Monday, August 9, 2010

Structured Notes: Too Good?

Structured notes offer above market interest income for investors who are willing to speculate that what sounds too good to be true might be good. So they take the income and run to the bank. It works great. Note to self... Ponzi schemes worked great too, for a long time. The danger with these complex investment products is that people do get lulled into a comfortable complacency and end up being unaware of a rising river until they are in the flow, heading swiftly downstream. I do not know this product very well. I base my opinion on the fundamental knowledge that above market interest rates are achieved by employing some form of investment derivative that multiplies the cash flow. This is not a natural, simple to understand, feature. And it may even have risks associated with the mixture of the natural cash flow with the unnatural cash multiplier that are not easily recognized.

For example, there are closed end funds that relied on auctions to provide regular refunding and liquidity for investors in these high grade investments. When the debt crisis started emerging, the auctions began to fail, meaning that investors who wanted to get repaid were forced to sell at deep discounts or wait for a successful auction. Then the auctions began failing regularly. These investments did not end up well for investors. This article on Bloomberg today reminded me of the closed end funds that held high grade bonds, agencies and some leverage (for that something extra) and that caused so much wealth to be transferred from retail investors. The article closed on this point... "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." I have maintained a preference for using investments that are simple, or natural, enough that I can understand and explain without needing an 8 hour course in the product. Not touching these things for the past couple of years has been the right decision for my clients. As I mentioned, they will be fine, until they aren't. I have no way of knowing when will be a good time to cut and run. I'm not that smart.