After the demise of Lehman Brothers (OTC:LEHMQ), I recall reading an article about the end of structured products on Wall Street. The author's premise sounded logical given that the purchasers of Lehman's structured products were considered unsecured creditors in Lehman's bankruptcy.
Who would line up to "lend" money to a bank without either FDIC insurance or as part of the FDIC's Temporary Liquidity Guarantee Program? Hence, the end of structured finance. The end of a lucrative line of business for banks and, hopefully, less ways to lose money for investors.
Well, wrong. Structured products are alive and well. They may not be quite as daring as a few years back, but they are being sold with abandon and playing to investors quest for a deal too good to be true. Want a 10+ percent return with a relatively short maturity, plus the possibility to earn even more yield if underlying security does well? Would you like it even better if you were given ten percent downside protection? These are the kinds of deals that a proliferating in todays market satisfying investors desire for yield, growth, and safety. But it takes about 170 pages of disclosure to protect the issuer.
The main components of the typical deal aren't terribly complicated. To varying degrees, the bank buys the index or security, sells a call, buys some downside protection, collects their fee and uses the excess, if any, money. An investor could do the same thing for a lot less cost and without any credit risk. Plus, it can be done more tax efficiently than structured as all ordinary income.
What I find offensive is the credit risk. In these structured products you are making an unsecured loan to the issuer. You aren't making an investment in the S&P 500 Index or Ford (NYSE:F
) or a commodity. The issuer owns the securities. All the buyer has is the issuer's promise to pay. An investor should substitute 'Lehman' for 'Bank of America' (NYSE:BAC
) or 'Citigroup' (NYSE:C
) when considering a structured product. Do you want to be an unsecured creditor? If you buy, you will be.
Government bailouts have kept these types of investments alive. "Too Big To Fail" takes some of the risk out of making big banks unsecured loans. But government policies can change. There isn't a law that says the government will protect all stakeholders the next time a big bank self destructs. And sales pitches that sound too good to be true, usually are.
Disclosure: Author owns SPY