Securities firms have sold over $30 billion of complex structured products to investors (often retirees seeking safe income) who do not understand the nature and risks of these securities, according to an article by Zeke Faux which was published in the October 4-10, 2010 edition of Bloomberg Businessweek under the title, “Individual Investors Duped by Derivatives.”
The securities firms mentioned in the article include Wachovia Securities (now Wells Fargo), UBS, Bank of America Merrill Lynch, JP Morgan Chase, and Morgan Stanley Smith Barney. The structured products described in the article include reverse convertible notes, so-called principal protected notes issued by now-bankrupt Lehman Brothers, and other exotic creations.
With interest rates near zero, retirees in need of income have been “seduced” into buying products they do not understand sold to them by brokers who tout the increased yields but do not adequately explain how the products work and what the risks are.
One such investor, an 84-year old former beautician was seeking safe and steady income from bonds when her Wachovia Corp. broker recommended securities paying 9 percent interest. She invested $20,000 and lost 30 percent of that within six (6) months, according to the article. What happened?
The “bond” she was sold was a reverse convertible. This supposed income investment was really a complex put option combination that put her principal at risk. The product is linked to a “reference asset” ? in her case, Merck stock. Apparently unbeknownst to her, if the price of Merck stock fell below a predetermined “knock-in” level, which it did, at maturity, Wachovia could repay her principal in shares of Merck stock, which Wachovia did. The Merck stock was worth significantly less than her principal. That is the way reverse convertibles work, but that is not they way they are explained to investors.
Reverse-convertible notes have an average yield of 13 percent, more than 10 times the average 1.2 percent rate on one-year certificates of deposit and more than three times the average U.S. investment-grade bond yield of 3.73 percent. With such high yields and no explanation of how these products work or the associated risks, sales of structured notes have increased 58 percent this year to $31.9 billion.
The Securities and Exchange Commission’s recently created Structured and New Products unit is investigating structured products, especially those marketed to individual investors. “We’re concerned about the sale of complex structured notes to retail customers because people don’t always understand the risks they’re exposed to,” Kenneth Lynch, head of the SEC’s Structured and New Products unit, was quoted as saying. “It’s very difficult for a person who isn’t immersed in this world to pick up a prospectus and really understand what are the different scenarios that would make an investment work out for them.”
“People develop a product which makes a modicum of sense, then they extend it to the point of ludicrousness until it blows up,” Satyajit Das, a former Citigroup Inc. derivatives banker, was quoted as saying, adding that investors are often “seduced” into purchases without understanding the risks.
Most individual investors and brokers lack the education and background to understand and value structured notes and their underlying derivatives, according to the article. Most structured notes are even more complex than the reverse convertible sold to the 84-year old former beautician, according to the article.
Why do firms sell products that even their brokers do not fully understand? One reason is, they are paid more money to sell structured notes than regular coupon bonds. The notes are sold to individual investors in order to fatten the Wall Street profits, according to Das. As an example, Morgan Stanley reportedly charged a hefty 3.5% sales fee on a structured product called Leveraged CMS Curve Notes.
“It raises questions about suitability for the investor when you have products that are that complicated,” Daniel Bergstresser, a Harvard Business School professor, was quoted as saying.
J. Boyd Page, senior partner of Page Perry in Atlanta, said: “Investors should know that firms selling and recommending these structured products have two very important obligations. The first obligation is to make sure that the recommendation is suitable or reasonable given the investor’s investment objectives and risk tolerance. The second obligation is to fully disclose the nature of the investment and all risks that are associated with the product when recommending it to the investor. In complex products like these, brokers often don’t fully understand the product, so how can they adequately describe something they don’t understand?”
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