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Financial Literacy

Structured Products: Another “Safe Investment” Bites the Dust

Structured Products: Another “Safe Investment” Bites the Dust

by Alexander Green, Chairman, Investment U
Investment Director, The Oxford Club
Monday, November 17, 2008: Issue #887

At an Oxford Club chapter meeting in Asheville, NC last summer, an attendee asked me what I thought about Wall Street’s much-ballyhooed “structured products.” My answer was brief.

“Not much.”



Today I think even less of them, as investors have lost billions in these so-called “safe investments” – and many are set to lose more.

Let me briefly explain how structured products work, why so many of them haven’t turned out to be the safe haven investors believed they were, and how you can avoid making a similar mistake in the future…

What Are Structured Products?

Structured products are securities that are sold as an opportunity to enjoy substantial gains with full principal protection.

For example, an underwriter might offer investors the upside potential of the S&P 500 – or a substantial percentage of that upside – over a certain period of time (say, five years) while guaranteeing no less than full value of the initial investment at maturity, even if the index goes down.

(Or, instead of the S&P 500, the investment might be linked to Asian currencies, or commodities, or something else.)

How can you offer all or most of the upside of a risky investment with a principal guarantee? Well, in the early days, Wall Street would take U.S. government zero coupon bonds – which sell at a discount and pay zero interest, but gradually compound in value until they mature at $1,000 – and combine them with index options.

So, for instance, if you invested $100,000 – and investors tended to bet large since their principal was guaranteed by Uncle Sam – $80,000 might go into zero coupon bonds and most of the rest into S&P 500 call options.

Most of the rest? Well, there were Wall Street fees that had to be covered, of course.

Nothing was wrong with these early investments, really. But they were nothing more than a gimmick. You could buy the zero coupon bonds and options yourself and achieve the same thing, saving yourself the fees that Wall Street imposed when it created these products.

Unfortunately, something happened along the way that changed the game completely. Yields on government bonds came down. And the cost of buying index options went up, especially in bull markets.

Yields on U.S. Treasuries just weren’t high enough to make this game work anymore. So instead of investing most of the money in U.S. government bonds, Wall Street firms substituted their own unsecured debt instead. This was disclosed in the prospectus, of course. And it seemed like no big deal as long as these Wall Street giants remained healthy.

But they didn’t.

Structured Products Are An Investor’s Nightmare

Investors who bought structured products from Lehman Brothers, for example, are today standing in line alongside the firm’s other creditors.

These “principal-guaranteed” securities are now selling for 10 cents on the dollar, according to SecondMarket, Inc., a specialist in illiquid assets.

SecondMarket says it has already heard from investors holding more than $2 billion worth of Lehman structured products.

The firm estimates that small investors bought $34 billion of these products through October of this year alone. This surpasses the more than $33.5 billion that were bought last year.

(In truth, of course, these products are sold, not bought. No one wakes up and says “I think I’ll invest in a structured investment product today.”)

Last week The Wall Street Journal told the story of Charles Brooks, a physician in Allentown, PA:

  • He put a significant sum in two Lehman structured products because he liked the idea of having some exposure to market gains along with protection from losses.
  • Today he says these “protected” assets are worth approximately seven cents on the dollar. Sixty-five years old, he is now delaying his retirement planning.
  • And he is angry at Wall Street. “There’s no end to things they can invent that seem to me little more than a gamble for the enjoyment of the inventors,” he says.

I don’t fault Dr. Brooks for believing that a note guaranteed by Lehman Brothers was pretty safe. Ninety-nine percent of investors would have made the same assumption 12 months ago.

Structured Products Are A Wall Street Gimmick

The shame, really, is that by buying these structured products, he was sold a Wall Street gimmick. There is nothing magical about these products that offer huge upside potential with a principal guarantee.

After all, I could take $100,000 from you, put the vast majority of it in U.S. government zero coupon bonds and use the balance to play roulette at the Bellagio for five years. If I win, you would get back a lot more than $100,000.

And if I lost everything, which of course I would, I could still guarantee the full return of your hundred grand when bonds mature.

Like I said, gimmick.

There are two lessons here for every investor:

  • The first is as old as investing itself: If it sounds too good to be true, it probably is.
  • Number two, however, is just as important. Whenever you hear that an investment, an insurance policy, an interest payment, a stock dividend, or a particular return is guaranteed, be sure to ask the next question: By whom?

Good investing,

Alex

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Today’s Investment U Crib Sheet

If you want to profit from the long-term movement of a stock or index without risking too much money, a call option could be right for you. This gives you the right to buy a stock at a specific price until a specific date.

Your risk is that if the stock does not move in the direction that you expected, you could lose your entire investment. This is what makes speculating on options so risky. Here are three things to keep in mind when considering options purchases:

Time is working against you.

For long-term value investors, time works in your favor. With options, time is working against you. You need to be right about both the direction of the stock and your timing to make money in options. Because they are wasting assets, every day they get closer to expiring, their value drops. Option contracts may extend outward to nine months, sometimes a year. Some of the longest contracts are called “LEAPS” (Long-Term Equity Anticipation Securities). But, you’ll pay a higher premium for the longer contract term. There’s no free lunch.

Limit your trading to stock and index options with good liquidity.

Check the volume and open interest before you buy a call or put option. Illiquid options can make it difficult to profit from seemingly profitable trades.

Play only with money you can afford to lose.

This is easier said than done, but it remains the truth with any investment.

Options can be used in many different ways, some that carry much less risk. Lee Lowell recently showed us how to get paid to buy the stocks you want using put options. It’s a simple options strategy that the professionals use all the time. Find out more in Investment U Issue #882, Put Option Selling: Get Paid to Buy the Stocks You Want.

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About

An expert on momentum investing, value investing and investing based on insider activity, Alex worked as an investment advisor, research analyst and portfolio manager on Wall Street for 16 years. He now runs the wildly successful Oxford Communiqué, ranked as one of the top investment newsletters by Hulbert Digest for more than a decade. He is also the author of four national best-sellers: The Gone Fishin’ Portfolio, The Secret of Shelter Island, Beyond Wealth and An Embarrassment of Riches. He shares his wisdom in his free daily e-letter, Liberty Through Wealth.

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