Leona Miller, an 84-year-old retired beautician, says she was seeking safe and steady income from bonds two years ago when her Wachovia Corp. broker recommended she buy securities paying 9 percent interest.
Within six months, Miller had lost about 30 percent of her $20,000 investment and the bonds were converted into shares of Merck & Co. in a falling stock market. The San Diego resident, who still doesn’t understand what happened to her money, had purchased bonds known as structured notes that include built-in derivatives.
Sales to Miller and thousands of other individuals have driven structured note offerings up 58 percent to $31.9 billion through August, according to data compiled by Bloomberg. With U.S. interest rates near zero percent, investors are snapping up bonds such as reverse-convertible notes with knock-in put options or Leveraged CMS Curve and S&P 500 Index Linked Callable Notes, some with face values of as little as $10.
“People develop a product which makes a modicum of sense, then they extend it to the point of ludicrousness until it blows up,” said Satyajit Das, a former Citigroup Inc. derivatives banker. Das, the Sydney-based author of “Traders, Guns & Money” (FT Press, 2006), said investors are often “seduced” into purchases without understanding the risks.
The Securities and Exchange Commission’s enforcement division started a group this year focused on investigations into structured products, including those marketed to individual investors.
Hard to Understand
“We’re concerned about the sale of complex structured notes to retail customers because people don’t always understand the risks they’re exposed to,” said Kenneth Lench, head of the SEC’s Structured and New Products unit. “It’s very difficult for a person who isn’t immersed in this world to pick up a prospectus and really understand what are the different scenarios that would make an investment work out for them.”
Miller and Wells Fargo & Co., which acquired Wachovia in 2008, are in arbitration, according to her San Diego lawyer, Ronald Marron. In a February 2009 letter, the bank’s legal department told Miller that the broker “explained very thoroughly his recommendation.”
Individual investors are incapable of valuing structured notes and their underlying derivatives, said Kevin Kelly, manager of Phoenix-based hedge fund Tontine Capital, which specializes in the securities. Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates.
‘You Don’t Know’
“If you don’t know what the components are worth, what are you doing trading in them?” said Kelly, who determines values based on computer models and negotiations with multiple banks.
Sales of structured notes in the first eight months of the year compare with $20.1 billion through August 2009, according to database StructuredRetailProducts.com. The growth shows investors are already forgetting the losses suffered when Lehman Brothers Holdings Inc. went bankrupt in September 2008 and defaulted on securities called principal-protected notes, which left investors holding paper that’s almost worthless.
U.S. clients of Zurich-based UBS AG, Switzerland’s biggest bank, allege in litigation pending since 2008 that they were misled into buying more than $900 million of the securities, which were aimed at “conservative, retirement-oriented investors.”
Structured notes have become popular as the Federal Reserve has kept its target rate for overnight loans between banks at zero to 0.25 percent since December 2008. Reverse-convertible notes paid 13 percent interest on average this year, Bloomberg data show. That’s more than 10 times the average 1.2 percent rate on one-year certificates of deposit, according to Bankrate Inc. of North Palm Beach, Florida. U.S. investment-grade bonds yield 3.73 percent, Bank of America Merrill Lynch index data show.
The notes are increasingly targeted at individual investors to boost banks’ profit margins, Das said. Morgan Stanley charged a 3.5 percent fee on the CMS Curve notes, which it sold Aug. 20, according to a prospectus. Underwriting commissions for U.S. investment-grade bonds this year average 0.5 percent, Bloomberg data show.
Brokers are paid more to sell structured notes than some other financial products because the securities aren’t standardized, making it difficult for buyers to shop around, said Christopher Whalen, managing director and co-founder of the Torrance, California-based research firm Institutional Risk Analytics.
JPMorgan Chase & Co. sold $223,000 of three-month reverse convertible notes on Aug. 26 that pay 12.3 percent annualized interest and are tied to the stock of Pittsburgh-based U.S. Steel Corp. Buyers were charged a fee of 5.1 percent, more than half of which compensated other brokers, the prospectus shows. The fee is five times the annual rate on stock mutual funds, according to the Investment Company Institute, a Washington- based trade group.
“The whole marketplace is set up to be unfair and inefficient by design,” said Whalen. “It’s like betting with the touts out on the edge of the racetrack instead of going to the window in the clubhouse.”
Compensated for Risk
Banks from Bank of America Corp. to Morgan Stanley, this year’s two largest underwriters of structured notes as measured by Bloomberg data, create the products by bundling bonds with privately negotiated over-the-counter derivatives. That means investors can lose money because of a range of variables beyond interest rate movements, said Whalen, who predicted in March 2007 the mortgage-backed securities market would collapse and testified before the Senate Banking Committee two years later on derivatives regulation.
Investors can benefit from higher returns, such as the 12.3 percent on U.S. Steel reverse convertibles, if their bets work out. Buyers are compensated fairly for the risk they take on and don’t need to know how derivatives work to evaluate the securities, said Keith Styrcula, chairman of the Structured Products Association, a trade group in New York.
Issuers disclose potential pitfalls of the investments in documentation provided to buyers. Many of the products, such as principal-protected notes, are less risky than stocks because sellers guarantee investors won’t take losses even if the market falls, said Styrcula, a former JPMorgan structured-notes banker.
“There’s a reason the market is booming,” he said. “Investors are having successful experiences with structured investments, and they’re coming back as repeat buyers.”
Wall Street began selling the notes to individuals in the 1990s. At the time, government officials questioned whether the securities should be subject to the same rules as the derivatives they contain, which would have barred sales to the public, according to Philip McBride Johnson, a former Commodity Futures Trading Commission chairman. The passage of the Commodity Futures Modernization Act in 2000 settled the issue in the banks’ favor.
The law, which excluded most trades between institutions from oversight, allowed banks to sell OTC derivatives to individuals as long as they were bundled with bonds into so- called hybrid securities, said Johnson, now a lawyer at Skadden, Arps, Slate, Meagher & Flom LLP in Washington.
In the Lehman case, the notes were designed to pay interest dependent on market movements, with principal returned at maturity as long as the issuer didn’t fail.
“UBS properly sold Lehman structured products to UBS clients,” said Allison Chin-Leong, a bank spokeswoman. “Any client losses were the direct result of the unexpected and unprecedented failure of Lehman.”
In April, New York-based Citigroup offered to buy Lehman notes back from more than 2,700 investors in Spain for 55 cents on the dollar, without admitting liability.
In Hong Kong, Lehman bond investors staged protests with bullhorns blaring a looped chant, “Rotten Deal -- Money Back.” Buyers included the elderly and poorly educated, according to a Hong Kong Monetary Authority investigation. Last year, banks agreed to pay investors at least 60 cents on the dollar in compensation.
Banks aren’t required to make markets for structured notes, just as they didn’t have to buy auction-rate securities, Whalen said. That $330 billion market collapsed in early 2008, leaving investors who sought higher-yielding alternatives to checking accounts with paper they couldn’t sell.
Seeking to settle with state and federal regulators, banks including Citigroup have since repurchased some of the securities, which are municipal bonds, corporate debt and preferred stock whose rates of return are periodically reset through auctions.
‘More Can Be Less’
“If you’re dealing with an unsophisticated person, and you’re selling them a very sophisticated product, how do you satisfy your regulatory obligations?” said Harvey Pitt, a former SEC chairman.
Risks should be disclosed clearly and concisely, he said. “More can be less” because long documents may confuse investors, said Pitt, founder of Washington-based consulting firm Kalorama Partners LLC.
Miller started managing her finances when her husband died and invested in structured notes in May 2008 at the recommendation of her broker, Robert Baldacci.
‘Like Anybody Else’
“I just wanted him to make some money for me, like anybody else,” Miller said. “You depend on them to take care of you. I assumed that bonds were safe.”
Miller lost money because the securities, issued by Eksportfinans ASA, an Oslo-based export-credit agency, were tied to the performance of Merck. A decline in the Whitehouse Station, New Jersey-based company’s share price to below $32 from $40 triggered the knock-in put option built into the note, allowing Eksportfinans to pay the debt with Merck shares worth $26 each.
Wachovia denied Miller’s request for compensation, according to the letter from the legal department, which also said Miller signed the prospectus and received a guide to structured notes.
“Mr. Baldacci recalled that you were familiar with Merck & Co. as they manufacture one of your medications,” Wachovia said in the letter, which was provided by Marron, Miller’s lawyer.
Last week, Miller chose to pursue the arbitration claim and withdrew a separate lawsuit against Wells Fargo and Eksportfinans that was filed in July, Marron said.
Kathryn Ellis, a spokeswoman for San Francisco-based Wells Fargo, and Baldacci, who no longer works for the bank, declined to comment. Jens Feiring, Eksportfinans’s general counsel, said he’s pleased Miller chose not to pursue legal action against the firm.
Most structured notes are more complex than the products Miller bought, Tontine Capital’s Kelly said. Morgan Stanley’s CMS Curve securities offer a fixed 10 percent rate for two years. The yield for the next 13 years is five times the difference between long-and short-term constant maturity swap rates, not to exceed 18 percent annually, earned when the Standard & Poor’s 500 Index doesn’t dip below 875, according to a regulatory filing.
If stocks plunge or short-term rates rise, the notes could pay no interest for more than a decade. Morgan Stanley also has quarterly options to unwind the transaction starting in 2012.
“It raises questions about suitability for the investor when you have products that are that complicated,” said Daniel Bergstresser, a Harvard Business School professor who’s studied structured notes. “Is that complexity a response to a legitimate desire the investor has or is it a smokescreen?”
The ‘D’ Word
Mark Lake, a spokesman for New York-based Morgan Stanley, declined to comment on the CMS Curve notes or sales practices. Bank of America, whose Merrill Lynch unit has the second-most brokers after Morgan Stanley Smith Barney, has underwritten $8 billion of structured notes in the U.S. this year, the most of any bank, Bloomberg data show. Morgan Stanley has sold $7.6 billion, the second most.
John Klock, 66, bought about $200,000 of structured notes starting in late 2007. He said he wouldn’t have made the purchase had his Merrill Lynch broker mentioned derivatives.
“He told me it was an index of stocks,” said Klock, a Newark, New Jersey-based lawyer. He said he’s waiting for a statement from his broker totaling the losses when he sold the notes back to Bank of America, which bought Merrill in 2009.
Selena Morris, a spokeswoman for Charlotte, North Carolina- based Bank of America, declined to comment.
“They don’t tend to mention the ‘D’ word very often,” Das, the author, said of the banks. “One of the reasons these products exist is to avoid having to tell the person that you’re dealing with that they’re trading in derivatives.”
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