Unrepentant Wall Street Inflating Another Bubble in Structured Notes

Last Updated Aug 10, 2010 1:48 PM EDT

For con men, a "shade" is anything that distracts the intended mark -- a loud argument, an attractive woman, a spinning card -- from noticing that he's being cheated. Wall Street has mastered the art.

Take the recent spate of stories in the press about big banks moving to sell their private equity and hedge fund units or exiting proprietary trading. Under this narrative, fed by more leaks than a BP oil rig, firms including Bank of America (BAC), Citigroup (C), Goldman Sachs (GS) and Morgan Stanley (MS) are considering spinning off all or parts of these businesses to comply with the recently passed Dodd-Frank financial reform law.

Don't fall for it. Although Goldman has practically shouted from the rooftops that the investment bank is likely to close its so-called Principal Strategies prop trading group, the firm plans to keep a much larger unit that also bets with the company's capital, according to the WSJ:
Goldman has said the unit won't be affected by the so-called Volcker rule provision of the new law because investing in long-term debt securities is lending, not trading.

"Goldman Sachs is a money-making machine, and if there is a component to the machine that is making money, they'll find a way to keep it alive," said Michael Driscoll, a former Bear Stearns Cos. executive who now is a visiting professor at Adelphi University in Garden City, N.Y.
But the misdirection goes beyond making a show of following the rules. In high finance, the real action is usually to be found in the back alley, safely out of view of regulators and the public.

To see the grift in action, look no further than the burgeoning market for so-called structured notes, a type of security that uses derivatives hedged against corporate or government debt to gin up returns for investors. Sales of the notes are up more than 70 percent from last year.

In other words, a bubble is forming, says banking analyst Chris Whalen of Institutional Risk Analytics. As with the mortgage-backed collateralized debt obligations or credit default swaps that transmitted financial chaos far and wide, no one outside Wall Street is really paying attention to structured notes, even as banks peddle them to institutional -- and retail! -- investors. He writes:
One risk manager close to the action describes how the securities affiliates of some of the most prominent and well-respected U.S. [bank holding companies] are selling five-year structured transactions to retail investors. These deals promise enhanced yields that go well into double digits, but like the subprime debt and auction rate securities which have already caused hundreds of billions of dollars in losses to bank shareholders, the FDIC and the U.S. taxpayer, these securities are completely illiquid and often come with only minimal disclosure.
Investors like structured assets because they offer a bigger return that what's currently available on Treasuries, Whalen says. Fair enough. The trouble is that the banks creating these securities aren't required to make markets for them. So if interest rates change in a hurry, buyers can be left holding the bag, as they were in 2009 with auction-rate securities.

Meanwhile, because the underlying assets backing structured notes are hard to measure, it is the firm that originates the security -- not the market -- that sets its value. Under such conditions, asset prices are at best a vague estimation; at worst, they're a scam.

If all of this sounds oddly familiar, it should. Unregulated markets. Opaque financial gizmos. Investors, positive that five will get them ten, lining up like pigeons. Find the lucky lady, folks.

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  • Alain Sherter On Twitter»

    Alain Sherter is an award-winning business journalist who has written for The Deal, MarketWatch and Thomson Financial Media.

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