Lehman filed for bankruptcy on Sept. 15, its structured notes were declared in default, according to data compiled by Bloomberg. Regulatory filings from Lehman listed $36.6 billion of ``hybrid financial instruments, primarily structured notes,'' on the firm's balance sheet at the end of May.

Some of Lehman's structured notes traded last week in the secondary market, mtn-i said in a Sept. 23 report. ``Dealers quoted a trading range between 10 cents and 55 cents on the dollar'' for the notes, according to the report. SecondMarket, a New York-based company that provides a marketplace for illiquid securities -- those in which there is no active market -- said in a Sept. 25 statement that it will begin trading Lehman structured notes, as well as bankruptcy claims.

Merrill's deteriorating credit, which contributed to a 36 percent plunge in its stock price during the week of Sept. 8, forced Chief Executive Officer John Thain to sell the third- biggest U.S. securities firm to Bank of America Corp. It had $86.3 billion of senior structured notes outstanding at the end of June, according to regulatory filings. That's an 85 percent increase from June 2007, and the percentage of total liabilities represented by the notes climbed to 29 percent from 19 percent.

Goldman, Morgan

Mark Herr, a spokesman for Merrill, declined to comment.

Morgan Stanley, the second-biggest investment bank after Goldman, had $42 billion of index-linked notes outstanding at the end of November, double the amount a year earlier, according to regulatory filings. The New York-based firm hasn't provided updated figures.

On a Sept. 16 conference call, Morgan Stanley Chief Financial Officer Colm Kelleher said that while the firm didn't sell bonds in the public markets during the last fiscal quarter, ``we did issue incremental non-public structured notes at attractive pricing levels.''

Morgan Stanley could do without the structured market because it already has met funding needs through the second quarter of next year, spokeswoman Jennifer Sala said. The firm was converted into a bank holding company last week, a status that will provide ``ongoing access'' to funds from the Federal Reserve, Morgan Stanley said in a Sept. 21 statement.

`Very Comfortable'

Goldman, which also converted to a bank, had $22.8 billion of unsecured long-term borrowings, which the New York-based firm said ``primarily includes hybrid financial instruments and prepaid physical commodity transactions,'' according to regulatory filings. A year ago the figure stood at $13.5 billion.

``Structured notes are not a core part of Goldman Sachs's funding,'' spokesman Michael Duvally said. ``We are very comfortable with our liquidity and funding profiles.'' Goldman raised $10 billion of capital on Sept. 24, including a sale of $5 billion of preferred stock to Warren Buffett's Berkshire Hathaway Inc. in Omaha, Nebraska.

Until this decade, the involvement of U.S. investment banks in structured notes was limited to underwriting the securities and collecting fees for structuring the derivatives attached to them, said Steve Kohlhagen, who worked as a trader at Lehman in the 1980s and retired in 2002 as head of fixed-income, derivatives and risk management at Charlotte, North Carolina- based Wachovia Corp.

`Popular' Offerings

Then, the notes were mostly issued by large banks with AA or AAA credit ratings. The offerings became popular because ``customers think it's a good deal,'' Kohlhagen said.

``They think, `wow, I'd like to get one of those things, because I can get benefits if the stock market goes up, and I don't lose if the stock market goes down,''' he said by telephone from his home in Colorado. ``Anybody who is sophisticated knows that what they're buying is a call option on the stock market, but it's attached to a note, so it looks less risky.''

Investment banks started issuing structured notes backed by their own credit because ``it's just a simpler way of doing it,'' said Robert Benson, a former head of the structured-products group at London-based HSBC Holdings Plc, the biggest European bank by market value.

Credit-Default Swaps

``At the moment, it's a big advantage to get the funding,'' said Benson, who left HSBC in 2001 to start his own firm, Arete Consulting Ltd., in London. ``In the past maybe that wasn't such a big part of the rationale.''

The riskiness of owning securities-firm debt has surged, based on prices in the credit-default swap market, which is used by traders to bet on the likelihood of a default.

Merrill's credit-default swap prices have climbed to 411, more than seven times the price a year ago, according to Bloomberg data. Lehman credit-default swap prices were trading in the low 300s earlier this month, before the bankruptcy filing. Morgan Stanley credit-default swaps were at 500 on Sept. 26, in addition to an upfront payment equivalent to 17.5 percent of the face value of the debt. Goldman's are at 449. Bank of America, Merrill's acquirer, has credit-default swaps trading at 161.

Morrison & Foerster's Pinedo said she doesn't expect ``a real downward trend'' in the market, although she says ``I'm sure there will be some effect.''

``It depends on what view you take on the future of these financial holding companies,'' she said.

She said more firms may sell structured notes in the form of certificates of deposits -- a banking product that's guaranteed by the U.S. Federal Deposit Insurance Corp.

To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net.

Last Updated: September 28, 2008 19:01 EDT