Everyone knows that there is little income to be had from safe savings vehicles and investments these day. The average income generated by every government backed, liquid savings product is well below one percent per year. After inflation; savings accounts, money market funds, CDs, and even most shorter-term Treasury securities end up losing you money, in terms of buying power. It's no wonder that so many investors are desperate to find a source of higher income. This is particularly true of older investors. However, with less time to regain losses, they need a high level of safety. The combination of these conflicting needs makes them easy prey for the masters of financial complexity who fill the ranks of big banks and brokerage firms.
Wall Street has perfected the art of financial illusion. They know what investors want and then find a way to remake or repackage conventional investments into "derivative" securities that seem to defy financial gravity. They can slice and dice bonds, mortgages, and other securities then mix them with pieces of others to create "Frankenpaper," products that carry fancy names like "absolute return," "principal protected," or "capital guarantee" securities.
These "structured products" are sold to investors as higher yielding vehicles with little or no potential loss of principal (zero loss potential is typically implied, even when it doesn't really exist).
The sale of a variety of structured products led to tens of billions of dollars of losses to individual investors following the collapse of Lehman Brothers in 2007. In the wave of financial reform that followed it would be reasonable to expect that sale of these complex and often dangerous securities to retail investors would have ended or slowed dramatically. It has not. Investors continue to ask for high yields and low risk. Wall Street and bankers see in these confusing "structured securities" the opportunity to make a quick buck with limited risk to their bottom lines. The fees involved in derivative securities are high enough to offset most expected losses from arbitration or litigation.
Securities regulators have long recognized the risks posed by these mashed up products, but are hard pressed to find a solution to the problem. The investment industry regulators, FINRA, posted a 2005 bulletin to members of the National Association of Securities Dealers (NASD) on their web site that said, in part:
"In the current investment environment, investors and brokers are increasingly turning to alternatives to conventional equity and fixed-income investments in search of higher returns or yields. Such products, including asset-backed securities, distressed debt, structured notes, and derivative products, are often complex or have unique features that may not be fully understood by the retail customers to whom they are frequently offered, or even by the brokers who recommend them. Some appear to offer benefits to investors that are already available in the market in the form of less risky, less complicated, or less costly products, prompting concerns about suitability and potential conflicts of interest."
Prior to the collapse of the derivative markets in 2006, the Securities Litigation and Consulting Group published a paper which warned that:
"Structured products can be too complex and opaque for retail investors and registered representatives to understand. This complexity and opaqueness allows structured products to survive in the marketplace despite their marked inferiority to traditional portfolios of stocks and bonds."
Despite these early warnings, the securities industry continued to sell these products through the collapse of the derivative markets in 2007-2008 and continue to offer "structured products" promising high yields and little or no risk to this day. There is too much money to be made, providing large pools of capital for lobbying and lawyering. Ordinary investors don't stand a chance, unless they develop a healthy amount of skepticism.
It would be nice if we could somehow get securities salespeople to fully divulge all of the risks and fees associated with investment products. Here is one great idea proposed by author John Wasik in his rent paper, “How Safe are Your Savings?” published in May by Demos:
“WARNING: This product may be hazardous to your wealth. Do not invest in this product if you need the money to pay living expenses or can’t afford any loss in principal.
THIS PRODUCT IS SOLD BY BROKER X AND UNDERWRITTEN BY BANK Y. IT IS NOT GUARANTEED BY ANY FEDERAL AGENCY.
Can I lose money?
Yes, under certain conditions. There is the risk that your underlying investment will decline in value or that the issuer will go bankrupt. Your principal is not guaranteed.
How much will it cost me?
The broker commission is 10% annually (paid upon purchase). The bank underwriting fee is 1%. Both fees are non-refundable. If you invest $1,000, only $890 will be put to work. You will also incur a commission if you sell this product back to a broker plus any loss in principal.
Will I be able to get my money out quickly?
No, this is an unlisted security with little or no secondary market. Your broker may be able to buy it back, but at a 10% discount or more. Buyback is not guaranteed.
Is this product recommended for risk-averse, income- oriented investors?
No, only investors placing less than 10% of their total net worth should consider this investment.What are the additional risks and conflicts of interest? You may lose money on the bid/ask spread within the contract. Poor performance by the derivative contracts contained within the contract could also result in losses. There is a risk that the issuer will be unable to pay a return on the note. There may also be an options pricing risk, meaning you could lose money on embedded derivatives contracts, and an interest rate risk, meaning you could lose money if interest rates rise. The seller receives a fee from the issuing bank and may have other conflicts.”
What such a disclosure would certainly help some small investors avoid big losses, don't get your hopes up. There isn't the political will to provide that kind of honesty, particularly when millions in campaign donations are at stake.
The most vulnerable of retail investors are older Americans, who are accustomed to working with banks for there savings and income needs. Extremely low interest rates on savings makes them easy prey for a securities salesperson stationed within the seeming safe confines of the bank. These "bank brokers" are trained to sell whichever product appears to meet the clients desires and delivers the best commissions and fees to the broker and the bank.
All of us need to be extremely careful with our investments. Don't trust someone just because they have a fancy office in a bank of high rise (who do you think pays for those palatial digs?). Demand that every promise made or implied be documented. Remember, if it isn't in writing they will deny they ever said it. Make sure you know how much you are paying. Every investment has a cost and most pay the person selling them a commission (which is often huge). If someone tells you something is free, again, get it in writing with no hedging or other ifs, ands, or buts. To really know what you're paying try to work exclusively with fee-only investment advisors. They are required to disclose all their fees and expenses in clear, simple language.
Another benefit to fee-only advisors is the fact that they are held to a fiduciary standard. In other words, they have a legal obligation to act in your best interests. Most brokers and insurance agents are NOT fiduciaries.
Finally, avoid anything you don't clearly understand. Don't trust a salesperson to take on that responsibility. Most have no idea how the products they sell actually work and what might happen in a "worst case scenario." This is easy to find out, just ask them. Rarely will you find a broker who truly understands how a "principal protected" product is really protected (and by whom) or how a "reverse convertible" security is structured. Invest in what you understand. Use a little common sense. If it sounds to good to be true, guess what? It probably is.