Structured products: what you need to know

It's also a misconception that soft protection barriers have not been breached in the past. That happened with many of the bonds sold around the turn of the Millennium because of the FTSE collapse after the dot com boom Savers lost a fortune, and advisers went bust with mis-selling claims. Another misconception is that investments are protected by FSCS. This is not the case if the counterparty for a structured investment product fails (as Lehman did in 2008).

You write:

' How the bank makes its money does not really concern us. Like a corporate bond, provided they are still solvent the bank must pay the promised return.'

I disagree.

I don't think the comparison with corporate bonds in the last sentence is fair as the structured product only promises to pay out under certain conditions while the corporate bond has to pay out unless the company goes bankrupt.

There is no doubt that WHATEVER the outcome that the writers of these options shall gain whether the structured product benefits the client or not as they shall have covered all possibilities to ensure they cannot lose.

My problem with structured products is that anyone with half a brain can construct these themselves and can therefore avoid the charges and commissions the IBs add on top.

Given that AAA rated structured products were a major contributor to the financial crisis it beggars belief that variations are being offered to ordinary investors. Anyone considering taking the plunge should read and fully understand all the terms and conditions. Within the last few days even professional investors have learned that Credit Default Swaps don’t provide the insurance cover that was expected. Why? -- because the banks writing the insurance have the right to determine whether a "credit event" has happened or not. Greece is not in default say the writers of the insurance! Try telling that to those that are having the 50% haircut!!

Structured products are a case of : "Heads you win; tails I lose".

CAVEAT EMPTOR!!!

"Structured products" means "complicated". "Complicated" means "garbage". That's all you need to know.

So true TS!

Charlie Munger put it so :

Make your widgets complex [because engineers know how to do complex!] and keep your financial matters simple.

IMHO "Structured" = designed to hide the true risk to the investor and reward the scurrilous product inventor, regardless, very much like RBS executives!

An added complication is that when/if some disaster occurs with structured products, previous experience indicates you can't trust FSCS to do its job in compensating you even if the plan you buy has been mis-sold. Case in point: we now have the absurd situation, after the Lehman's collapse, that regarding one plan sold by NDFA, NDFA's own administrators' counsel say the plan was mis-sold, but FSCS's counsel says it wasn't mis-sold, and FSCS refuse to pay out. You can't find out why FSCS's counsel thinks what he thinks because FSCS isn't covered by the Freedom Of Information Act, and FSCS, indefensibly, is judge and jury in its own court so you can't challenge its decision not to compensate except via a judicial review, which of course ordinary mortals can't afford. It would of course be utterly ridiculous to suggest that FSCS's refusal to pay out has anything to do with trying to keep the IFA levy down, wouldn't it?

I wonder if there is some way for us (me) to cover against the FTSE halving in value, and still come out ahead, some sort of leveraged bear etf maybe?

Yeah there's a leveraged short FTSE ETF (2x) or you can just buy FTSE puts or sell the futures. Quite a number of ways.

Re David Sanders comprehensive post, I would add that FSA also said the Plans had been mis sold. In fact apart from FSCS, everyone,including several lawyers, qualified accountants and many IFA's agrees they were mis-sold.

As for Structured Products, in the form of Reverse Convertibles,which is what NDFA invested in, the FINRA review concluded that they are probably the highest risk product in the market, are virtually incomprehensibe, yield large fees, and conceal substantial charges which are virtually unidentifiable, and essentially were to be generally condemned. FINRA says that because they are so risky and unpredictable the normal life of such investment is no more than a 12 month term- 2 years absolute tops. So 5 years as per NDFA is a risk much too far.

Even Lehmans own Prospectus, not sent to retail investors, set out substantial, clear and ominus warnings- and stated - 'if you don't understand the product don't invest'. One might think that retail investors ought to be told that, not have it all condensed into a broad-brush', one liner.

Re the Ratings- named in Brochures, or otherwise. Standard & Poors say its ratings are merely a guide to default risk, they are NOT a guide to the merit of investment.

Don't really see what all the fuss is about. Structured contracts are great but they are a gamble. Do your due diligence and read all the risks and then make a decision about how much you should risk on them.

They're a great way to make higher returns but if you lose the lot don't start crying about it. It's a gamble. Oh and buy them off t'internet and you can get most of the commission rebated to you.

As for the article above the 12.5% claim is a bit over egging it because in an email they said it was with Barclays as counterparty but I rang Barclays Wealth and they said no way. Think Investec do a 12.5% but they are the counterparty so perhaps a bit worrying. You can get 9-10% with RBS or Aviva.

Counterparty aside, if the Euro collapses we could see soft protection barrier breached. With the FTSE at 2500 or so everyone now would say 'wow what a buying opportunity' but that's easier to say now than if we were actually there, if you see what I mean?

John Thorley

As you said 'a gamble' - I prefer higher returns for, to me, less perceived risk.

Right now I agree with you that any soft protection could easily be breached if Italy isn't sorted out very quickly as if Italy tumbles then the euro is definitely likely to collapse as bailing Italy out would cost too much and if the interest rate becomes unsustainable for Italy then Italy would eventually have to default; the knock on effects would be hard to quantify but obviously bad news all round unless you make money out of the misery of others!

John Thorley - I think you haven't got the point. The vast majority of punters have no wish or expertise to carry out their own due diligence - they assume their IFA will be doing that for them. In fact I suspect the vast majority of IFAs don't have the expertise to do it either, but rather like the idea of the commission . . . .

In any case you have little chance of finding out how reliable the counterparty is, because Lehman Bros didn't exactly look shaky before its collapse.

So you get back to the old rules : Don't invest in something you don't fully understand, and If it sounds too good to be true, it probably is.

Maverick

Very well written.

BUT for those who know exactly what the product is[having done their own due diigence] and are prepared to take the gamble then good luck to them.

For myself, I saw one of these products that looked very inviting, did a little research and decided I'd rather invest my money elsewhere as (even though it seemed good on the surface) it was a gamble with a very unknown probability as I have no crystal ball to determine where the index will be at a given time and have no way of deciding what the probability is apart from a gut feeling and a gut feeling isn't really good enough for making an investment decision.

If an overview of Lehmans is undertaken, there is a continual downward slide in its share price over the preceding 12 months. Lehmans was laying off staff by the thousand and closing funds. Even S&P recommended 'sell', whilst maintaining a Strong,- but Negative outlook. Small wonder when Lehmans went into the market 4 months before collapsing, in attempt to raise US $ 100,000,000,000 and offering 45% growth to investors over 5 years, it did not want Plan Managers to expose its name. Certain Plan managers agreed to keep Lehmans name undisclosed, despite the EU Directive 2003/71/EC saying otherwise- Oh and by the way FSA also said that there was no loophole in the rules requiring identification of an Issuer. FSA said it was not a legitimate way to get round the Prospectus Regulations.

So, fine, do your own Due Diligence, don't rely on a Plan Manager doing it- but, of course you would need to know what Issuer you were researching!

Thanks for all the comments. Like anything else, deciding whether or not to invest in such products involves weighing up the risks against the rewards. The point of the article was to give a little food for thought as to what risks you need to consider.

John Thorley - I'd like to respond to your specific point about the "rate" of the product described.

The product described was a bespoke product created especially for our clients. Due to the size of the investment and the volatility of the markets at the time we got a rate of 12.75% per annum (not compound). This is an actual investment we are currently using - not an example.

I was using this as an example of the types of investment out there. I tried to make it clear that this was a bespoke product and retail investors would probably get lower returns - sorry if this wasn't cystal clear. I think Barclays were offering about 8.25% to direct investors last I saw.

Going back to the risk/return trade off, we only invested 3% of client money in this product with a further 3% each in two other products with different banks.

I welcome all comments and feedback.

Mike Deverell (author of the article)

Mike Deverell

My broker sent me some information 'just for interest' about a similar product that paid 15.5% and that, I believe, could be traded in the market (so could be bought for more or less than the initial price of the structured product) so retail investors can actually get better returns than your bespoke 12.75% but at a probably higher risk.

We both decided it was not an investment either of us were prepared to gamble on at the time and if we had I doubt it would have been more than 1% of a portfolio.

I should really dig out the email for the details; it was, I believe, a euro not sterling investment but based on the FTSE 100 index.

You have made the point that there ARE products that give a good return if one is prepared to take the risk or, in this case, a gamble.

3 x 3% = 9% and quite a chunk out of your clients portfolios so I hope that the gamble pays off for them and that you can take the credit and cover yourself in disclaimers if they don't.

The problem with these products is that the risk is so hard to determine and if just based on options then why not just buy the options oneself instead of putting them together in a fancy package that must increase the ultimate cost to the client.

I am sure that those writing the options have themselves 100% covered so that, thanks to the clients money, they have a guaranteed gain and whether the client gains or loses is of no real concern to them as they are 'quids in' no matter what.

Dear Anonymous 1

your wrote Yeah there's a leveraged short FTSE ETF (2x) or you can just buy FTSE puts or sell the futures. Quite a number of ways.

Take us through it please. Would this effectively eliminate all risk except counterparty risk?

So we are supposed to check their "credit default swap spread". What the hell is that Mr Deverell?

If you are trying to impress us with your familiarity with high finance jargon, we are not impressed. You do not know either.

@Franco - attacking someone because they know something you don't isn't a favourable trait. Far from being "high finance jargon", CDS spreads can actually give a good indication of the likelihood of a bank defaulting so it is something worth monitoring.

@ Steve Hayes - first of all you can never totally eliminate risk as there is no such thing as the perfect hedge plus it's also pretty hard to eliminate counterpart risk. With options and futures you have counterpart risk through the broker and with ETFs you obviously have counterparty risk from the issuer

@Steve Hayes - to elaborate further, assume you held securities which broadly gave you FTSE-like exposure, whether you are selling futures, buying leveraged short ETFs or buying puts, each has their own set of risks and it generally makes sense to try and match your long exposure if you are concerned about protecting the whole portfolio against large sell-offs in the market.

As the title says, Leveraged ETFs quite obviously....um leveraged. Futures are also leveraged instruments and by going short either of these, you can get cleaned out if the market rallies. Buying puts however means that you know what your maximum loss will be....ie the premium you pay for owning the option....still a risk but arguably less than the other two in this particular example

Why is there so much negative comment?

Barclays have a whole range of Structured Products (also known as Investment Notes) and many are quite straightforward to anyone with a modicum of investment knowledge. Of course there are risks (as with all investments) but there are also advantages. Some of them offer 2, 3 or even 4 times the rise in the FTSE100 Index (with a cap) whereas others offer an annual rate of return provided the Index Targets are met

A big advantage of these Notes is that they are traded daily. The latest Barclays 'Autocall' Note offered a 'simple' annual Return of 13% subject to the FTSE100 Index being equal to or greater than the Initial Index on any of the six Anniversary dates. If the FTSE100 never achieved its Initial Index level the initial capital would be returned after 6 years provided the FTSE100 had not fallen below 60% of its Initial Level

There are risks but also potentially very attractive returns. They are not complicated

CDS's are now useless as a hedge against debt default. The ISDA, consisting of all the underwriting banks, came to the dubious conclusion that Greece hasnt defaulted!! The only hedge now is the tax payer!!

Truffle Hunter

Whilst any haircut is 'voluntary' then Greece has not defaulted, but how can the EU decide what a voluntary haircut is if all the parties have not agreed.

I believe that those who took out DCS were party to a contract and if they have been denied their payment because of an INVOLUNTARY 'voluntary' haircut then somebody is screwing the 'private investor' big time!

The writers of CDS should not be allowed to get away scott free from the contracts they wrote.

I'd love to see the contracts for difference unravel and see where all the risk has been hiding!

Anonymous 1

I agree with you when you write:

'CDS spreads can actually give a good indication of the likelihood of a bank defaulting so it is something worth monitoring.'

I have exposure to some corporate bank bonds and the above IS useful.

DCS typo should read CDS

What's a DCS I ask myself: a 'Dumb Credit Swap'?

~shrugs~

I've just spent the last 5 minutes googling

Credit Deafult Swap Rates Barclays BNP Paribas Citibank

ie trying to find a table

I cannot find it in this short time

Please someone where is this data hidden?

Steve it's all on Bloomberg, let me know what you need and I'll post it tomorrow.

@ Truffle Hunter - as far as countries are concerned yes maybe but CDSs on many other things are still very valid instruments

Franco - thanks for the constructive criticism!

The article I submitted to Citywire included the link below showing a selection of CDS spreads. It seems to have been lost from the body of the text but is in the side bar under where it says "More from us":

http://www.citywire.co.uk/wealth-manager/rocketing-cds-which-banks-have-the-biggest-debt-risks/a530822

As I say in the article "To find out what the market thinks of the bank right now, you can check their credit default swap spread. The higher the spread, the higher the potential risk."

Hope this helps.

I included the comment about CDS (Credit Default Swap) spreads because, to be frank, ratings agencies are next to useless. CDS spreads show what the market as a whole thinks of that bank right now, whereas S&P, Moodys and the like are typically way behind the curve.

Have a look at CompareStructuredProducts.com and make your own mind up.