Let’s say a broker or banker offered you a way of reaping market gains while protecting your principal. You’d jump at it, wouldn’t you?
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Thousands did and were burned to the tune of more than $113 billion in complex “structured” products since 2008, including Florida businessman Charles Replogle and his 86-year-old mother. They were told that the principal-protected notes sold by UBS Financial Services were safe. He bought the six-percent-yielding Lehman Brothers notes from UBS for his mentally disabled brother and mother.
Replogle trusted his broker, a friend whom he had known since he was nine. The Replogles lost every penny of the $130,000 they invested in the notes when Lehman went bust in September, 2008.
“There was no mention of Lehman Brothers,” Replogle said. “I felt UBS deceived us. You can’t sell a guaranteed product and not guarantee it.”
UBS neither admitted nor denied that it was involved in wrongdoing, even though it was fined a paltry $2.5 million by the securities industry self-regulator FINRA on April 11 and ordered to pay $8.25 million in restitution for “omissions and statements that effectively misled investors.” UBS sold about $1 billion of these dogs.
(A UBS spokeswoman told Reuters on April 11 that the bank “pleased” to settle the case, which concerned “a limited number of investors who purchased certain Lehman principal protection notes during a discrete 3 1/2 month period of time.” She said a “significant majority” of UBS’s sales of Lehman structured products were conducted properly.)
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If the Replogles were the victims of a Madoff-like Ponzi scam, you could shrug your shoulders and attribute the incident to outright fraud.
Yet “structured” products like the Lehman notes were — and continue to be — sold to investors by major banks and brokers. These vehicles are loaded with derivatives, which are risky bets on underlying investments. They were found in everything from plain-vanilla bond mutual funds that contained mortgage securities (that tanked) to exotic “reverse convertibles.”
I know this subject particularly well since I spent more than a year studying them under a grant from the Nation Institute and published by Demos, the New York-based progressive think tank.
Many of these highly risky products were sold to older, conservative investors who just wanted to get a better yield in a single-digit-return environment.
What’s the common thread in all of this? Wall Street continues to peddle opaque, illiquid complex investments that most people don’t understand. It was a $52 billion market for banks and brokers last year because it’s highly profitable. They promise to shield principal from downside risk, and use derivatives to do it — but don’t clearly disclose how they do it or the total risks involved.
Sellers of structured products win going in the door because of the fat commissions, underwriting fees and embedded costs you may never see. They get their money upfront, yet rarely give you daily pricing or the ability to sell back your investment with a full refund.
Sure, there may be some structured products that make sense. You can customize them to hedge against nearly any index or stock. But you have to weigh the outsized expenses and alternatives carefully. You may find a better deal writing an options contract or buying an inverse exchange-traded ETF.
If you don’t understand how a structured product works, don’t fall for the broker’s pitch. Walk away. Only buy one through a fiduciary registered investment adviser or certified financial planner who can explain them completely and tell you how they may or may not fit into your financial plan.
Brokers operate by a weaker set of rules that put their firm’s sales quotas above your best interests. Unless that changes with the SEC’s proposed “fiduciary standard of duty” for brokers --the SEC has this pro-investor rule on the back burner--you’re on your own.
Now for my Dr. Pangloss moment about this business: Shouldn’t Wall Street take the high road in protecting investors from the wretched excesses of the meltdown era? It would show the investing public that they have learned their lesson and want to do the right thing. Yet Wall Street wants to dilute or destroy pro-investor rules emerging from Dodd-Frank financial reforms and is fiercely lobbying Congress, the SEC and Commodity Futures Trading Commission to do it.