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Shines Light on Derivative Backed Notes
Feb. 7, 2013 (Bloomberg)
– In a move to improve pricing transparency for U.S. structured
notes, the Securities and Exchange Commission plans to require
banks to disclose an estimated initial value of their securities
in offering documents. The two largest structured note issuers
in the U.S. by sales last year, Bank of America Corp. and
Goldman Sachs Group Inc., have begun disclosing the initial fair
value of their securities. The estimates appear on the first or
second page of prospectuses for the products.
Most of the
notes issued by the banks had an estimated value between 96 and
98 cents on the dollar, according to data compiled by Bloomberg.
The lowest price was 89.6 cents on the dollar for 10-year range
accrual securities tied to the Russell 2000 Index that Goldman
Sachs issued on Oct. 26.
What does this mean for investors? By making this information
available in advance of a potential purchase, the investor should
have a better idea of what the note will be worth when it hits
their account on settlement date. The new disclosure requirement
is akin to knowing how much the value of a new car will drop when
it is driven off the salesman's lot.
According to data
compiled by Bloomberg, most notes' estimated value immediately
dropped between 2% to 4%. The data suggests that the longer the
term of the note and/or the inclusion
of any "exotic features", the greater the gap in value between
purchase price and secondary market value.
Securities has been encouraging investors to "Replicate" their
favorite structured notes by using some combination of ETFs and
listed options on those ETFs that are backed by the Option
Clearing Corp ("OCC"). Many of the notes that are sold to
investors have very basic pay off profiles that can easily be
recreated by using various combinations of options. For instance a
"Buffered Structure on the S&P 500" is simply a combination of a
put purchase plus a put sale and the purchase of the SPY ETF. The
purchase of these types of securities is exactly how the dealer is
hedging themselves behind the scenes; we are simply eliminating
the counterparty risk and a layer of fees and providing the
investor with their desired payoff profile.
The benefit of
building your own vs. buying it off the shelf includes reduction
of fees, reduced Counterparty Risk (remember Lehman Brothers?) and
much greater liquidity, transparency and flexibility. Also, one of
the biggest benefits is that the purchaser can sell in the market
and is not beholden to any one single counter party if they want to
exit early and does not need to beg their way out.
Investors armed with
this new information should be empowered to ask the right
questions and build a structured note themselves thereby cutting
out the middleman when possible. We continue to stand ready to
assist those so inclined.