Twice Shy On Structured Products?

By LARRY LIGHT Wall Street burned thousands of investors with so-called structured products that were supposed to provide healthy profits and limit losses. Brokers, hoping investors' memories are short, are pushing these high-fee products again with safety as the big selling point. Overall, investors purchased $5.9 billion of structured products in last year's fourth quarter, down 75% from 2008's first quarter, according to data provider mtn-i. Sales have started to nudge upward, rising 7% compared to the fourth quarter, though they are still way down from a year ago. "There's more appetite for them today than we had six months ago," says Lori Heinel, a Citi Private Bank managing director who oversees structured products. But the action now is with the safer kinds, called principal protected notes and return-enhanced notes. They have dethroned once-popular reverse convertibles, bond instruments that last year often posted losses worse than the market's. Brokers are eager to sell these structured products because commissions are high, but they face explaining why many of these products didn't perform as advertised. They also must convince clients that the firms behind these products are solid. Investors who bought products backed for firms that failed, such as Lehman Brothers, have big losses. Structured products are distant cousins to other derivatives such as credit default swaps and collateralized debt obligations that helped sink the world financial system last year. The Obama administration has said it wants tighter regulation of derivatives, and structured products may well be swept up in that. The Norwegian government last year banned selling structured products to individuals, reasoning they were too complex for people to understand the risks. Before the bear market hit, structured products sold exceedingly well. Sales surged from $62 billion in 2006 to $105 billion in 2007, then lost altitude as 2008 wore on, finishing at $70 billion. Unlike, say, mutual funds, structured products aren't a portfolio of securities. Instead, they are a contract in which the issuer, often an investment bank, promises to pay the purchaser specific payments in specific circumstances. When Lehman Brothers Holdings Inc., which floated at least $900 million in structured products last year, filed for bankruptcy in September, investors sustained big losses. Many are hoping to recover just 20% of their investment, says John Barry, chief executive of fixed-income trading platform Bonds.com. Jay Wang, a 33-year-old oncologist, and his brother Jimmy, 32, a dental student, last year invested almost $70,000 in Lehman principal-protected notes, glad to be in one of the safest structured products. Now, what is left of their money is mired in court. The brothers, who bought the notes through a Houston branch office of UBS Financial Services, have filed an arbitration complaint against UBS with the Financial Industry Regulation Authority, in a bid to get their money back. UBS refused comment. Some of the worst blow-ups occurred with reverse convertibles, perhaps the most risky structured product. Following a single well-known stock such as Apple Inc. or AT&T Inc., these instruments are short-term bonds that give fat interest yet slam investors if the underlying stock tanks. Instead of getting their money back, investors receive the shriveled shares, valued at far less than the principal. "Reverse convertibles are dead," says Mr. Barry of Bonds.com. "They burned people badly." Dominic Annino, a retired contractor now 78 years old, invested $300,000 in two reverse convertibles offered by Wells Fargo Investments. Half of it was in reverse convertibles tied to Jet Blue stock; the other half was linked to IndyMac Bancorp stock. In an arbitration complaint filed with Finra, the Santa Monica, Calif., man claims he insisted to the Wells Fargo broker that he wanted nothing to do with the stock market, and was misled about how the instruments were connected to it. The broker told him he was investing in triple-A bonds of these companies, he contends. The holdings paid an appealing 16% and 17% annually. But when they matured after six months in late 2007, JetBlue and IndyMac stock had tumbled and he ended up losing money. Mr. Annino says he didn't know that, if the stock fell to a certain point, known as the "knock-in" level, he would be force-fed those lower-value shares, in lieu of his principal. Mr. Annino found himself the unwilling owner of JetBlue shares, down 36%, and IndyMac, off 34%, the complaint says. Wells Fargo says it disputes the claims and will "vigorously defend" itself. Among the most popular structured products these days are principal-protected notes where most of the initial investment is put into federally insured certificates of deposit to add another layer of protection. The rest is invested in securities that track stock-market indexes. In the past, this principal had been invested partly in the issuers' zero-coupon bonds. With these products, investors are shielded from market losses but only get a bit of upside if markets rebound sharply -- perhaps half the Standard & Poor's 500-stock index's gains. While they generally didn't harm investors in 2008, their sales also dropped because of the taint from other structured products. "They are a conservative way to play the market, especially in the CD format," says Phillipe El-Asmar, head of investor solutions at Barclays PLC's Barclays Capital. Write to Larry Light at larry.light@wsj.com