Wall Street banks are creating the “next investment bubble” by selling opaque and unregulated structured notes to investors hunting for yield, according to Christopher Whalen, managing director of Institutional Risk Analytics.
Using the same “loophole” that allowed over-the-counter sales of collateralized debt obligations and auction-rate securities, firms are pitching illiquid structured notes whose value is partly derived from bets on interest rates, Whalen wrote today in a report.
Whalen, who predicted in March 2007 the collapse of the mortgage-backed securities market, said that these structured notes “promise enhanced yields that go well into double digits” and “often come with only minimal disclosure.”
“The only 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,” Whalen wrote.
Dealers say they buy the securities back from investors, providing liquidity, according to Keith Styrcula, chairman of the Structured Products Association, a trade group that organizes industry conferences. The products are used by sophisticated investors to make tailored bets, he said.
“While it’s true that firms make clear in the prospectuses that they are under no legal obligation to provide liquidity, they have provided it over the last two decades without a single hiccup,” Styrcula said today in a telephone interview.
Based on ‘Nothing’
Structured notes, which are derivatives packaged with bonds, are sold to accredited buyers in private deals and to the public in trades reported to the Securities and Exchange Commission. Sales of the securities to individual investors in the U.S. rose 72 percent from a year ago to $29.6 billion through July, according to StructuredRetailProducts.com, a database used by the industry.
“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 wrote.
The financial regulatory reform legislation known as the Dodd-Frank Act, signed by President Barack Obama on July 21, prohibits banks from engaging in proprietary trading and limits investments in private-equity funds.
Individual investors, who “love the higher yields” on structured notes, will lose money when benchmark interest rates climb, according to Whalen.
“We already know of two hedge funds that are being established specifically to buy this crap from distressed retail investors as and when rates start to rise,” said Whalen, a former Federal Reserve Bank of New York official and co-founder of the Torrance, California-based research firm.