Structured products ‘absurdly destructive’ for retail investors: Report

Structured notes and other derivatives products have been marketed by Wall Street as safe and secure investments. Of course, there’s safe and then there’s safe. Retail investors of all stripes have lost at least $113 billion by purchasing these purportedly safe instruments, according to a new study conducted by the nonpartisan policy center Demos and The Nation Institute, a media think tank.
“In my three decades of Wall Street experience, I have not seen any other product as absurdly destructive as retail investments linked to structured products,” securities arbitration consultant Louis Straney wrote in the report.
That’s worrisome, considering financial institutions appear to be ramping up the sales of these products. Last year, banks and brokers sold more than $52 billion in structured notes, according to the study. In the past, the notes were sold strictly to sophisticated institutional investors. In recent years, however, structured notes have been repackaged and sold to retail investors — often, senior citizens —as a principal protection tool.
Indeed, structured notes with principal protection are among the most popular products being pitched to income-oriented investors, the study said. These investments combine a zero-coupon bond and an option whose payoff is linked to an underlying asset, index or benchmark, or a basket of benchmarks. The notes, which pay off based on the performance of the linked index, can provide reasonable returns and upside potential — certainly attractive given today’s puny money market and CD rates.
But as the name implies, structured products can be complex. Last week, regulators warned investors that structured notes with principal protection often come with confusing terms, low guarantees and can tie up money for as long as a decade. The alert from the Securities and Exchange Commission and the Financial Industry Regulatory Authority Inc. stressed that the investments are not risk-free.
The SEC said principal-protected notes vary wildly by issuer and that investors tend to ignore or don’t understand what is spelled out in prospectuses. Also, the commission warned that principal-protected notes do not always protect principal.
Some issuers of principal-protected notes guarantee only a certain amount of the principal — in some cases, as little as 10%. Sometimes, the principal is protected only if a contingency stipulated in the prospectus is met.
Other sellers of the notes do guarantee 100% of principal. But even that’s not a lock. If the issuer of the note goes bankrupt, the investor likely will lose all or most of the money invested.
In April, for example, UBS Financial Services Inc. agreed to pay $10.7 million in fines and restitution to settle Finra allegations that its advisers misled investors about the “principal protection” feature of structured notes issued by Lehman Brothers Holdings Inc. that it sold a few months before that firm collapsed.
In its complaint, Finra said that some UBS advisers didn’t understand the complexity of the 100% principal-protected notes that Lehman issued and failed to tell investors that they were unsecured obligations.
In settling the case without admitting wrongdoing, UBS said that it was pleased to have the matter resolved and that most structured-product sales had been done properly.
The Securities Industry and Financial Markets Association, which represents most Wall Street firms, did not respond to a request for comment Thursday about the suitability of structured products for retail investors.

A Scared Group
To be sure, the $113 billion that the report said individuals have lost includes more than just investments in principal-protected notes. It also included auction-rate securities, as well as certain municipal bond hedge funds (as reported by regulators or lawyers monitoring losses).
“Ninety-nine percent of the $113 billion cited is not to be attributed to the structured products industry, in particular principal-protected notes, which by and large have performed superbly in this volatile market environment,” said Keith Styrcula, spokesman for the Structured Products Association.
The only losses from structured notes have been those from the Lehman bonds — probably less than one billion dollars in the U.S., he said.
Still, abuses relating to structured products and/or derivatives have been reported in about a third of the 50 states. The director of Alabama’s securities commission, Joe Borg, said he’s looking into cases involving income-oriented investments that lost money.
“There’s no doubt that structured products are targeted toward older folks,” Mr. Borg wrote in the report. “There’s the issue of outliving their money when it is tied up in low-yielding CDs and bonds. They’re a scared group.”