As Market Fear Heightens, Risky and Opaque Structured Notes Make A Comeback

Just as market volatility has picked up steam, stock brokers, who love the hard sell and the quick commission, have once again started to increase their push of risky structured notes.

Indeed, the markets have been capricious and startling. The Dow Jones Industrial Average, the mainstay stock indicator, has had 300 point swings on almost a daily basis over the past couple of weeks while the Chicago Board Options Exchange’s volatility index, dubbed the VIX, has also recently spiked to fresh highs.

Right on cue, stock brokers began pumping high risk, high commission structured notes, which “follow fear and volatility the way mushrooms sprout after rain,” wrote Wall Street Journal columnist Jason Zweig over the weekend.

“Over the two weeks that ended October 10, 343 structured notes totaling $2.17 billion were issued” by various investment banks. That’s more than three times the amount of deals issued over the same time last year, reported Mr. Zweig, who cited research by Exceed Investments in his report.

The ever cautious Zweig warned, if a broker pitches you a structured note: buyer beware.

“These short-term bonds are typically structured to limit or eliminate your exposure to losses while giving you a stake in potential gains, making them especially alluring in weeks like the one we just had, when stocks were glowing red,” Zweig reported. “But whether you should buy them depends on the exact terms of each note—and on whether you can trust your advisor when he says he understands them.”

Sound confusing? You bet, and that’s the way unscrupulous brokers and Wall Street banks like it. The problem with these products is that most financial advisors are not properly trained to sell them and can’t explain them to investors. The pitch is all about “upside” without a fair and balanced discussion of downside risk.

Zweig points to two recent offerings, one by Goldman Sachs, the other from Credit Suisse, as examples of structured notes simply larded with risk.

“These notes can be tied to stocks or other assets in countless ways—not all of which fully guard against loss,” Zweig wrote. “On Oct. 6, Goldman Sachs Group issued $1.5 million in structured notes linked to the Russell 2000 index of small stocks. You are protected against moderate losses and participate almost fully in decent gains.”

“But if the Russell 2000 goes up more than 25%, the note will pay no income at all; you will merely get your principal back,” Zweig reported. “And if the stock index goes down more than 15%, you will lose money, with the potential for your investment to go to zero, according to the offering document.”

“Notes priced by Credit Suisse on Sept. 30 have their own wrinkle,” according to Zweig. “In short, if the worst-returning index falls in price by 10%, you earn 16.5%. If it falls 20%, you break even. If it goes down 20.01%, you lose 40.02%. If it drops 50% or more, your investment goes to zero.”

Zweig concludes that, with notes like these, an investor is betting on a very specific, narrowly defined outcome. And investors can really be punished if they end up with something outside that outcome.

Do brokers understand the risks of such products and explain them fully to clients? Recent history shows they don’t, on both counts.

While some deals work the way they are designed, other structured notes have caused thousands of investors harm, all the while drawing the scrutiny of securities fraud attorneys. UBS and other brokerages sold structured notes in 2008, and many of those deals were issued by the now defunct Lehman Brothers. After Lehman filed for bankruptcy, the structured notes were worthless. The spate of lawsuits by customers and regulatory actions that followed underscored the complex and opaque nature of these critters and how investors were misled by their advisors.

Should the structured note sales boom continue, it is essential that brokers and investment banks make full and clear risk disclosure to investors. We are not predicting a Lehman-like collapse that would create panic and havoc in the broad market and also wipe out a swath of structured note holders, however, each deal is complex and laden with risk. Stay away if you don’t understand the devastating losses structured notes could create in your retirement savings.

Zamansky LLC are investment and stock fraud attorneys representing investors in federal and state litigation and arbitration against financial institutions.

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