The Dark Side of Wall Street, Part 1

“Wall Street’s sales and marketing machine is continuously pumping out fairy tales: fanciful fables filled with legendary deeds and winning exploits. The only differences between many of the Street’s product ‘innovations’ and other types of fairy tales are that the stories are designed for adults, and they rarely have happy endings.

Like the apple given to Snow White by the Evil Queen, these products offer enticing features designed to lure investors, but almost all have one thing in common: Despite their seeming appeal, they have attributes that make them more attractive to the seller than the buyer. These products typically fall into the category called structured products. ” – Larry E. Swedroe and Jared Kizer.

Another “Safe” Bet Leaves Many Burned is a good overview article by Eleanor Laise on several “structured products”.  It appeared in the November 11, 2008 edition of The Wall Street Journal.

The gist of the story is that Wall Street firms sold complicated products which promised high returns with little risks. The risks were understated; the returns never materialized.

To see how complicated structures products are, read this article.

How many brokers or investors really understood the mechanics behind such whiz bang inventions such as the following?

• Principal-protected notes
• Reverse convertibles
• Return-enhanced notes

The projections (a.k.a. promises) for these products were based on hypothetical scenarios best viewed through rose-colored glasses. Naturally, disappointment followed when the outcome proved otherwise.

All of this brings to mind the old oft-told advice, “If it sounds too good to be true, it probably is.”

Here are some choice quotes from the article:

In recent years, Wall Street firms raced to sell small investors “structured products” linked to everything from stock indexes to currencies. They were often marketed as a relatively safe way to get a slice of market gains.

Now, in the midst of the market turmoil, many investors holding these complex products are getting burned.

With structured products, which are issued by big Wall Street firms, investors can get exposure to commodities, stocks or other investments without actually owning those assets. The products may promise to give investors a portion of any gains in, say, U.S. stocks or Asian currencies while offering some protection from market losses. They typically behave like packages of bonds and options, but what investors are actually buying with most of these products is the unsecured debt of the issuer.

With Wall Street in turmoil, many of the risks of structured products are now coming to light. “Reverse convertibles,” for example, offer fat yields but leave investors exposed to steep losses if a stock price collapses. “Principal-protected notes” typically are designed to return the principal investment at maturity, along with some portion of the gains in an underlying benchmark, such as the Standard & Poor’s 500-stock index. Yet investors selling before maturity may not recoup their full investment, and the principal protection depends on the issuer’s ability to meet its obligations. Many “return-enhanced notes,” meanwhile, offer some multiple of an index’s gains but provide no protection against stock-market declines.

When an issuer goes belly up, as Lehman Brothers Holdings Inc. did in September, structured-product investors are generally left standing in line with other creditors and may face a long wait to determine how much, if anything, they’ll be able to recover. Some Lehman structured products now are trading for less than 10 cents on the dollar, according to SecondMarket Inc., a marketplace specializing in illiquid assets, which says it has heard from investors holding more than $2 billion worth of Lehman structured products.

The problems are coming at a time when small investors have been on a structured-product buying binge. This year through early November, nearly $34 billion worth of structured products were sold to small U.S. investors, surpassing the $33.5 billion sold in all of 2007, according to StructuredRetailProducts.com, an independent research firm.

The recent upheaval is particularly painful for investors because structured products are often sold to people who are in or near retirement and seek relatively secure or high-yielding investments. Principal-protected notes, which were offered by Lehman and other issuers, were generally designed to at least give investors their original investment back at maturity, and were often touted as safer than direct investments in, say, a stock-market index. The double-digit yields commonly offered by reverse convertibles, meanwhile, may be enticing to people living on a fixed income.

The current problems come on top of longer-standing concerns about these investments. They can be difficult to sell for a decent price before maturity and often carry embedded fees that are tough for individual investors to decipher. Regulators in recent years have raised alarm bells about structured products, voicing concerns about the marketing and sales practices of brokers who sell them.

Conclusion

While it is nice that “regulators in recent years have raised alarm bells about structured products,” that hardly seems enough to protect investors. Transparency is missing for these products, because they “often carry embedded fees that are tough for individual investors to decipher.”

This year has been particularly difficult for all investors, as most strategies have failed, at least in the short term. Even so, in investing, some things are constant. To wit:

• Risk and reward are inextricably related. (There is no such thing as a free lunch.)
• A straightforward approach is usually the best.  Keep it simple: Diversification via low-cost mutual funds.
• Avoid hyped synthetic, “enhanced” products, which typically have high fees and hidden risks. Complex structured products benefit Wall Street much more than they do investors.

Forgive me for being cynical, but it comes from listening to fee-only financial advisors who used to be stockbrokers. They have, in essence, come over from the “dark side.”

One thing I am quite confident of is that the brokers were compensated handsomely for selling these “safe” investments. Rick Ferri (a former stockbroker) is quoted in The Bogleheads’ Guide to Investing, “Wall Street wants you to believe they are there to make money for you, but their true purpose is to make money from you.”

To be continued.