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The Next Big Thing - Structured Inv

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Jan 5, 2008 10:17 pm

A poster in a previous thread mentioned the “coming storm” in the markets. I couldn’t agree more. I also think a lot of investors believe the same thing. For that reason, I believe structured investments (SI’s) are going to be the next “big thing”. People seeking shelter from the “coming storm” are going to dump their money in these SI’s 1) without knowing exactly how they work, 2) the hidden charges involved, or 3) the financial ability of the product sponsor to carry out the terms of the investment.

  It's another mortgage debacle waiting to happen; although, I may be about 3-4 years too early to make that kind of statement.   1) Is a given. Gee, how many times have we seen this: internet stocks, LTCM, CDO's, etc. 2) The more complex and "sophisticated" the SI, the better to hide charges. Like Warren Buffett said (paraphrased): "If the financials are too complex, someone is hiding something." 3) Newbies are learning that AAA doesn't necessarily mean AAA. Example: CDO's & SIV's. What's backing-up the promise of the product sponsor to do as they say? An SI with fantastic terms might be the last desperate attempt, by the product sponsor, to shore up their business. You really want in on that? I'll pass.   So, what to do? For me and my clients, plain vanilla tastes just fine. Asset allocation with a heavier than normal topping of dividend-paying foreign stocks and high-rated foreign bonds.   My investment theme with my clients (from day one actually) is high quality and simplicity. Wanna speculate on cr*p? Open an e*trade account!    Just a poor schlob's opinion.            
Jan 5, 2008 11:43 pm

We have seen a huge push of structured investments at my firm.  I do not use them, most other advisors do not either, but a few do love them.

Jan 6, 2008 2:00 am

We have seen a huge push of structured investments at my firm.  I do not use them, most other advisors do not either, but a few do love them.

  Be prepared to be treated as an outcast, by your fellow SI-selling brokers. In the coming months, you'll hear of brokers selling the heck out of these things and making the big bucks. The temptation to give in and sell SI's will be great. At sales meetings, you'll be singled-out as someone who isn't "getting with the plan".   In the meantime, the markets will be roiling and your clients will be feeling the pain. On days when the markets has dropped 500-600 points and you're stuck putting out fires, your fellow SI-selling brokers will go out golfing and partying, confident their clients' principal is protected. Oh yeah, life will be easy (for them) for a while...   Then 12-24 months down the road, the unthinkable happens. A major product sponsor is found to be insolvent. The counterparties to the derivatives held by the sponsor, that formed the structure of various SI's, were found to be in violation of numerous loan covenants. The lenders to these counterparties have taken action to seize the assets and liquidate what they can. The SI sponsor is already highly leveraged, possessing little collateral with which to carry out the terms of the SI product and; therefore, must declare bankruptcy. The investors in the SI products are now considered "unsecured creditors" of the sponsor and must wait for the final ruling from the bankruptcy judge to determine how many "cents on the dollar" they will recover from their investment.   In the meantime, the market has finally rebounded, and your clients' portfolios are in positive territory once again....Oh, and by now, your fellow SI-selling brokers have either left the business or are in arbitration.    What I've written above is a synopsis of what I've seen and gone through, in my 15 years in the biz. I've seen internet stocks, leveraged bond funds, CDO's, etc. wipe-out clients and brokers. I was never the top broker during my wirehouse days, but I'm still around and arb-free.    I simply stick with what makes sense.   Not preachin', just sayin'.
Jan 6, 2008 5:29 am

dobe I couldn’t agree more…

Jan 6, 2008 6:39 am

Guy’s I have been considering these lately and can’t see what you’re saying exactly.  (I’m trying to understand tham before I use them.)  Many of these are FDIC insured products, some even by banks which are deemed “Too big to fail”.  Low risk any way you slice it.

  The others by highly rated financial institutions.   Which should be  the same level risk as buying a bond of one of these institutions.    And doberman, it sounds like you're leaning into two of the best performing asset classes of recent years, foreign stocks (esp value) and foreign bonds.  You seem to think these are going to continue to outperform other asset classes.  Not sure if I can buy that these will perform better over time.  (Nor that you can predict the timing.)     Are these SI's really as bad as you think? 
Jan 6, 2008 7:23 pm

I’m using structured notes on a limited basis. I’m looking at one right now from JP Morgan that runs 18 months, tracks the S&P and Russell, is FDIC insured, and pays 25% if it stays ±18% and 2% if it doesn’t. Sure, there’s a decent liklihood that it will only pay 2%, but I can think of many alternatives that pay less or may even lose clients money, and that includes pure bonds such as treasuries.

My point is that while I respectfully disagree with some of Dobe’s arguments, there is wisdom in his warning to know what you are offering your clients. I have little doubt that there are dangerous varieties of structured notes out there that will burn you and cost you clients. There is a reason that LPL requires (1)training before you can sell, (2)additional disclosures for clients to sign off, (3)options approval for some varieties of structured notes and (4)recommends no more than 10% exposure to this asset class.

Thanks for a thought-provoking post, Dobe…I promise I’ll be careful…

Jan 7, 2008 12:05 am

I don’t fully agree either Doberman, at our firm we write all of our own Structured Notes(investments).  What I am refering to are only the products our firm puts out there we don’t do any third-party SI’s, so I don’t know what all is out there.  However the SI we issue and the SI’s I have put clients into are extremely safe and have actually done very well in the past couple of years. 

  We write Accelrated Return Notes which take an index or individual stock and actually write our own 14 month (for long-term cap gains) calls and puts on the index or stock to give the client a 3-to-1 upside to downside on the index.  I looked at a figure the other day that we put out on SI's and we have written somewhere around 36 of these ARN's and only 4 of them have not capped out, which means made the client 3 times what the index made.  They are very sophisticated, but it's not like we are playing craps with someones IRA.    I think they are great for the guy who comes in after reading some article in "Money" that tells him to only invest in index funds everything else is a rip-off.  I ask him "would you rather invest in a S&P index fund that gives you a 98% return to the index or this S&P ARN that gives you 3 times the upside of the S&P and 1-to-1 on the downside.  It's the easiest sale I can make, and it's the right thing to do for the guy. 
Jan 8, 2008 1:19 am


  I'm with Jones and relatively new, so I know there's a lot I don't know but...  If there is truly 3x the upside and the same downside, why isn't EVERY equity investor buying these?  And if the "secret" gets out will the risk/reward be the same as now?
Jan 9, 2008 1:31 am


  I'm with Jones and relatively new, so I know there's a lot I don't know but...  If there is truly 3x the upside and the same downside, why isn't EVERY equity investor buying these?  And if the "secret" gets out will the risk/reward be the same as now?[/quote]   Like I originally said I have no experience with "outside the firm" Structured Investments so I do not know the overall availability of SI's in the market.  They are still realitivley new and not well understood, but as more advisors understand what they can provide for the client I think you will see a really large flow into SI's in the next couple of years.  Think ETF's, now we know they are a great tool to use, but it took people a while to really feel comfortable enough to invest in them.  In our firm in 2007 alone we have doubled are overall numbers in the Accelrated Return Notes(SI), it's catching on and people are making real money.    If the "secret" gets out will the risk/reward be the same, I would say the way it's structured now, NO.  The more money you see flowing into these products the harder it's going to be to make money on the Note just because the demand would start to play with the volitility in the options.  The Note would have to evolve to handle large inflows in cash, we'll see what happens. 
Jan 9, 2008 1:41 am

The way I see it: SI’s are simply a way of transfering all or a portion of market risk to another party. The ability to carry out the terms of the SI depends on the financial strength of that other party. But there’s a very real possibility that the other party has employed one or more counter parties to help it carry out the terms of the SI. In fact, hedge funds come to mind, as active participants with the majors in these types of deals. Given the fact that hedge funds were famous at obtaining 8-10 times leverage for every dollar in assets, I’d think SI’s would be fertile ground for “harvesting returns”.

  If I ever considered recommending an SI, it would have to be transparent as to its structure and expenses. Being able to analyze the structure would allow me to determine if it made logical sense and who was assuming the market risk. However, I've rarely seen an SI that showed how it worked and how much it cost. Too much of a "black box"-feel for my taste.   Also, for those SI's that sport an FDIC guarantee, be careful. Sure, FDIC offers a return of principal if the institution fails, but there are conditions involved in this guarantee:   1) There could be a considerable delay in returning the principal. 2) The terms of the SI will no longer be honored, since those terms were backed by the now failed institution. For example, assume the SI offers 3x market return, then the institution fails; the money could just sit there earning no return, while the market could soar.  3) While all this is happening, the FDIC is looking for another institution to buy the one that failed. Assuming a buyer comes forth, the investor may or may not be given the opportunity to back-out of the investment penalty-free. If not allowed to back-out, then the investor is subject to the terms the buyer imposes on the SI. For example, if the SI had a 5-year term and 2-years later, the institution fails; the failed institution's buyer could pay the investor only 2%/year interest, for the remainder of the term.   The same also goes for failed banks. The FDIC guarantee only applies to the principal, not the terms of the CD/investment. Earning 10% on a bank CD? Great! I just hope your bank doesn't fail, 'cause the buyer won't be obligated to pay that rate.   Let's be careful out there and for gosh sakes, wear protection!
Jan 9, 2008 3:56 am

Good to hear everyone’s thoughts on these as I’m still on the fence.  Haven’t rolled them out to my clients yet, but something I’m considering.  I certainly don’t like them as a “one and done” product, but as place to park $10,000 of a $500,000 portfolio, I could see that as an option.

While I haven't done that much research myself, I understand that structured notes have been quite popular and accepted in Europe for quite sometime.  As I said, I'm still doing more research of my own, but I appreciate the debate.   Thanks everybody for your thoughts and viewpoints.
Jan 9, 2008 6:49 am

From the FDIC’s website

  How long does the FDIC take to pay insurance on deposits after an insured bank fails?

Federal law requires the FDIC to make payment as soon as possible. Historically, the FDIC pays insurance within a few days after a bank closing either by establishing an account at another insured bank or by providing a check. Deposits purchased through a broker may take longer to be paid because the FDIC may need to obtain the broker's records to determine insurance coverage.