Structured products are a hugely profitable business line for investment banks. They allow banks to package up risks and pass them on to third parties in the form of an investment where the buyer may win or lose, but the seller always stands to gain.
The enormous success of firms such as Société Générale and BNP Paribas, which have for many years leveraged their strengths in equity derivatives into the structured products and generated handsome profits, has prompted every major investment bank to try to get into the market.
With more players, the business has moved into new areas. As well as equity-based products, deals linked to fixed income, foreign exchange and commodities have also become widespread.
At the same time, structured products have become much more popular with investors because of the potential for enhanced returns that they can offer in a low-yielding, low-volatility environment. It’s hard for an investor’s eye not to be turned by a deal offering a guaranteed return of 6%, even if it is for a limited period.
That’s what investors were offered in a spate of structured issues that came to the market in a 12-month period beginning in the first half of 2004. As our cover story on page 60 reveals, investors who bought these deals are now sitting on a 20% loss, or more.
A case of buyer beware? Perhaps not. These deals were bonds whose payout, once an initial high coupon had disappeared after 12 months or more, was linked to a tier 1 perpetual constant maturity swap. Sounds complex, doesn’t it? The type of thing that should only be sold to savvy institutional investors who can comprehend the risks. But these deals were sold to one of the least sophisticated investor bases: retail buyers and, in particular, the clients of private banks.
Such incidents throw up two issues. Structured products are, in the majority of cases, a welcome addition to the range of investment products that the capital markets offer. But banks and their selling agents must be impeccably scrupulous about what type of deal they sell to different classes of investors; otherwise they risk tarnishing the entire market.
The precedent already exists. Selling CDO-linked products to retail investors in Italy was probably not a great idea in the first place. But when, in 2004, Parmalat went into bankruptcy and the Italian grandmothers were sitting on high losses, the local regulator effectively shut down what had been the testing ground for the most esoteric structured products. In countries such as Germany, leading banks are trying to form a voluntary code for the selling of structured products, driven by the fear that their regulator may do it for them and limit future opportunities.
Secondly, it raises the spectre of one of the longest-standing suspicions in the financial markets: that investment banks put pressure on their private banking arms to sell their most profitable products (often these structured deals) to wealthy clients.
Complaints about the increasing weight of regulation are becoming more common in Europe. But situations such as the CMS tier 1 deals undermine opposition to stronger controls. No doubt the selling banks did their due diligence and spent time with the lawyers going through the documentation. But the complexity and nature of the product always stood in the way of clarity.
Caveat emptor is too frequently used as a defence against the indefensible.
