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Retail Derivatives: Overpriced at a Broker Near You?

Wednesday, August 5, 2009 - 00:00
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We wrote this week about retail derivatives, one of several ways banks are still playing the risk game. So just how risky are these structured products for the average investor?

Good luck figuring that out. If history is any judge, the answer is “pretty risky” — and investors won’t do a good job evaluating the risk. Research suggests you’ll probably be overpaying for what you get.

We’ll get into why in a second, as well as why it’s probably a good thing for the banks issuing them. But trends in the retail-structured-product market — yes, there’s a vibrant one — suggest this isn’t just a problem for the well-to-do: has reported steady growth in the market since the financial crisis peaked last fall, to $15 billion in the second quarter.

The crux of the issue here is complexity: It's tricky enough to piece together the mechanics of these instruments -- and once you do that, there's still no guarantee you'll have a good grasp of whether you're paying too much for what you get.

Take these examples of recent offerings from major financial institutions: 

  • 6-month LIBOR and S&P 500 Index Range Accrual Notes: Issued by Morgan Stanley, these pay an attractive and guaranteed 10% interest for two years, and after that continue to pay 10% a year -- except on days when 6-month USD Libor goes over 7%or the S&P 500 falls below 675. Granted, both of those look pretty unlikely at the moment, but the financial crisis shows rare events can happen -- the S&P 500 came close to 675 within the last year, a level unseen since 1996. Moreover, Morgan Stanley can cancel the notes at any time if they get too costly; otherwise, investors are locked in until 2024. (Morgan Stanley says it helps train brokers in identifying investments suitable for their customers.)
  • Reverse Convertibles: UBS has issued a slew of these lately. A recent prospectus offered investors six-month notes with rates of 16.5% to 20.5% annual interest (so investors would actually get roughly half that much), but each class of notes came with a twist tied to the share performance of specific stocks, including Sprint Nextel, Freeport-McMoRan Copper & Gold and Potash Corp. of Saskatchewan: If the shares stayed above a certain threshold -- 60% of the late-July share price for Sprint, 70% for the other stocks -- and the share price for that issue closed above the starting price at the end of January 2010, then investors holding reverse convertibles tied to that company's stock get their principal back. Otherwise -- in other words, if the shares close down andthe stock price broke through that floor at some point during the six-month period -- the investor gets back as much stock as their investment would have bought in late July. (UBS, which has offered similar securities recently on Ford, General Electric, JPMorgan Chase and others, declined to comment.)

Got that? Despite the apparently high interest rates, these can be attractive for investment banks to sell. In part, that's because what matters to them is the spread over their cost of funding. Morgan Stanley's own funding costs correlate with Libor, so an instrument like the one above helps the company hedge; as long as the difference between its funding costs and the promised rate works out to no more than the cost of buying a similar hedge from another bank, it wins. The UBS instrument amounts to a put on the various stocks linked to the notes; if paying Joe Investor 20.5% costs less than its cost of funding plus the cost of buying a similar put from, say, Goldman Sachs, UBS wins.

What about investors? Let's take the UBS issue. You're buying concentrated downside stock risk in return for a nice yield -- if the stock dips sharply over six months and closes down, you eat the stock losses. Put another way, if Sprint tanks, UBS wins and you lose, unless your coupon payments cover the difference; if Sprint soars, UBS gets the upside, and you get your money back with interest. Good deal or bad?

To really answer the question, finance experts and market participants say, you've got to understand the value of the put option you're selling the bank in return for the juiced up interest rate. Investment-bank traders are going to use models based on the Black-Scholes formula, factoring in expectations of the stock's future volatility (usually extrapolated from its past volatility) and the length of time the put persists. How many retail investors, or their brokers, are likely to be able to do that reliably?

Not many, as it turns out. In the early 1990s, one former industry lawyer tells me, puts on the Nikkei were sold just weeks before the market tanked. Deeply in the money though the puts were, institutional traders quickly calculated that the puts would be worth more over time, and by rights they should have traded at a premium over their exercise value; but instead of selling them, retail investors were exercising them right and left.

More recently, an analysis of the Swiss market for similar products in April 2007 found that they were overpriced by 3.4%. And the higher the nominal coupon on the notes, the more more overpriced they were, "indicating that investors tend to overweight the sure coupon and underestimate the risk involved," concluded University of Fribourg finance professor Martin Wallmeier and coauthor Martin Diethelm.

The conclusion echoes other research, including a 2003 look at the German market for structured products -- which found "significant differences in the pricing of structured products, which can mostly be interpreted as being in favor of the issuing institution" -- and a 2005 paperby Central Michigan University and Florida Atlantic University researchers, which found that products similar to UBS's exhibit "significant pricing bias in favor of the issuing financial institution."

Brokers are likely to want to sell these kinds of instruments. I'm told they can pay 1.5% commissions or higher -- attractive compared to what plain-vanilla stocks and bonds might pay -- and prospectuses indicate total commissions (wholesale and retail) as high as 2.25%. Investors may be drawn by the high interest rates or the novelty.

But not surprisingly, some see these kinds of instruments as a textbook argument for beefing up brokers' obligations to investors. Right now they must only conclude that a security is "suitable" for a given investor -- not that it's the best option for them. There are calls on Capitol Hill for making brokers stick to the same fiduciary standards that investment advisers must follow -- obliging them recommend investments in their customers' best interest.

That only makes sense, argues Tamar Frankel, a Boston University law professor who wrote the book on money-manager regulation (as well as ones on securitization and fiduciary law) and has lately explored the role of trust in business. Indeed, she would take the argument further. "I would say that if the underwriters offer this type of document, they must be fiduciaries, regardless of the disclosure they provide," Frankel told me by email.

"Such instruments are very close to the doctor's advice. They become dangerous, like a medicine unwisely taken without understanding its consequences (unless you spend 9 years studying medicine). So if the broker's advice is not a professional advice ... and if the broker has serious conflicts (which the broker has) and does not explain the conflict (which he hardly ever does), the underwriter and the brokers should be liable for the losses to the investors."

Expect the brokerage industry to put up a stiff fight if that gets near President Obama's desk.