Yet another mainstream media piece (URL) on the unsavory and frankly unethical practice associated with trading in risk-shifting financial instruments.
Wall Street is selling complex securities to yield-hungry investors who may have no idea how they work—and how risky they are
By
Zeke Faux
Leona Miller, an 84-year-old retired beautician, says she was seeking
safe and steady income from bonds two years ago when she bought
securities recommended by her Wachovia (WFC)
broker, Robert Baldacci, paying 9 percent interest. Within six months,
Miller lost about 30 percent of her $20,000 investment, and the bonds
were converted into shares of Merck (MRK)
in a falling stock market. "I just wanted him to make some money for
me, like anybody else," says Miller, who lives in San Diego. "I still
don't understand too much about it."
Miller had bought a structured note—a bond combined with a derivative.
In her case, it was a reverse-convertible note with a knock-in put
option tied to Merck stock. The option meant the security could offer a
relatively high interest rate. It also added risk, as Miller learned too
late. A decline in the drugmaker's shares, to below 32 from 40 when
Miller bought the notes, triggered the put option. That allowed the
note's issuer, the Oslo-based export-credit agency Eksportfinans, to pay
Miller off with Merck shares, then trading at 26. Kathryn Ellis, a
spokeswoman for San Francisco-based Wells Fargo (WFC), which acquired Wachovia in 2008, and Baldacci, who no longer works for the bank, declined to comment.
While customized derivatives have been criticized for their role in the
credit crunch, securities laws allow them to be sold to individuals as
long as they're bundled with bonds into structured notes, and the
financial sector reforms enacted since the crisis have not addressed the
issue. The Securities and Exchange Commission's enforcement division
started a group this year to investigate structured products, including
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," says Kenneth R. Lench,
head of the SEC's Structured and New Products unit.
With interest rates near 0 percent, investors are ignoring potential
risks and snapping up bonds that promise higher yields, even if they
carry obscure names such as Leveraged CMS Curve and S&P 500 Index
Linked Callable notes. Reverse-convertible notes paid 13 percent
interest, on average, this year, according to Bloomberg data. That's
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.
Sales of structured notes rose to $31.9 billion through August, up 58
percent over the same period last year, according to data compiled by
Bloomberg and StructuredRetailProducts.com. "People develop a product
which makes a modicum of sense, then they extend it to the point of
ludicrousness," says Satyajit Das, a former Citigroup (C) derivatives banker. Das, the author of Traders, Guns & Money, says investors are often "seduced" into purchases without understanding the risks.
The notes are targeted at individual investors to boost banks' profit margins, Das says. Morgan Stanley (MS),
for example, charged a 3.5 percent fee on the Leveraged CMS Curve notes
that it sold on Aug. 20, according to a prospectus. Underwriting
commissions for U.S. investment-grade bonds this year average 0.5
percent, Bloomberg data show.
Individual investors are incapable of valuing structured notes and their
underlying derivatives, says Kevin Kelly, manager of Scottsdale
(Ariz.)-based hedge fund Tontine Capital. Most structured notes are more
complex than those Miller bought, he adds. Morgan Stanley's CMS Curve
securities offer a fixed 10 percent rate for two years. The yield for
the next 13 years is five times the difference between long- and
short-term constant maturity swap rates, not to exceed 18 percent
annually, earned when the Standard & Poor's 500-stock index doesn't
dip below 875, according to a regulatory filing.
"It raises questions about suitability for the investor when you have
products that are that complicated," says Daniel Bergstresser, a Harvard
Business School professor. "Is that complexity a response to a
legitimate desire the investor has or is it a smokescreen?" Mark Lake, a
spokesman for Morgan Stanley, declined to comment.
Buyers are compensated fairly for the risk they take on and don't need
to know the details of how derivatives work to evaluate the securities,
says Keith Styrcula, chairman of the Structured Products Assn., a trade
group. Issuers disclose potential pitfalls of the investments in
documentation provided to buyers. Many of the products are less risky
than stocks because sellers guarantee investors won't take losses even
if the market falls, says Styrcula, a former JPMorgan Chase
structured-notes banker. "There's a reason the market is booming," he
says. "Investors are having successful experiences with structured
investments, and they're coming back as repeat buyers."
Miller and Wells Fargo are in arbitration, according to her San Diego
lawyer, Ronald Marron. In a February 2009 letter, the bank's legal
department told Miller that the broker "explained very thoroughly his
recommendation." The letter, which was provided by Marron, also said
that "Mr. Baldacci recalled that you were familiar with Merck & Co.
as they manufacture one of your medications."