Is your money really safe?

7 July 2010

The collapse of US investment bank Lehman Brothers showed that an alarming number of structured products were making promises which were literally too good to be true. Now, the industry’s fight to prove that it can offer low-risk, high-return products is being undermined again, this time by the turbulence in Europe.

Will the latest concerns over the health of the banking sector spell the end for structured products?

While the name may not be familiar, the products almost certainly will be. More than £42 billion is invested in these products, which are promoted by virtually every bank and building society as a way of getting equity-type returns without the risk.

Their names sound reassuring – Target, Protected and Guaranteed are typical words – and their offering sounds simple enough: you get a certain percentage of the rise in the FTSE 100 or a similar type of index, which can be as low as 10 per cent or as high as 200 per cent. If the index falls, however, you will get all, or most, of your money back.

Yet the structure behind these products is far more complicated  – a complexity which explains why so few investors and advisers were aware of how risky they were. Exposure to the underlying asset class is often achieved through a derivative product issued by an investment bank. The guarantees are also usually achieved through a financial product issued by an investment bank.

As the collapse of Lehman Brothers in 2008 showed, a derivative is only as good as the bank which stands behind it. Thousands of investors lost out last year as companies such as ARC Capital & Income, NDFA and DRL, all of which used Lehmans as counterparty, went bust. Then Keydata, which supplied structured products to many banks and building societies, collapsed amid a Serious Fraud Office investigation.

These disasters sparked a  rather belated investigation into the structured products industry by the Financial Services Authority. As well as paving the way for investors who had lost money to make claims under the Financial Services Compensation Scheme, the regulator wrote to the biggest promoters of these plans telling them to review their sales and marketing procedures. The FSA is still investigating the area and is expected to announce its findings by the end of the year.

Structured product providers reacted by insisting they should not all be tarnished by the Lehman connection, citing a range of reasons that they were different: they use only top-rated banks as counterparties; they spread the risk among a number of different banks; they use government bonds to back their promise; their products are conservatively managed and so on.

Their protestations have had little impact: in our sister publication, Money Observer’s own, admittedly unscientific, survey of financial advisers, none would recommend structured products. While they cited a variety of reasons, one was constant: it is impossible to assess the credit risk in these products without carrying out far more analysis and investigation than financial advisers are willing, or usually qualified, to carry out.

Perhaps because of the failure of that campaign – or possibly because they fear a bigger crackdown by regulators – the industry has gone to ground. Leading players such as Barclays and Morgan Stanley refused to be interviewed by Money Observer and even the UK Structured Products Association, the trade body set up to promote the industry, struggled to come up with a response to our questions.

That is extremely worrying because, while Lehman’s collapse may be fading into history, credit risk remains a major issue – in fact, it could soon be thrust back to the top of investors’ worries. The Greek crisis has turned the spotlight on to the financial health of Europe’s banks again. There are constant rumours about which banks are dangerously exposed to the debt of the Greek government, or to that of Spain and Portugal, which are in almost as parlous a financial position.

Investors were particularly nervous ahead of the publication of the results of a ‘stress-test’ of Europe’s banks, being carried out under the auspices of the European Central Bank. The impact of a sovereign debt crisis is likely to be one of the key variables which banking regulators will be testing for.

Martin Bamford, managing director of Informed Choice and a chartered financial planner, warns: "The eurozone crisis could trigger further bank collapses which could undermine the backing of some structured products in the UK.  The trouble is, it is close to impossible to understand where the financial protection actually rests with a structured product."

Tim Cockerill, head of collective investment research at Ashcourt Rowan, agrees. "It is clear there are significant stresses in the [European] banking system. Counterparty risk is a big issue. Recent experience has shown that [a bank] can be rated highly but the reality is different."

Robert Lockie, a partner in Bloomsbury Financial Planning, says: "I have not got the time, and I suspect most advisers do not, to go and dig into the detail of the operations of the guaranteeing banks and to ferret out the potential liabilities which might be lurking there. A lot of derivative instruments are not on the balance sheet anyway.

"And your bank may have no derivative exposure but it may have lent to other banks which do. And you have to monitor changes in the future. Is it worth doing all that for a £50,000 investment in a structured product?"

The fact that guarantees underwritten by banks can be unexpectedly flimsy is not the only – or even the major – reason for avoiding structured products. There are plenty of other drawbacks too.

The drawbacks

It is impossible to work out what your investment will be worth. The products promise a return of, say, 50 per cent of the gain on the FTSE 100 between two dates but, apart from the impossibility of forecasting what that gain will be, different providers calculate the gains in different ways. And, for much of the past five years, there has been no gain so investors will have had to fall back on the guarantee that they will get just get their money back – so why lock yourself in and pay the costs of these products to get a return worse than a building society?

"It is an extra layer of complextity which does not have much practical benefit," says Lockie. "If you want a return half as as much as the FTSE 100, just invest half your portfolio in it."

Of course, anyone buying a unit or investment trust is also buying blind as no-one can predict how they will perform. But it is easy to buy and sell these trusts; with structured products, investors are locked in for a fixed term and could face big losses if they try to get out before the product matures. And, while some products lock in returns as they go along, others can be severely affected by a sudden stock market crash just before they mature.

"They are sold by banks and building societies – that tells you all you need to know," says Mark Dampier, head of research at Hargreaves Lansdown. Indeed, many of the mis-selling scandals of recent years – like precipice bonds, endowment mortgages and payment protection insurance – have been products which are sold mainly by banks and building societies.

"I have never seen anything I particularly wanted to buy which has a fixed investment term –  I want something I will be able to roll over," adds Dampier.

He also points out that structured products generally pay no income during their term. "A dividend is a massive part of investment returns, if you take the dividend away, you take away a big chunk of these returns."

While charges are rarely spelled out in detail, the complex structures and expensive guarantees mean they are an expensive way to invest. The lack of transparency about these costs is indicative of how complicated they are.

"My over-riding view is that, the simpler and more transparent a product is, the better," said Cockerill. "That way, you do not risk unpleasant surprises."

The Investment Management Association has complained that these products carry far fewer restrictions about the way they are sold, and how they can be marketed, than unit trusts – yet they have been shown to be far riskier.

The irony is that, when the measures outlined in the Retail Distribution Review, which governs how advisers must behave, come into effect in 2012, advisers will have to consider structured products for their clients.

"Our view here is that we can take a view generally as a firm that we will not use them, giving reasons," says Lockie. "If a client wants them we will have to tell them to go elsewhere."

This article originally featured on our sister publication's website -

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