SEC Shines Light on Derivatives-Backed Notes: Credit Markets

Photographer: Andrew Harrer/Bloomberg

A man walks past the Securities and Exchange Commission (SEC) building with an umbrella in Washington, D.C. The SEC will require banks to provide a “narrative disclosure” of how it valued the securities. Close

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Photographer: Andrew Harrer/Bloomberg

A man walks past the Securities and Exchange Commission (SEC) building with an umbrella in Washington, D.C. The SEC will require banks to provide a “narrative disclosure” of how it valued the securities.

Lenders from JPMorgan Chase & Co. (JPM) to Bank of America Corp. (BAC) that sold $51 billion of securities backed by equity derivatives the past two years are being pushed by regulators to disclose that the banks valued the debt as much as 10 percent less than customers paid.

Banks are being given 10 days to tell the U.S. Securities and Exchange Commission whether they will comply with rules intended to increase transparency in the structured-notes market, the SEC said in a letter sent to some banks this month. Goldman Sachs Group Inc. (GS), Bank of America, and Royal Bank of Canada began disclosures as early as May on securities sold at prices that were typically 2 to 4 cents on the dollar more than where the banks valued them, data compiled by Bloomberg show.

Regulators are increasing oversight of equity-linked note sales that have soared 39 percent the past two years as investors buy them as an alternative to traditional bonds with record-low yields. The securities generally are sold to individuals who lack pricing models employed by banks to value the securities, which use derivatives to boost yields.

“These are complex and opaque products, and the more sunshine and disclosure, the better,” said Jacob Zamansky, a lawyer at Zamansky & Associates in New York representing investors in lawsuits over structured notes. “It’s important that the SEC focus on the disclosure of structured products because they’re exploding in sales to ordinary retail investors.”

Sales Surge

U.S. investors bought $25.6 billion of securities last year that use derivatives to pay yields tied to stock returns, up from $23.1 billion in 2011 and $18.4 billion in 2010, Bloomberg data show.

The five-page letter sent to banks Feb. 21 doesn’t set a date for when all structured-note issuers must include market valuations in offering documents. The SEC will require banks to provide a “narrative disclosure” of how it valued the securities.

Related story: A Devil's Bargain Faces Investors in Popular Structured Notes

They also will be required to explain why the value they place on the note may be higher than the price at which an investor could sell the security on secondary markets immediately after being issued, according to the letter.

Regulators “believe that investors should be able to understand the difference between the issuer’s valuation and the original issue price that they are paying for the structured note,” the SEC said in the letter, signed by Amy Starr, head of the agency’s capital markets trends office in Washington.

Bernanke Support

Elsewhere in credit markets, Federal Reserve Chairman Ben S. Bernanke defended the central bank’s unprecedented bond- buying, saying they are supporting the expansion with little risk of inflation or asset-price bubbles. Philip Morris International Inc. (PM) plans to issue bonds in a three-part offering that may include its first floating-rate debt since the tobacco seller’s spinoff from Altria Group Inc. in 2008.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, rose to the highest level this year, climbing 0.4 basis point to a mid-price of 90.5 basis points as of 12:10 p.m. in New York, according to prices compiled by Bloomberg. The measure, trading at a three- week high, has risen in four of the past five trading sessions.

GE Bonds

In London, the Markit iTraxx Europe Index tied to 125 companies with investment-grade ratings climbed 8.9 basis points to 122.4, the highest since Nov. 30.

Credit swaps typically rise as investor confidence deteriorates and fall as it improves. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of New York-based Citigroup Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.4 percent of the volume of trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Bernanke and his colleagues on the Federal Open Market Committee are debating whether to curtail $85 billion in monthly bond-buying amid concern the Fed’s record $3.1 trillion balance sheet may encourage excessive risk-taking by investors and complicate the Fed’s exit from easing. Several participants at the Jan. 29-30 meeting said the Fed should be prepared to vary the pace of purchases as the economic outlook changes, according to minutes released last week.

Inflation ‘Subdued’

“We do not see the potential costs of the increased risk- taking in some financial markets as outweighing the benefits of promoting a stronger economic recovery,” Bernanke said today in testimony to the Senate Banking Committee in Washington. “Inflation is currently subdued, and inflation expectations appear well anchored.”

Philip Morris intends to sell two-year notes with a coupon linked to the London interbank offered rate, as well as 10- and 30-year fixed-rate bonds, according to a person familiar with the offering. Proceeds may be used to meet working capital requirements, buy back stock or refinance debt, the New York- based company said today in a regulatory filing.

Russell 2000

Goldman Sachs started disclosing its valuations for equity- linked structured notes it sells in May. Charlotte, North Carolina-based Bank of America, the biggest issuer of the notes last year, followed in October, and Toronto-based RBC began this month, data compiled by Bloomberg show.

“We decided to do this because we think it’s good for clients to have more transparency of the approximate cost of these products,” Michael Dweck, a managing director in the private investor products group for the Americas at Goldman Sachs in New York, said in an e-mail.

Most of the notes issued by the lenders had an estimated value between 96 and 98 cents on the dollar, the data show.

The lowest estimate was 89.6 cents on the dollar for 10- year securities tied to the Russell 2000 Index that Goldman Sachs issued on Oct. 26. The $4.51 million offering yields 10 percent a year if the benchmark doesn’t fall below 80 percent of its value on the day it was sold, according to a prospectus filed with the SEC. The coupon falls based on the number of days below that level. Investors can lose their principal if the index falls more than 50 percent, and all capital is at risk.

Fees, Hedging

Goldman Sachs also issued the note with the highest estimated value, a three-month note linked to the Tokyo Stock Price Index that the bank sold on Sept. 28 and valued at 99.7 cents on the dollar, Bloomberg data show.

Florence Harmon, a spokeswoman for the SEC, declined to comment on the agency’s letter, as did Keith Styrcula, chairman of the Structured Products Association, an industry group, and Elizabeth Seymour, a spokeswoman for JPMorgan.

Matt Card, a spokesman for Bank of America, and Elisa Barsotti and Sanam Heidary, of RBC, didn’t return e-mails and telephone messages seeking comment.

Banks have already been disclosing distribution fees and hedging costs on offering documents. Issuers will not be able to include most of those fees in their estimation of the notes’ values, according to the SEC letter.

Structured notes are bonds bundled with derivatives to create customized bets. Banks may value the notes using so- called internal funding rates which are the bank’s own estimation of its own creditworthiness and can differ from the secondary market, the SEC said in the letter.

Secondary Markets

The value estimates probably won’t stop investors from buying the notes, said Tom Balcom, founder of 1650 Wealth Management, a Lauderdale-by-the-Sea, Florida, investment adviser with a third of its $50 million in assets in structured notes.

“A structured note is not something to be bought and sold like a stock or a bond,” he said.

The SEC asked issuers in April how they value their notes and how they create secondary markets for the illiquid securities. In a Jan. 15 letter, the agency denied a Freedom of Information Act request by Bloomberg News for records related to the matter, saying its review was “still pending.”

Law firm Morrison & Foerster LLP said in a bulletin on its website that the SEC would require banks to include a calculation of the bond part of a note and a description of how the banks valued the derivative part.

Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

To contact the reporter on this story: Kevin Dugan in New York at kdugan4@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net

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