In “A Short History of Financial Euphoria” the late economist John Kenneth Galbraith wrote, “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” Witness then, yet another Wall Street innovation: the Principal Protected Note – aka, the Structured Note.
Structured Notes are “IOUs” to pay the holder at a guaranteed rate of return (and a possible upside) in one to ten years which contain embedded derivatives that are tied to securities market indices, a stock, commodity, currency, or some combination thereof. They are marketed by many brokerages as if they are a virtual ‘no lose’ proposition—a guaranteed minimum rate of return plus an upside based on the stock market or other index. Sales of these products by firms like Bank of America, Bear Stearns, Goldman Sachs, Morgan Stanley, UBS, Wells Fargo, and Lehman Brothers have been robust–$40 billion in 2008 alone. They have been marketed under trade names like Merrill Lynch’s Market Index-Target Term Securities (MITTS), Citigroup’s Equity-Linked Securities (ELKS), Morgan Stanley’s Performance Leveraged Upside Securities (PLUS), and Protected Performance Equity Linked Securities (PROPEL).
So are they safe? Not exactly. First, remember that a note is only as good as the financial strength of its issuer, so if your long-time UBS broker sold you Lehman Brothers’ “Principal Protected Note,” Lehman’s bankruptcy in 2008 put an end to any illusion that your principal was really protected. And please do not believe that the fact that a bank is selling the Structured Note means it has FDIC protection; it doesn’t.
Another risk factor is the very complexity of these products. The interest rates paid on them are tied to a dizzying array of indices. Sometimes there are multiple reference indices as well as “caps” that limit the upside gains.
Liquidity is also a problem. Structured Notes do not trade often. Unlike stocks of public companies, this illiquidity means that if you need to cash out there are few buyers which mean poor prices. Obviously, the sellers of Structured Notes are in the business to make a profit. Typical fees for a “one-year note” are as much as 1.5-2% and can be higher for longer duration notes. The investment bank which issues the note gets a fee, and brokers who sell them may also get commissions.
Structured Notes are dangerous and complicated products with risks seldom understood by either the individual stockbrokers who sell them or the clients to whom they are sold. They should not have been sold to conservative investors. The only good news for those who got burned is that customers who were misled into buying these products and those for whom they were simply unsuitable, may be able to recover their losses by bringing claims in FINRA arbitration. Incredibly enough, however, brokerage firms have fought hard to resist claims of customers who believed that a note sold as “Principal Protected” was really protected. So don’t expect recovery to be easy, but don’t give up hope either.