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The Structural Problems with Structured Products

Last week I discussed FINRA’s 2012 ‘watch list’ of products that it will examine this year. And on that watch list are investments known as structured products. But the concerns about structured products are not new to 2012, and FINRA is not the only agency to take a closer look.

Last year, the Securities and Exchange Commission (SEC) issued a report on problems they found in examining sales of structured products to investors.

The term ‘structured product’ is kind of a broad title rather than a pinpoint definition. The SEC considers a structured product to be a security “whose cash flow characteristics depend upon one or more indices or that have embedded forwards or options or securities where an investors’ investment return and the issuer’s payment obligations are contingent on, or highly sensitive to, changes in the value of the underlying assets, indices, interest rates or cash flows”. In other words, broadly speaking, ‘structured products’ are customized, prepackaged investments that have a principal component (such as a bond) combined with a performance component (an underlying asset).

Basically, a structured product takes a security, like a bond, and replaces the traditional coupon payments with payments that are linked to the performance of an underlying asset (such as a basket of securities, indices, or options). The SEC categorizes structured products as follows:

Principal protected notes: These products may have full, or partial, principal protection. That means that regardless of the performance of the underlying assets, investors are assured of the return of some or all of their principal…bearing in mind that structured products with “full” protection tend to have the lowest yields. Often the underlying performance asset for these notes is a widely recognized index like the S&P or the Russell 2000.

Enhanced-income notes: These products may have some level of principal protection, with a higher coupon payment…but the returns based on the performance of the underlying asset are often capped. The underlying asset is often a basket of stocks (or a single stock), or an index.

Performance/Market participation notes: The performance of these products is linked to an investment strategy (such as a long-short strategy).

Leveraged/Enhanced participation notes: These products have a leveraged upside, sometimes 2 to 3 times the performance of the underlying asset…but there is typically a cap on the upside return. And there is a leveraged risk of loss on the downside…and usually no principal protection.

There are obvious risks here. The credit quality of the issuer is a factor: As with any security, there is a risk of principal loss on the insolvency of the company. There are liquidity problems: There is almost no secondary market for structured products. Since they rarely trade after issuance, investors are basically stuck with the product until it matures…unless they are willing to sell at a steep discount and eat the loss. Price transparency is another problem: Many issuers work the pricing into the product in such a way that there are no explicit costs visible to the investor. Even though the costs may be implicit, if investors can’t see them, they can’t really compare one structured product to another.

But it’s not just the risks inherent to the products themselves…its how they are sold to investors that is a problem. In its report, the SEC revealed that the broker/dealer firms they examined often had “weaknesses” in areas related to the sale of structured products. “Weaknesses” translated to “questionable sales practices”, like omitting material facts about the products and recommending unsuitable products.

Firms are required to “train registered personnel about the characteristics, risks, and rewards of each structured product before they allow registered persons to sell that product to investors”. The SEC found that broker/dealers often had deficiencies in training…some had no training requirements at all.

The SEC found that some firms sold structured products to investors that were not suitable to those specific clients needs. Not only did some firms sell products that did not match the investor’s objectives and financial profile, but they also failed to do any type of supervisory review of the suitability of recommendations.

A lack of disclosure was found at some firms. The report found failures to disclose the risks to investors, and the fees broker/dealers charge. In one case, a firm marketed a structured product as “100% principally protected”…but nowhere in the prospectus did they reveal that investors had the risk of principal loss if they redeemed the note before maturity. In another case, a firm claimed that the upfront sales fee for the broker/dealer from the issuer was 0%…the fee was actually between 1.5% to 3%. To be fair, the firm did update the prospectus to reflect the fees…after the SEC forced the issue.

Some structured product investors might not even know what they are invested in. The report found that some firms inaccurately listed structured products as “Preferred Securities” on customer statements. Another firm listed the structured products under the heading “Preferred Stocks”. There is no way either of those titles reflect the real characteristics of the investment.

The bottom line: structured products are not clear or homogeneous by nature…they are murky and complex. And because investors have to hold them through maturity if they want their money back, these are really a buy and hold investment…or as I would call them, a “buy and stuck with it” investment.

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