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Structured Investment Products: The Good, The Bad And The Ugly

Structured investment products have become a catchphrase in 2008, denoting images of massive financial losses for investors who put their money and their faith behind some of the more complex financial products in this asset class - investments that promised supposed protection for investors and then failed to deliver. Among those at the center of controversy: credit-default swaps.

In simple terms, a structured investment product combines traditional financial instruments - shares, bonds, or commodities, for instance - with derivative instruments, the value of which is based on an underlying security. As with any investment, some structured investment products go a long way toward helping investors achieve diversity in their portfolio, while reducing risk and volatility. Other structured investment products can have the opposite effect. Case in point: Credit-default swaps.

While credit-default swaps may resemble standard insurance, they are far from it. A credit-default swap is a type of insurance contract where one party pays another to protect it from the risk of default on a certain debt instrument. If the instrument - which could be a bond, a loan or a mortgage, for example - defaults, the insurer pays the insured for the loss. Because credit-default swaps are unregulated, the market itself presents obvious potential risks for investors.

As reported Nov. 6 on Bloomberg.com, credit-defaults swaps were the subject of a newly released report by New York-based Depository Trust and Clearing Corp., which operates a central registry for the credit-default swaps market. The Nov. 4 report showed there were at least $35 trillion of credit-default swap trades outstanding on governments, companies and asset-backed securities worldwide as of Oct. 9. What the report apparently failed to reveal, however, is information on privately negotiated credit-default swaps that insurers such as American International Group (AIG), MBIA and Ambac Financial Group sold to guarantee collateralized debt obligations (CDOs). By including only a partial summary of contracts linked to mortgage securities, the actual amount of net credit-default swaps exposure could be underestimated by as much as 40%, according to the Bloomberg article.

Trading of credit derivatives has increased dramatically in the past five years, with financial services companies, hedge funds and insurance companies using the contracts to protect against losses or speculate on debt they do not own. In particular, CDOs, whose assets are divided by credit rating firms that assess their value into various levels of tranches, have played a key role in the growth of the derivatives market.

Since the beginning of last year, banking institutions worldwide have taken nearly $700 billion write-downs and losses on loans, CDOs and other investments. As for investors holding the riskier slices of CDOs in companies like Lehman Brothers that filed for bankruptcy on Sept. 15, they have lost more than 90% of their investment.

Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage-related investment losses.

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