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Wall Street Turns Stock Gains Into Investor Losses With Structured Notes

Banks sold more than $6 billion of bonds linked to the performance of stocks last year, promising returns of as much as 64 percent at a time when interest rates were at historic lows.

Instead of reaping such extraordinary gains, reverse convertibles, as the products are known, lost 1 percent on average, according to data compiled by Bloomberg on 1,481 of the securities sold in the U.S. last year that matured by Nov. 30. The Standard & Poor’s 500 Index returned 8 percent during that period and corporate bonds gained 11.1 percent, including reinvested interest, Bank of America Merrill Lynch index data show.

“Here’s an asset class that’s basically failed on all counts,” said Glenn Tongue, a money manager who oversees about $200 million with Whitney Tilson at T2 Partners LLC in New York. “I doubt these are being pitched as an opportunity to lose 1 percent.”

Barclays Plc, based in London, and UBS AG in Zurich led more than a dozen banks selling reverse convertibles, which are short-term bonds generally marketed to individuals that convert into stock if a company’s share price plummets. The securities are being created as part of a boom in structured notes, or bonds packaged with derivatives whose values are derived from assets including stocks, bonds, currencies and commodities, or from events such as changes in interest rates.

Sales Soar

Structured note sales rose 46 percent last year to a record $49.4 billion in the U.S., Bloomberg data show. The securities fed demand from individual investors frustrated with record low rates on everything from certificates of deposit to money market funds with the Federal Reserve holding its target interest rate for overnight loans between banks in a range of zero to 0.25 percent since 2008. Banks issued $33.9 billion in 2009, according to StructuredRetailProducts.com, a database used by the industry.

Royal Bank of Scotland Group Plc sold $1.15 million in three-month notes tied to Rochester, New York-based Eastman Kodak Co. on June 10 that paid 24 percent annualized interest, a filing with the U.S. Securities and Exchange Commission shows. That’s 24 times the average rate on one-year certificates of deposit, according to data from Bankrate Inc. in North Palm Beach, Florida.

Buyers couldn’t lose money unless shares of the camera maker fell to below $3.54 from $5.06. Kodak dropped to $3.50 on Aug. 31 in New York trading. RBS converted the bonds into stock and investors lost about 18 percent even with the high interest rate.

RBS Losses

Investors lost an average of 2 percent on the 180 reverse convertibles issued by RBS last year that matured by Nov. 30, Bloomberg data show. The securities had a total face value of $69.3 million. Pholida Phengsomphone, an RBS spokeswoman, declined to comment.

“This isn’t something that a retail investor calls up and asks for,” said Marilyn Cohen, who oversees $250 million as chief executive officer of Envision Capital Management in Los Angeles. “Is it ever explained to them that you might end up with the stock and there’s a large probability that will happen?”

Buyers profited on 75 percent of the notes analyzed by Bloomberg. The average return was negative because investors lost more on the unprofitable ones than they gained on those that made money. Investors also took on credit risk because the notes are unsecured debt.

SEC Examination

“There’s no free lunch,” Tongue said. “If you’re going to get super-standard returns, that means you’re taking super- standard risks.”

Reverse convertibles aren’t traded on exchanges and their performance isn’t reported publicly. Investors lost $27 million on the $2.19 billion of securities compiled by Bloomberg. Banks also sold $4.56 billion of reverse convertibles whose returns weren’t included because they didn’t mature by Nov. 30.

Kenneth Lench, head of the SEC’s structured products unit that investigated Goldman Sachs Group Inc.’s subprime-mortgage investments, said in a September interview that the agency was examining whether brokers overcharged investors for the notes. He declined to comment for this article. SEC Enforcement Director Robert Khuzami said at a Senate Judiciary Committee hearing the same month it has looked at reverse convertibles.

“The reason these are popular is they’re kind of an easy sale,” said Charlie O’Flaherty, who used to oversee U.S. structured products and derivatives at Bank of Ireland. The products are marketed as a way to earn higher yields during times when stock prices are stable and interest rates are low, he said. Buyers aren’t told how they have performed in the past, he said.

Bank Fees

Banks charged fees that average 1.6 percent on a three- month reverse convertible, or about 6 percent a year, the data show. The average annual fee on stock mutual funds is 1 percent, according to the Investment Company Institute, a trade group in Washington.

The three-month reverse convertibles sold by Edinburgh- based RBS and linked to Kodak, a photography company founded more than 100 years ago, paid brokers a 2.75 percent commission.

The fees, which sometimes exceeded the securities’ maximum possible yield, cut into returns and probably account for the losses, said O’Flaherty, who left the industry last year to manage his own investments.

Professional money managers generally don’t buy reverse convertibles because they can pay less in fees by trading derivatives directly, according to Tongue and O’Flaherty. Small investors would need a computer model and access to options pricing data to see if they’re being compensated fairly for the risks they’re taking on, O’Flaherty said.

‘Big-Boy Investor’

“If you were a big-boy investor, you’d just do it yourself,” O’Flaherty said. “You’d structure it yourself and take all the middlemen out.”

Leroy and Carol Conklin, a retired couple in Sun City Center, Florida, said they were pitched an investment in reverse convertibles by James Tuberosa, a broker at H&R Block Financial Advisors whom they met at the retirement community’s annual FunFest fair.

They bought reverse convertibles from Tuberosa in 2007 and 2008, including $20,000 of notes linked to Mooresville, North Carolina-base home improvement retailer Lowe’s Cos. that paid 9 percent and that the broker called corporate bonds, the Conklins said in an interview.

“I said, ‘Boy, this is a good investment,’” said Leroy Conklin, 80, who earned a Silver Star in the 1950-1953 Korean War and worked as a high school principal.

‘No Idea’

The Lowe’s notes converted into stock at a $4,000 loss, said Jason Doss, the Conklins’ lawyer at Doss Firm LLC in Marietta, Georgia. The couple lost more than $130,000 on reverse convertibles overall, Doss said.

“We feel so stupid,” Carol Conklin said, adding that she still has “no idea” what derivatives are.

The Conklins filed an arbitration claim that’s pending against Ameriprise Financial Inc., which bought H&R Block’s financial advisory business in 2008. Tuberosa, who works for Ameriprise in Sun City Center, declined to comment, as did Benjamin Pratt, an Ameriprise spokesman. A hearing is scheduled for May.

State regulators are seeing an “influx of concerns and complaints” from individual investors about structured products, including reverse convertibles, said Joseph Borg, director of the Alabama Securities Commission. Brokers who sell the investments sometimes don’t understand them, Borg said in a telephone interview.

Losses, Gains

Barclays sold $757.4 million of reverse convertibles in 588 offerings in the U.S. last year that matured by Nov. 30, the most of any bank, Bloomberg data show. Investors lost about 2 percent on average. Kristin Friel, a Barclays spokeswoman, declined to comment.

Royal Bank of Canada’s 505 reverse convertibles with a total face value of $372.9 million lost 1 percent on average, as did Wells Fargo & Co.’s 27 with a face value of $156.8 million, Bloomberg data show. Morgan Stanley issued $294.9 million in seven deals that lost an average of 6 percent.

Citigroup Inc. sold $274.1 million of reverse convertibles in 15 deals that made an average of 6 percent, the data show. Investors made an average of 1 percent on the 114 JPMorgan Chase & Co. reverse convertibles with a face value of $85.2 million that Bloomberg analyzed. UBS sold 44 with a total face value of $177.7 million that also made about 1 percent on average.

Spokesmen for the banks declined to comment.

JPMorgan Fees

JPMorgan, based in New York, charged about 3 percent on average in fees, the data show. In some cases, the fixed fees gave banks and brokers more profit than investors could earn on the securities.

The bank sold a three-month note on April 27 linked to West Chester, Ohio-based steelmaker AK Steel Holding Corp. that paid 3.5 percent in interest over the term of the security, or 14 percent on an annualized basis, according to an SEC filing. JPMorgan charged 5.2 percent in fees.

The bond couldn’t be converted into stock unless shares of the company fell more than 20 percent from their initial level of $17.43. AK Steel plummeted and triggered the conversion when it dropped to $13.40 on May 20. Investors lost 13 percent. Justin Perras, a JPMorgan spokesman, declined to comment.

“It sounds too good to be true, but the markets are stacked against you,” said Envision’s Cohen. Reverse convertibles are “really a toxic product,” she said.

Linked to TiVo

On May 11, JPMorgan sold $800,000 of reverse convertibles linked to TiVo Inc. that paid 64 percent a year in interest, according to a prospectus the bank filed with the SEC. Three days later, the Alviso, California-based digital-video recording pioneer dropped 42 percent after an adverse court ruling. Investors ended up losing 42 percent, including interest. The bank charged 1.75 percent in commission on the two-month notes.

While banks must pay competitive commissions to brokers, the fees on some short-term reverse convertibles are “very high” compared with other investments, said Richard Sandulli, a former head of structured products at Morgan Stanley and Wells Fargo who left the industry last year and is now a consultant.

Most structured products are “valuable tools” that spread the fee over a longer period of time, he said. Paying too much commission cuts into investors’ returns and encourages brokers to act against their clients’ best interests, he said.

“Just because something can be sold doesn’t mean it should be,” Sandulli said.

To contact the reporter on this story: Zeke Faux in New York at zfaux@bloomberg.net.

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net.

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