Commentaries

Contrarian Capital…not so much

With a name like Contrarian Capital one would think this Greenwich, Conn. hedge fund would have been savvy enough to sniff-out the impending trouble at Lehman Brothers. But apparently, the managers of Contrarian weren’t contrarian enough.

A week ago, Contrarian filed a rather large $100 million notice of claim in the Lehman bankruptcy, an indication that it was a bit too bullish on the failed investment house. But what makes the claim really interesting is that it stems from losses on Lehman-issued structured notes–something often sold to retail investors.

I’ve been writing a lot about structured notes being a terribly flawed investment product. The main problem with structured notes is that they generate big fees for investment banks and often are falsely pitched as conservative investments. Many are described as being “principal protected.” But as the Lehman experience has shown, that guarantee means nothing if the issuer goes bust.

Additionally, the main feature of a structured note–an embedded derivative that tries to capture the price increase in an underlying basket of stocks, commodities or a particular index–is something that often can be replicated by a investor without the aid of an investment bank. And the embedded derivative is notoriously complex and simply adds more counterparty risk into the financial system. 

Yet structured notes, up until the financial crisis, were a big business for banks in Europe and Asia. The main buyers: retirees and average investors.

And here’s what really interesting about the notes purchased by Contrarian–they were issued by a little-known Lehman subsidiary in Amsterdam that sold some $35 billion in these now worthless securities. Back when I was a reporter for BusinessWeek, I wrote a long article about this Lehman subsidiary with my former colleague David Henry. In the story, we described how dubious products like structured notes had imperiled the concept of global banking and posed a big problem for regulators trying to tackle the derivatives mess.

It’s been nine months since Lehman collapsed and the bankruptcy case is quickly fading from the headlines. But it shouldn’t. In many ways, the Lehman case is just getting going as the battle over the fallout from the messy unwind of Lehman’s hefty derivatives book is just getting started.

Investor protection, Singapore style

Who needs a whole new government agency to protect  consumers from irresponsible banks? Authorities in Singapore have taken a refreshingly straightforward approach in tackling banks deemed to have been less than scrupulous when selling structured notes dragged down by the failure of Lehman Brothers: they banned them.

The Monetary Authority of Singapore on Wednesday banned 10 banks from selling structured notes until they can prove that they have improved processes to highlight the risks involved. Banks including DBS and ABN Amro, now part of Britain’s Royal Bank of Scotland, are out of the business for at least six months. Hong Leong Finance receivd a two-year ban. (The full list is here.)

The so-called Lehman Minibonds are one of the many scandals triggered by the Wall Street investment bank’s collapse. They were sold as bonds that offered principal protection and an attractive rate of interest. In fact, they were complex structures supported by synthetic CDOs with Lehman acting as a swap counterparty. When Lehman filed for bankruptcy, the notes collapsed.

The MAS report is fairly dry, but nonetheless it is fairly clear that banks either didn’t understand the risks of what they were selling, or failed to tell their clients.

Some of the specific failings highlighted by the MAS include:

a) risk ratings assigned by some financial institutions to some series of the Notes that were inconsistent with risk warnings stated in the prospectus and pricing statement;

b) insufficient steps taken by some financial institutions to ensure that all their financial advisory representatives were properly trained before marketing and selling the Notes; and

c) weaknesses in how some financial institutions ensured that their financial advisory representatives were properly equipped with accurate and complete information about the Notes.

This is some consolation for the 7,000-odd Singaporean investors who lost money on the notes. Though 67 per cent of investors have received compensation, they have got just 30 per cent of their money back.

Scoring investment risk

The Bank for International Settlements is thinking the right way in calling for a global standard of ranking financial instruments based on their risk and suitability for different kinds of investors.

The BIS Annual Report argues that financial instruments, markets and institutions all require reform if a truly robust system is to emerge. For instruments, it means a mechanism that rates their safety, limits their availability and provides warnings about their suitability and risks.

One way to do that would be to require investment houses to slap a Surgeon General cigarette-style warning on every exotic security that gets peddled to retail investors.  This warning would be attached to every piece of marketing material for a financial product, disclosed by brokers everytime they pitched the security and prominently displayed on every investor account statement.

For instance, the warning on a structured note could read something like this: “Even though this security is marketed as principal protected, you could still lose everything if the bank that issued it goes bust. Additionally, structured notes generate fat fees for the both the issuing bank and the bank that sells them. In many cases, an investor could achive the same asset exposure by buying a basket of stocks, commodities etc. on his or her own.”

Let’s hope this idea from BIS is adopted by the SEC and the new consumer financial protection agency the Obama administration wants to create.

Goldman fills the Lehman void

Lehman’s collapse left a big whole in the world of structured products–a largely unnecessary investment vehicle that’s been all too popular in Europe and Asia. But it seems Goldman Sachs is rushing in to fill the void.

A week ago, a three-month-old Goldman Sachs subsidiary filed a registration statement with Irish authorities for the future sale of structured notes in the UK and elsewhere–but not in the US. The so-called “base prospectus” filed by Goldman Sachs Financial Solutions PLC is the second structured note offering a Goldman subsidiary has filed this year with Irish regulators.

Up until now, Goldman hasn’t been one of the big players in churning out structured notes, which use derivatives to give investors exposure to a wide range of asset classes. The biggest sellers of structured notes have been UBS, Citigroup, Morgan Stanley and Lehman–that is before it collapsed in bankruptcy last September.

In fact, a former Lehman subsidiary in Amsterdam churned out some $30 billion in structured notes over the past decade. The notes were sold by a slew of banks in the UK, Belgium, Germany, Italy, Switzerland and throughout Asia, and they are all pretty much worthless now. Most of the buyers of these notes, which offered investors exposure to a commodities index or a basket of stocks, were sold to average folks–not particuarly wealthy people.

Structured notes generate fat fees for the banks that issue them and other banks that peddle them to retail investors. In many instances, investors could get the same kind of exposure by simply buying an exchange-traded fund, a index fund, or put together their own basket of stocks, bonds or commodities.

But the biggest knock on structured notes is that many of them are pitched to investors as “principal protected” investments. Investors are told they may not make money on the underlying investment, but they won’t lose their principal either.

But the guarantee on these notes is only as good as the creditworthiness of the issuer. Investors who bought Lehman structured notes have found out that guarantee doesn’t mean in the wake of the firm’s bankruptcy.

Et tu Schwab?

Discount brokerage Charles Schwab may be facing a Lehman-sized headache.

It appears some Schwab brokers were actively selling so-called structured notes–derivative-like investments–that were issued by the now bankrupt Lehman Brothers. The structured notes were pitched as principal protected, meaning investors might not make a lot of money if a strategy failed, but they wouldn’t lose their initial investment either.

The only problem with the sales is pitch that the Lehman issued structured notes were guaranteed by Lehman. The notion that an investors’ prinicipal investment was 100% protected went out the window when the Wall Street firm filed for bankrupty last fall.

Lehmans’ collapse is proof that unless an investment is backed by the federal government there really is no such thing as a “100% principal protected” note.  In other words, there are no free lunches for investors on Wall Street.

Seth Lipner, a New York securities lawyer, says he’s on the verge of filing an arbitration claim against Schwab on behalf of a Florida couple who purchased Lehman structured notes through Schwab. He claims Schwab “misrepresented” the risks associated with these notes. Lipner’s clients invested $60,000 in these now all-but-worthless notes. But Lipner suspects Schwab peddled Lehman notes to many other customers.

Schwab wasn’t immediately available for comment. But if they call back, I’ll update with their response.

Up until now, UBS was the biggest known seller of Lehman structured notes in the US. In fact, New Hampshire securities regulators, earlier this month, filed a cease and desist notice against UBS over the sale of Lehman structured notes. Regulators claim UBS brokers “exaggerated” the safety and security of the notes.