Go Ahead and Buy Structured Notes Even If You're Stupid


While today's Lehman lawsuit ruling is of most interest to those directly involved (Dick Fuld, Erin Callan, certain firefighters, UBS, Ernst & Young), it also contains a little item that may interest those involved in the structured notes business.

One of the many ways you could lose money on Lehman (owning its stock, being a derivatives counterparty, using it as a prime broker, or just having any involvement whatsoever in the global financial system) was by investing in its "principal protected notes," structured notes that are typically zero-coupon and at maturity return the greater of (1) par or (2) some higher amount based on returns on some other security or index (here's one Barclays issued last Friday). These are a way for banks to get cheap funding by packaging an unsecured debt security with an equity/credit/commodity/whatever derivative and selling it to customers who don't have ISDAs or otherwise aren't down with OTC derivatives. They're called "principal protected" because even if the linked index goes down, you still get all your money back (albeit at zero yield). But that only happens if the issuer doesn't go bankrupt - if they go bankrupt, you're hosed just like other noteholders.

Which, duh, or so we thought. The notes after all said that they were Lehman's unsecured obligations and that "an investment in the Notes will be subject to the credit risk of Lehman Brothers Holdings Inc, and the actual and perceived creditworthiness of Lehman Brothers Holdings Inc. may affect the market value of the Notes." But that wasn't enough for these plaintiffs, or for the judge, who is going to let the structured notes claims go to trial:

While these statements would have made the nature of these securities clear to a careful and intelligent reader, the principal protection statements were displayed more prominently and frequently than the warnings. The first line of the each pricing supplement submitted with the defendants’ motion states "100% principal protection" in large letters. The first page lists the "Features" of each investment, which include "100% principal protection if held to maturity" and "[a]t maturity, you will receive a cash payment equal to at least 100% of your principal." Each mentions 100% principal protection at least four times on the first page. By contrast, the risk that investors could lose their principal if Lehman went bankrupt is not mentioned on that page at all.

So the advice to structured notes desks is (1) put everything on the first page and (2) don't assume that your customers are "careful and intelligent readers."

How can we put this gently? We suspect that part of the appeal of issuing structured notes is that not every single one of your buyers is "careful and intelligent." And we suspect that banks were not exactly sad that retail customers thought "100% principal protected" really did mean that you couldn't lose money even if the issuer went bankrupt. That's probably going to be harder to get away with after today's ruling.

Coincidentally also released today: SEC Staff Issues Summary Report of Sweep Examination of Structured Products Sold to Retail Investors [SEC]


Today In Swiss Banks With Creepy But Defensible Structured Products

I don't really understand it but the TVIX thing is creepy fun. If you haven't followed it, Credit Suisse issued this exchange-traded note called TVIX that was a 2x levered bet on the VIX. They suspended new issuance about a month ago due to position limits, and people were just so damn excited to own the thing that its price crept up to 189% of its fair value, where "fair value" is a reasonably easily measurable thing based on the formula in the TVIX prospectus. Then last week Credit Suisse announced that they would be creating more units, and the price plummeted to and then through fair value, which is what you'd expect to happen. Except that it started plummeting a few hours before that announcement, which is Suspicious. So of course people are sad and so there's a Bloomberg Brief with sort of sad-funny quotes like: “When it started to fall, I bought more because I couldn’t believe how low it was going. I didn’t realize I was playing with a hand grenade.” – Michael Gamble [heh! - ed.], 67, who doubled down on his TVIX investment before the price collapsed. Investors “all think: ‘Oh, I’ll just buy these things, I’ll be hedged against volatility and everything will be wonderful.’ And now they’ve seen the market goes down and their volatility protection goes down too, and they’re going ‘Hmm, what happened here?’ These people are going to have to pay a really expensive lesson.” – Larry McMillan, who manages $30 million as president of McMillan Analysis Corp. So, yes, Larry, they are going to pay a really expensive lesson. But what is it? Stephen Lubben has a little thing in DealBook today where he frets: