Structured Products are sometimes not what they seem

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It is vital people know how to navigate safely round the minefield of personal investment products. Two of the biggest areas of concern are pensions and “structured products”, a group of risky financial instruments that are typically promoted as “100 percent capital protected” but more often than not can leave investors in the lurch. In this column, I’ll focus on structured products.

Structured products are offered to investors under a variety of names by banks, building societies and financial advisers. They normally run for fixed terms of three months or longer and are variously described as “guaranteed”, “protected” or “dynamic”. In some cases they are given impressively complex titles such as “capital accumulator auto-call option”. The implication is that that these reassuring titles confer a higher level of investment security. The reality is that the opposite is all too often the case; structured products frequently carry additional higher risks, such as “counterparty risk” which can render the investment worthless.

The counterparty is usually a bank, insurance company or financial institution which provides the “guarantee” or “protection” in return for the majority of the investors’ capital being deposited within the counterparty’s own fixed interest instruments such as zero coupon bonds. A zero coupon bond is a fixed interest instrument that actually does not pay out the interest earned but rolls it up increasing the price of the instrument until it reaches a predetermined value at a specified point in the future, providing the capital protection element of the product.

In extreme cases counterparties may require over 99 percent of an investment deposited in such instruments, leaving less than 1 percent investable. This means that effectively 99 percent of your investment is invested in and reliant upon the solvency of the counterparty and only 1 percent is invested in the underlying asset. Consequently derivative instruments or high leverage may be used to try to juice up the returns this small exposure can generate. The returns on any structured product are therefore dependent in very different extents on the leveraged performance of both the underlying asset (often an index, such as the Dow Jones Industrial Average) and, far more significantly, the guarantor’s deposit vehicle. When Lehman Brothers, whose collapse helped accelerate the global financial crisis, filed for insolvency in September 2008, investments “guaranteed” by the failed bank, most notably those promoted in the UK and Singaporean markets, were rendered worthless overnight.

This was hardly an isolated incident. The Profitable Group promoted a “Boron CLS 12.5% return Bond” that ended in tears with reports of litigation in Singapore from investors unable to recover their capital let alone any return from the “guaranteed” contracts. Only a few years earlier structured products known as “precipice bonds” had spectacularly failed due to another risk – that of leverage – when the markets fell way beyond expectations. These had offered higher market participation, promising big returns in rising markets, but at a cost of a punishing downside penalty and little in the way of a safety net if the markets should fall.

When equity markets fell by almost half from the peak in 2000 to the lows in 2002, leveraged investors bearing a 2 percent drop in their investment for every 1 percent the market declined were virtually wiped out. The Investment Management Association (IMA), which represents the UK fund management industry, has for some time been at loggerheads with structured product providers over the transparency of their plans, saying that the disclosure requirements for products which compete in the same market as funds need to be similar.

I would argue that it should be much higher; structured products are more complex and very often investors face a very high transparency risk. Many Singaporean and UK investors were shocked to find out that what they thought were safe deposits, akin to fixed term deposits, were in fact high-risk bets based on the survival of Wall Street’s shakiest banks. The weaker the bank, the greater its need and the higher the price it will pay for capital. So it is often the weaker banks that offer the best zero coupon rates. Other dangers include “guarantees” that are not what they seem to be.

Recent examples of this include:

– “Guarantees” issued by small subsidiaries that may not carry the full faith of the major institutions.

– “Guarantees” that only cover a small part of the investment value.

– The use of low-cost subordinated instruments, like sub-prime or toxic notes, rather than an institution’s primary debt structures.

– The use of a remote jurisdiction whose legal structure makes enforcement of the contracts practically impossible.

The nature of many structured products is that the beginning and end values are supposedly defined, but there is no investment valuation available for the period in between. Basically, how can you put a price on something that has no value?

In short, not only do investors often not understand the risks of what they are investing into or the contractual nuances but also, in many cases, they have no idea what it is worth at any given point between the start and the maturity of the investment.

As a result structured products have become the natural hiding place for every kind of illiquid or untraded asset whose value is impossible to establish with any degree of certainty in advance of its expected maturity date such as forestry products, traded or second-hand life insurance or endowment policies or litigation funding.

Does this mean that all of these products are a scam? No, not necessarily. But the risks become much higher when dealing in assets that are difficult to tie into any referenced valuation. In general, the longer the term of these kinds of investment, the greater the risks are. Worse still, risks don’t stop there. Structured products at the current time are either tainted with interest rate risk or liquidity risk. Interest rate risk relates to the fact that even if the counterparty remains good for the “guarantee”, the market value of the guarantee itself can fall dramatically simply because of interest rate fluctuations and currency exchange rates.

If interest rates increase from today’s record low levels at any point during the life of the structured product then whatever intermediate value the guarantee has in the open market will be adversely affected. Assuming rates remain low now but return to “normal” levels of say 5 percent in five years time then a 10 year structured product’s “guarantee” would fall in value by around 20 percent at that time – a big hit to take on a “low-risk” investment.

If you have invested in, for example, a USD product with another currency then the risks are compounded even more.

Financial structuring and engineering has become the tail that is wagging the dog. The world has been so turned upside down that there are now structured products available in which banks pay investors a small fee in return for the investors agreeing to guarantee the future value of the bank’s investments and assets. The right structured notes on the right terms in relation to the right assets may have some validity but too many of the structured products that are currently available suit the product designers and distributors much better than they suit the investors.

We should not forget that the credit crunch was largely brought on by the combination of financial engineering and greed which resulted in the failure of Bear Stearns High-Grade Structured Credit Strategies funds which were left holding the toxic baby when the music stopped on Wall Street’s game of pass the risky debt parcel.

The current wave of structured products for retail investors now seem to be trying to pass that risk to individual investors instead while allowing the banks to continue generating huge fees at our expense. Forewarned is forearmed – most structured products should be seen as predatory financial instruments, something that marks a very clear and very present danger on your investment radar. To beat the bank you have to take some risk. How much is up to you but the best way to protect yourself against any downside is to remain liquid.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]