Structured Products? You Should Steer Clear

Lots of people seem to be searching the web lately for information about “structured products.” This robust search traffic could mean that a lot of folks are chasing yields and thinking about buying structured products. Or it could mean that a lot of folks already own them and are looking for ways to get out. We suspect it’s both, but in either case, this increase in interest concerning structured products is bad news. In our view, structured products are the Frankenstein’s monster of investments, and like that monster, they’re too dangerous to be trusted. In fact, we suspect that think that these products are being manufactured in secret Wall Street laboratories by crazed financial alchemists; evil geniuses seeking to design new methods for separating the unwitting masses from their gold.

The term “structured products” refers to a category of varied investments that share a core set of characteristics. Broadly speaking, they’re customized, prepackaged hybrid investments consisting of two components: a traditional type of security and an underlying asset or group of assets meant to drive investment performance. For example, an issuer might create a structured product by taking a conventional security, such as an investment-grade bond, and replacing its usual payment features (e.g. periodic coupons and final principal) with non-traditional payoffs derived, not from the issuer’s own cash flow, but rather from the performance of one or more underlying assets such as a call option, a basket of underlying stocks, or a particular market index like the S&P 500 or Russell 2000.

Types of Structured Products

In a 2011 staff report, the SEC categorized structured products into four basic types — principal protected notes; enhanced-income notes; performance/market participation notes; and leveraged/enhanced participation notes —  and also mentioned a fifth type consisting of any adjusted or combined versions of the first four types, a prime example being the incredibly risky reverse convertible note. (Collateralized debt obligations (CDOs) and similar asset-backed securities also are often thought of as a subset of or close relation to structured products.) Despite these broad category designations, it’s tricky business for many investors to figure out that they even own a structured product, given that product names alone are rarely descriptive of the investment’s true nature.

Risks of Structured Products

The SEC staff found some serious problems when examining how structured products were sold to investors and the staff’s report highlighted some risks that aren’t obvious to the average retail customer.

Credit Quality of Issuer

One risk concerns the credit quality of the issuer. As with any security, principal can be lost if the issuer becomes insolvent. Nationally, this risk was driven home in a big way when Lehman Principal Protected Notes became worthless upon Lehman’s insolvency. These notes had been sold in droves by the investment firm UBS, whose brokers represented to customers that the investments had no downside risk of principal loss. These brokers rarely, if ever, mentioned to customers that the notes were unsecured, let alone explained what that could mean.

Liquidity Problems

There also are liquidity problems with structured products. There’s almost no secondary market for them. Since they rarely trade after issuance, an investor who is unwilling to sell at a steep discount and eat his or her losses is pretty much stuck with the product until it matures years later.

Lack of Price Transparency

Price transparency also is a problem. In most instances, investors can’t see the extensive costs built into the products so they can’t compare one structured product to another, nor can they compare the costs of a structured product with an alternative type of investment.

Questionable Sales Practices Related to Structured Products

But the biggest problem with structured products isn’t structural. The SEC indicated in its report that the brokerage firms examined by SEC staff often had “weaknesses” in areas related to the sale of structured products. There were questionable sales practices, such as recommending unsuitable products and misrepresenting or omitting material facts about the products, including their inherent risks. The SEC also found that firms often had deficient training of advisors and that some firms had no training at all. Firms also failed to engage in adequate supervisory review of the suitability of recommendations. Finally, some firms inaccurately and misleadingly listed structured products as “preferred securities” or “preferred stocks” on customer statements, though neither title reflected the real characteristics of the investment.

In summary, structured products are bad news for most ordinary retail investors. If you don’t own one, you’re lucky. You probably shouldn’t buy one. But if you already own one, or if you aren’t sure but think you might own one, talk to us. We’ll tell you what you have, whether your broker should have sold it to you, and what we can do about getting your money back.