Push to attract small investors worked. Until it didn’t.

75% PLUNGE

in new investment in structured hedge fund products

After an abysmal year for hedge funds and hedge fund-related investments, some banks are quietly backing out of the very businesses they prized as innovative and groundbreaking a mere two years ago.

Banks are getting rid of their New York structured hedge fund products divisions at a rapid clip, and the remaining players will mostly be European and Asian banks, whose customers still have an appetite for hedge fund-linked instruments.

Last week, HSBC reportedly closed its New York structured hedge fund operations, while leaving the group that operates in Asia intact. Earlier this month, J.P. Morgan Chase disbanded a similar unit, reassigning about 150 employees to other divisions. And last summer, Bank of America sold its prime brokerage unit, which also created and sold these securities.

Creative banking has fallen out of favor across the board, says Timothy Clark, a partner at Proskauer Rose in the hedge fund practice. Some of those instruments turned out to be much more dangerous than investors expected, and people are now turning away from them.

Supposed to dampen risk

These investment arrangements were designed to dampen the risk of hedge fund investing and to appeal to small investors who in the past wouldnt have qualified to play in hedge fund pools.

The bank typically commits to paying back an investors princi-pal after a fixed period of timesay, five years. In the meantime, it puts the money to work, investing in a variety of hedge funds and other securities.

“It looked smart”

By selling the securities as principal-protected notes, the banks are able to edge around wealth requirements that used to limit participation in hedge funds to the most elite individual and institutional investors. And by backing the investments with their own credit, the banks are ostensibly taking the risk out of alternative investing.

It looked smart compared to the rest of the market, says Keith Styrcula, chairman of the Structured Products Association, whose 9,000 members champion this type of financial innovation. In the normal [market] environment, you never know when a fund is just going to blow up. This took the risk out of being in a hedge fund during a shrinking market.

At least, that was the idea. These securities were among many factors that helped spread hedge funds to thousands of new investorsand led to an explosion in the number of hedge funds, which reached more than 15,000 at the 2007 peak. By 2007, the U.S. market for structured hedge fund products had ballooned to $114 billion, up from just $28 billion in 2003.

Lehman Brothers was one of the U.S. pioneers in packaging and selling these investments. The now-defunct investment bank had about $900 million worth of structured finance products outstanding at the time of its bankruptcy filing last September.

The U.S. market for structured hedge fund products has collapsed since last fall. New investments in the fourth quarter of 2008 dropped 75% from the beginning of the year, to $5.9 billion, according to alternative-investment research firm mtn-i.

“People got burned”

Its no wonder banks are following their customers out of the sector, paring down their structured hedge fund units.

One by one, says Mr. Styrcula, banks are quietly looking to lay off these types of positions.

Its mostly the U.S. banks that are steering clear. The New York offices of French banks BNP Paribas and Sociйtй Gйnйrale, Germanys Deutsche Bank, Japans Nomura and the Royal Bank of Canada are busy, reports Mr. Styrcula. Theyre just busy serving non-U.S. customers.

People got burned, says Mr. Clark of Proskauer Rose, adding that many of these principal-protected notes or hedge fund-linked products are structured offshore, which makes complex investments even harder to investigate. Investors are so concerned about liquidity now, theyre having a hard enough time thinking about whether or not to invest in hedge funds, period.