Reacting to news of increased regulatory scrutiny of the $275 billion structured note market, some experts are saying said there is little need for risk managers to invest in the complex instruments anyway.
There are simpler tools available that accomplish the same hedging objectives as the structured notes, they argue.
For instance, some investors who expected interest rates to behave contrary to market expectations have bought constant maturity series Treasury note floaters -- or CMT floaters.
These structured notes offer enhanced yields if the investor's bet on interest rates is correct. But experts say buying a traditional floating rate note would have worked the same way if the objective was merely to hedge the risk.
"There's no good reason to do a structured note if it's just going to express itself in a plain vanilla form," said Heinz Binggeli, a managing director of Emcor, a Irvington, N.Y.-based risk management consultancy.
Structured notes --- also known as designer notes or hybrid securities -- are complex securities consisting of virtually any combination of two or more building blocks, such as bonds or notes, swaps, forwards or futures, or options.
Unlike other derivatives their value is not merely tied to an index. The structured notes are an investment in the bonds or notes. Thus, unlike swaps and other derivatives, the structured notes are counted as assets on a banks' balance sheets.
In the above example, CMT floaters are based on constant maturity notes, such as the two-year series that resets each quarter for five years. The payoff generally is the two-year CMT rate plus or minus the difference between the rate of the two-year CMT note and the London interbank offered rate.
The equivalent traditional floating rate note, on the other hand, is a fixed-principal instrument with a long life, whose yield is periodically reset based on short- or intermediate-term interest rates.
Because the structured notes are mainly issued by government-sponsored entities like the Federal Home Loan Mortgage Corp., they carry high credit ratings.
Last week the Office of the Comptroller of the Currency said that more than 100 banks in the Southwest have large investments in structured notes and could be in trouble if the instruments lose more of their value in the rising interest rate environment.
The OCC said that of the 780 banks in Texas, Oklahoma, New Mexico, Arkansas, and Louisiana, 64 held structured notes with a book value of 50% to 100% of their equity capital.
More than 30 had holdings equal to between 100% and 200% of capital. Ten had notes with book value greater than 200% of capital. And one bank had structured notes valued at more than 400% of capital.
The OCC did not name the institutions. The agency also pointed out that such high concentrations of notes do not necessarily mean the institutions are in danger.
According to Mr. Binggeli there is little reason for banks to use structured notes, except to generate big returns in the event that their expectations about the market are correct.
"Banks bought them for the built-in leverage, not for the investment value," he said. "The leverage is the risky thing. There's no reason to do it if it's not leveraged,"
The main problem with structured notes, however, is not necessarily the risk that the instruments will lose value, but the lack of a liquid secondary market, Mr. Binggeli said.
If institutions hold high concentrations of the notes, they usually pose no problems. But when interest rates rise and the notes lose value, many institutions panic and try to sell the notes, usually at a discount.
"We've heard horror stories of people selling them for 20 cents on the dollar," he said.
Gay H. Evans, a managing director of Bankers Trust International and chairman of the International Swaps and Derivatives Association, said structured notes do not in themselves create new risks, but allow investors to handle risk in new ways.
"It comes down to proper management," she said. "You can use them at one end for conservative hedging and at the other for speculating and assuming risk. They can have as much or as little risk as you want to embed in them."
Ms. Evans also denied that there is a lack of liquidity in the market for structured notes. She noted that there are "several players in the market" who can price the notes.
"The great thing about derivatives is that you can bundle and unbundle them," said Ms. Evans, adding that if you break the notes into their individual components, they should not be hard to price and sell. "It depends on how you structure your transaction," she said.
Investors run into problems when they use structured notes to hide the true value of the balance sheets, said James Midanek, chief investment officer at Solon Asset Management, Walnut Creek, Calif., which specializes in mortgage securities.
"Structured notes allow investors to do things they wouldn't otherwise have been allowed to do," he said. "They have narrow uses. There is not a very wide application for them."
Emcor's Mr. Binggeli said banks that hold structured notes should not panic and sell them now that the market has moved against them.
"Banks should not do a fire sale. They should hold on to the notes. The worst is over. They should maybe hedge out some of the risk," Mr. Binggeli said.