The fourth part of a series on financial products and practices takes a look at Octave Notes
Your Money explained last week how unfortunate investors lost their money on Octave Notes gone sour. With the prospect of another round of minibond-style protests brewing over these structured products, let us take another look at Octave Notes and examine how they work and just how risky and complex they are.
To describe each Octave Note specifically I would need the entire newspaper. So let us focus on the basic structure that governs this and a lot of other similar products, which is more or less the same.
This product falls into the broad category of 'credit-linked-notes'. Credit-linked notes are, or at least were, a very popular derivative dreamt up by the people who brought you the accumulator, the asset-linked deposit and the mortgage-backed security - very clever bankers who probably no longer have jobs.
A credit-linked note (CLN) in the present context is basically a credit default swap packaged into something that looks a bit like a bond. This is how it works: an institution, called the Issuer, creates the CLN with a load of paper and agreements and special-purpose companies in tax-efficient jurisdictions. The Issuer then offers investors a solid interest rate, say 3 per cent a year for five years. Investors buy the CLN from the Issuer and look forward to sitting back and collecting interest.
The institution then does two things. First it puts all of the money from investors in a safe place, usually by purchasing a bond or some other security from a highly rated entity, like a government. This will yield a small interest and, assuming nothing goes wrong in five years, will be available to repay the investors' principal.