Individual Investors Duped by Derivatives

Leona Miller, an 84-year-old retired beautician, says she was seeking safe and steady income from bonds two years ago when she bought securities recommended by her Wachovia (WFC) broker, Robert Baldacci, paying 9 percent interest. Within six months, Miller lost about 30 percent of her $20,000 investment, and the bonds were converted into shares of Merck (MRK) in a falling stock market. "I just wanted him to make some money for me, like anybody else," says Miller, who lives in San Diego. "I still don't understand too much about it."

Miller had bought a structured note—a bond combined with a derivative. In her case, it was a reverse-convertible note with a knock-in put option tied to Merck stock. The option meant the security could offer a relatively high interest rate. It also added risk, as Miller learned too late. A decline in the drugmaker's shares, to below 32 from 40 when Miller bought the notes, triggered the put option. That allowed the note's issuer, the Oslo-based export-credit agency Eksportfinans, to pay Miller off with Merck shares, then trading at 26. Kathryn Ellis, a spokeswoman for San Francisco-based Wells Fargo (WFC), which acquired Wachovia in 2008, and Baldacci, who no longer works for the bank, declined to comment.

While customized derivatives have been criticized for their role in the credit crunch, securities laws allow them to be sold to individuals as long as they're bundled with bonds into structured notes, and the financial sector reforms enacted since the crisis have not addressed the issue. The Securities and Exchange Commission's enforcement division started a group this year to investigate structured products, including those marketed to individual investors. "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," says Kenneth R. Lench, head of the SEC's Structured and New Products unit.

With interest rates near 0 percent, investors are ignoring potential risks and snapping up bonds that promise higher yields, even if they carry obscure names such as Leveraged CMS Curve and S&P 500 Index Linked Callable notes. Reverse-convertible notes paid 13 percent interest, on average, this year, according to Bloomberg data. That's more than 10 times the average 1.2 percent rate on one-year certificates of deposit and more than three times the average U.S. investment-grade bond yield of 3.73 percent.

Sales of structured notes rose to $31.9 billion through August, up 58 percent over the same period last year, according to data compiled by Bloomberg and "People develop a product which makes a modicum of sense, then they extend it to the point of ludicrousness," says Satyajit Das, a former Citigroup (C) derivatives banker. Das, the author of Traders, Guns & Money, says investors are often "seduced" into purchases without understanding the risks.

The notes are targeted at individual investors to boost banks' profit margins, Das says. Morgan Stanley (MS), for example, charged a 3.5 percent fee on the Leveraged CMS Curve notes that it sold on Aug. 20, according to a prospectus. Underwriting commissions for U.S. investment-grade bonds this year average 0.5 percent, Bloomberg data show.

Individual investors are incapable of valuing structured notes and their underlying derivatives, says Kevin Kelly, manager of Scottsdale (Ariz.)-based hedge fund Tontine Capital. Most structured notes are more complex than those Miller bought, he adds. 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-stock index doesn't dip below 875, according to a regulatory filing.

"It raises questions about suitability for the investor when you have products that are that complicated," says Daniel Bergstresser, a Harvard Business School professor. "Is that complexity a response to a legitimate desire the investor has or is it a smokescreen?" Mark Lake, a spokesman for Morgan Stanley, declined to comment.

Buyers are compensated fairly for the risk they take on and don't need to know the details of how derivatives work to evaluate the securities, says Keith Styrcula, chairman of the Structured Products Assn., a trade group. Issuers disclose potential pitfalls of the investments in documentation provided to buyers. Many of the products are less risky than stocks because sellers guarantee investors won't take losses even if the market falls, says Styrcula, a former JPMorgan Chase structured-notes banker. "There's a reason the market is booming," he says. "Investors are having successful experiences with structured investments, and they're coming back as repeat buyers."

Miller and Wells Fargo 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." The letter, which was provided by Marron, also said that "Mr. Baldacci recalled that you were familiar with Merck & Co. as they manufacture one of your medications."

The bottom line: Wall Street is selling complex securities to yield-hungry investors who may have no idea how they work—or how risky they are.

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