Germany Probes Sales of Risky Credit Notes to Unwary Investors

  • Global sales surged 26 percent this year to $11.5 billion
  • Notes were the subject of litigation after Lehman bankruptcy

Germany’s financial watchdog is investigating whether banks are adequately alerting investors to the risks of credit-linked notes, complex securities that some regulators consider too racy to be sold to individuals.

BaFin is seeking information from issuers and some 100 sellers of the securities about how many are sold to individuals and how they’re being advised. The regulator is concerned that low interest rates available on the world’s bond markets may be “forcing yield-oriented clients to take on greater risks” with the structured notes, it said in a statement. German banks were the top three issuers of the securities worldwide last year, Bloomberg data show.

Global sales of the notes, which are tied to credit-default swaps, have surged 26 percent this year to $11.5 billion, Bloomberg data show. That may raise the risk of mis-selling, with six securities watchdogs reporting faulty sales of various structured products in an outlook published this month.

“The question is whether sales personnel are sufficiently trained and provide sufficient disclosure” about notes that are sold to individuals in Germany, said Kai Andreas Schaffelhuber, a partner at law firm Allen & Overy LLP in Frankfurt. He said he doesn’t believe an outright ban of the products is likely however.

Underlying Assets

BaFin said it’s asking firms about the size of coupons on the notes, which bonds back them and whether advisers receive adequate training to sell them. It expects to wrap up the investigation by the end of the year. BaFin spokeswoman Anja Schuchhardt declined to comment beyond the release.

BaFin may be focused on credit-linked notes because the securities “gained some fame from an investor protection perspective” after litigation arose over alleged mis-selling in Germany in 2009 and 2010, according to Schaffelhuber. Investors who lost money on “first-to-default” notes that contained default swaps on Lehman Brothers Holdings Inc. sued banks after the lender declared bankruptcy in 2008, he said.

The review is unlikely to result in an outright ban on sales of the securities because of Germany’s “extremely liberal” attitude towards structured notes, said Schaffelhuber. “We have a saying here that everything is forbidden except driving fast on the motorway and selling derivatives to mom and pop,” he said. “There’s some truth to that.”

What’s more likely to follow are guidelines for advisers on selling the securities or limitations or a ban on sales to individuals of the riskiest securities, such as first-to-default or “zero-recovery” notes, according to Christian Storck, a partner at Linklaters LLP in Frankfurt who advises banks.

Top Issuer

Germany’s Landesbank Baden-Wuerttemberg issued as much as $13.5 billion of notes across 246 deals last year, data compiled by Bloomberg show. Bernd Wagner, a spokesman for LBBW, declined to comment.

Italian regulators recommended against selling credit-linked notes to individuals last January, saying they are "particularly difficult" for untrained investors to understand. The U.S. Securities and Exchange Commission forbids banks from selling them in registered form because they’re too opaque, Amy Starr, chief of the office of capital market trends, said in a May 14 speech.

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