The Campaign to Make Structured Notes Transparent: Is the SEC on a Fool’s Errand?

Structured notes have been around since the 1980s, but for years sales were restricted to institutional investors.  With the recent surge in sales to retail investors, the SEC is demanding more transparency.  According to American Banker, over the past twelve months the SEC’s Office of Capital Market Trends has been trying to obtain information from Citigroup, Bank of America, JPMorgan Chase and other structured note issuers about their pricing practices and risk warnings for these products.

The question is whether it is even possible to make structured notes transparent.

Structured notes come in many forms, including the reverse convertibles that are the subject of our December 19, 2012 article.  These products are so complex and variable that it is difficult to come up with a single definition that applies to every type of structured note.  In their most basic form, they are unsecured loans that – instead of paying interest like regular notes and bonds – pay returns based on a derivative tied to an index, equity or fund.  Like any debt security, structured notes are subject to the credit risk of the issuer.  However, that risk is often not made clear to retail customers.  The SEC is asking that sellers provide prominent warnings about credit risk.

Structured notes are being marketed to investors as attractive alternatives to bonds in the low-yield environment that currently exists.  However, the pricing of structured notes is not at all the same as the pricing of bonds.  The SEC is concerned that issuers and financial advisors are not adequately explaining those crucial differences to investors.

Pricing Concerns: Structured products are difficult to value, since they are illiquid securities that often reference hard-to-value derivatives.  Furthermore, the issuer often adds inadequately disclosed fees that add to the cost to the customer.  The absence of an active secondary market for structured notes can hide both the inflated valuations and the added costs.

It is common practice for issuers to estimate the value based on the prices of other bonds and derivatives that are traded more often.  This practice can lead to estimated valuations that are not just inaccurate; they can be misleading.

In a letter to JPMorgan quoted in American Banker, SEC Office of Capital markets Chief Amy Starr expressed concern about using more widely traded derivatives to arrive at these estimates (called “mid-market inputs”).  “If you do not use mid-market inputs, we believe you should disclose this fact, describe what you use, and the risk that the embedded derivative is being valued differently than other similar derivatives.”

Of even more concern, is the possibility that the issuers’ valuations may purposely inflated.  Sometimes multiple, inconsistent values are placed on the same product.  The American Bankerreports that the SEC is also questioning banks’ practice of providing customers with valuations for the notes that are higher than their own internal valuations.

Can the SEC make structured notes transparent enough for the average investor to understand their value and their risks? Not according to Norway.  In 2008, the Norwegian government made it unlawful to sell structured notes to retail investors. Five years later, the SEC is still trying to put duct tape on a product that may very well be unfixable.

Reverse Convertible Concerns

Reverse convertibles are a type of structured note.  It is essentially is an unsecured loan to a company – the note component – wherein at maturity the investor may receive common stock of a publicly traded company that the structured product is tied to as opposed to repayment of the principal amount of the loan.   In other words, if you buy a structured note tied to Microsoft stock, then the lender can repay you the principal loaned to you if Microsoft’s stock price goes up and, if the price of Microsoft stock goes down below the knock in level/barrier during the life of the loan, the investor can get put a predetermined number of shares of the stock to you instead of repaying any of the principal of the money loaned. Reverse convertibles can be notes tied to individual stocks or stock indexes or other indices. Also, firms sell inverse reverse convertibles, which have knock in levels when the underlying stock goes up rather than down.

You may own Reverse Convertible notes without even knowing it.   Because each brokerage firm has very different names for these products,  “Reverse Convertible” is usually not part of the name. Regulators share some of our concerns regarding these products.  It is our belief that the major brokerage firms are overselling reverse convertibles to fixed income investors looking for low risk products with better returns than are now available from traditional fixed income products.

The complexity of reverse convertibles leads some regulators to believe that many individual financial advisors do not fully understand the product they are recommending. Some regulators have also asserted that reverse convertibles should only be recommended to investors who are approved to do options trading.

Although trying to describe reverse convertibles can be complicated and confusing, it can be greatly simplified by replacing Wall Street with an individual investment advisor.  Consider, the following example:

One’s trusted investment advisor coming to their home one night and says, “I have a great investment for you. I would like you to give me a loan for $100,000 with a term of one year.”

He doesn’t say what he needs the loan for or even that he needs a loan.  Rather, he is recommending this deal to you as a good investment. He could go to the bank and borrow the money, but they would require him to secure it with collateral that the bank could seize in the event he didn’t pay back the loan with all interest.

He says, “so, as your trusted advisor, in order for me to make this a good deal for you, I need that $100,000 on an unsecured basis.  As an incentive, I will pay you extra interest over the life of the loan.” He offers two methods of recovering your money, “when the loan matures, either you will get you your money back with interest or you will get back today’s value in the stock of Microsoft which is selling at $25 a share, so you would get 4000 shares.”

What the client may not understand is that the financial advisor determines whether the loan will be repaid or whether he will get the stock instead. Simply put, the investor gets the $100,000 loan repaid with a bit of interest back if Microsoft stock goes up, or the investor gets 4,000 shares of Microsoft stock if the share price drops.  In the latter case, the investor gets  less than the original amount borrowed. This trusted financial advisor assures his client that this is a good deal for him.

Now, setting aside the significant risk of loaning significant funds on an unsecured basis (credit risk), this trusted advisor now has the client’s $100,000 to use or invest however he sees fit. For the sake of this example, let’s say he already owns the 4,000 shares of Microsoft in his personal portfolio when he makes this proposal. If Microsoft’s stock drops to $10 a share, the trusted advisor is covered. He simply delivers 4,000 shares of Microsoft, now valued at $40,000 and he  keeps the $100,000. He just purchased $100,000 for only $40,000. If the price of Microsoft goes up to $50 a share, the advisor sells his 4,000 shares of Microsoft for $200,000, returns the investor’s $100,000, and pockets the extra $100,000.  The client took on enormous risk in order to benefit the advisor, and while the client might come out a little bit ahead, it is the advisor who took on no risk and made all the profit.

The only difference between this example and what is going on today in major brokerage firms around the country is that the loan is being made to the Wall Street firm where your trusted advisor works rather than directly to your trusted advisor.

As you can see from this example, reverse convertibles pose unique risks in addition to the risks that are common to other forms of debt securities.  While a traditional short term note exposes the purchaser to the issuer’s credit risk (will the issuer be able to repay the debt?) and the liquidity risks of other forms of structured products, investors in reverse convertibles are also separately and additionally exposed to the risk of a decline in the price of the referenced stock.  Those risks were dramatically demonstrated when Lehman Brothers collapsed and the issuers of notes tied to Lehman stock were able to avoid repaying the loans by substituting worthless Lehman stock from their own inventory for the note.

Wall Street focuses on the potential for the (capped) gains in portraying this as a good investment  while ignoring the conflicts of interest and the profiteering off the deal by Wall Street.  However, we at Vernon Healy believe because this this huge conflict of interest is not acknowledged, even the best financial advisors may be hampered in their efforts to  put the interests of the client first.

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