Tuesday, August 10, 2010

Structured Products

During the last Bull Market, a lot of money was invested into what were called “Auction Rate Preferred Funds”. These funds offered high Interest Rates and monthly liquidity and were sold as alternatives to Money Market Funds. They worked great until the Financial Crisis hit in 2007 and then their flaws were exposed.

The Financial Crisis revealed that one could only sell these funds each month if there were a buyer on the other side of the trade and that buyer actually turned out to be the brokerage firm that sold the funds. When the banks stopped buying these funds, you could not sell them.

The reason the banks stopped buying these funds back was that a little county in Florida froze its version of an “Auction Rate Fund” that they set up to manage cash holdings for other towns and counties. This Florida fund held a bunch of subprime loans and was pricing them at 100 cents on the dollar. This intentional mispricing made the value of the fund look larger than it actually was and by definition inflated the share price to more than it could be worth. When Lehman blew up, people understood that the fund’s holdings were mispriced too high and there was a run on the fund. The fund realized that it would have a negative net worth if everybody tried to sell, so they froze the fund and would not let anybody else take their money out.

The banks saw this and stopped offering to buy back their Auction Rate funds, because they know the holdings were mispriced and when the pricing became accurate, they did not want to take the losses – better that the client get hit instead…

The holders of these securities were then told that they would get their money back when the securities matured (in 30 years), or they could sell them back to the banks at a discount (say at a 20% loss) and get access to their money immediately.

There were lots of lawsuits and eventually many banks ended up writing some very large checks to their now former clients.

According to Chris Whalen, there is a product class that is being sold to investors, desperate for higher yields, which is the next “Auction Rate Preferred” debacle. That product class goes by the name of “Structured Products” -

http://us1.institutionalriskanalytics.com/pub/iramain.asp

“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. Like the subprime deals where residential mortgages provided the basis, these transactions are being sold to all manner of investors, both institutional and retail.”

“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.

The dirty little secret of the Dodd-Frank legislation is that by failing to curtail the worst abuses of the OTC (Over The Counter) market in structured assets and derivatives, a financial ghetto that even today remains virtually unregulated, the Congress and the Fed are effectively even encouraging securities firms to act as de facto exchanges and thereby commit financial fraud. Allowing securities firms to originate complex structured securities without requiring SEC registration, is a vast loophole that Senator Christopher Dodd (D-CT) and Rep. Barney Frank (D-MA) deliberately left open for their campaign contributors on Wall Street.”

“Of course retail investors love the higher yields on complex structured assets. Who can blame them for trying to get a higher yield than available on treasuries, while the Fed keeps rates at historic lows to, among other things, re-capitalize the zombie banks. The only trouble is that the firms originating these securities, as was 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. And because of the bilateral nature of the OTC market, only the firm which originates the security will even provide an indicative valuation because the structures and models behind them are entirely opaque.

In fact, 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. The sponsors expect to make returns in high double digits by making a market for the clients of large (Bank Holding Companies) who want to get out of these illiquid assets.”

Yet another asset class that cannot be priced and cannot be sold. Fantastic. Structured Product sales to Individual Investors are up 72% versus last year (as of July). Equally fantastic. Know what you own! Structured Products are a combination of derivatives betting on stock prices and Interest Rates. How could that possibly have a bad outcome?

The rules of investing changed when Lehman started to unravel in 2007. I became clear then that you could not own Limited Partnerships, Hedge Funds, Real Estate Partnerships or any other asset class where the fund manager had the discretion to price the holdings in the fund and the ability to deny future redemptions if the fund holdings were not trading at a price the fund manager liked.

After reading what Whalen had to say, it becomes clear that these funds blow up if Interest Rates rise. Interest Rates will finally rise when foreign investors become no longer willing to buy Treasuries at these low yields. That is when the Inflation wave will hit us, because then the Fed will simply be printing money to pay the bills of the US Government.

The other thought I have is that the Mortgage Securitization machine caused massive distortions in the economy, as money chased rising real estate prices that were fueled by the money created as investors chased yield in stuff like Auction Rate Preferred funds. Is the next bubble going to be money chases these “Structured Notes” which then turn around and buy dividend paying stocks and high-yield bonds?

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