SEC investigating structured products: Déjà Vu all over again?

3 Apr
Never let it be said that the denizens at the Securities and Exchange Commission are a stodgy, humorless bunch. A recent WSJ article, Complex bond faces regulators Scrutiny , almost got me. I am not sure if they meant to have an early jump on April Fools, or if some fat fingers at the WSJ was involved.  In any event, well played Schapiro!
The Complex bonds being scrutinized, also known as “reverse convertible notes” falls under the broad investment category of structured products or in the old school vernacular Derivatives, the eleven letter four letter word.
According to the complaint, apparently the bad boys of Wall Street:
“failed to disclose the risks and fees to the investors before they bought the notes.” and possibly failed to disclose “potential conflicts of interests, such as selling a note linked to the stock of a company it is advising.”
Not only have we been down this path before, but with a few well placed directorships, maybe an IPO allocation or two, whatever the legislation and if indeed there is one, it will be tepid and ineffective. I have many reasons for my opinion but I will give three. One is history, two is legislating for greed, stupidity and downright laziness is nigh on impossible and the third I will give you at the end.

So, a brief history lesson: In the early to mid 90s, the SEC, CFTC and the Senate Banking committee “investigated” similar structured investments, after many well-known firms announced multi-million losses resulting from derivative transactions in which, they claimed, they were misled. The most infamous of these were Gibson Greetings, Procter & Gamble, and Orange County.

There followed a plethora of law suits, most of which were settled out of court. Any of this sound familiar?

One such settlement involved Bankers Trust, a big player in the derivatives market at the time.  BT was found to have been less than forthright in its dealing with clients, fined $10 million by the CFTC and the SEC, and entered a written agreement – naughty boy smack on wrist without admitting guilt –  with the Federal Reserve Bank of New York

Under this “agreement”, Bankers Trust was directed to make sure that its customers know about every wart, wrinkle, and whisker of their leveraged derivatives. Most significantly, Bankers is required to provide “transparency” about prices. If a client, for example, has entered into a highly leveraged contract, it is entitled to know on a daily basis what the contract’s value is.

Moreover, in 1995 to pre-empt further regulatory initiatives on derivatives, the Derivatives Policy Group comprising senior officials from six of the United States’ largest broker-dealers (Goldman Sachs, Merrill Lynch, CS First Boston, Salomon Brothers, Morgan Stanley and Lehman Brothers) released a code of conduct, Framework for Voluntary Oversight with the subheading the OTC Derivatives activities of Securities firm affiliates to promote confidence and stability in financial markets.

Inasmuch as there has been some chicanery in the marketing of structured products, I firmly believe investors should start sharing some of the blame.  For some obscure reason while the general public may have outgrown Santa Claus and the Tooth Fairy, much of the investing public still firmly believe in the Investing Genie – He of the above average return with below average risk .

Back in January I posted light hearted pokes at structured products. I detailed a JPMorgan offering on Bank of America and a Morgan Stanley Offering on Bank America. I found the disclosures to be quite adequate for those with a basic grasp of english comprehension and math skills. In spite of one such offering disclosing that :

“We may engage in business with or involving Bank of America Corporation WITHOUT regard to your interests”. and   “Hedging and trading activity by our subsidiaries could potentially adversely affect the value of the securities”

over $100 million notional of these investments were sold.  At $1000 per unit, 10,000 of this things were greedily snapped up.

As with anything that requires a modicum of intelligence and a smattering of getting one’s hand dirty or brain into gear, left in the hands of the lazy, incompetent and yes the downright stupid – it WILL lead to tears.  At some point in time investors must be held accountable for their actions and indeed inactions. My erstwhile blog mate the_analyst has advocated a revolutionary notion on many an occasion. One with which I whole-heartedly agree with.

License investors! Put the Series 7 to good use, have the general public take and pass it with annual re-certifications.

I leave you with my third reason why I think this investigation will come to naught:

1. At the January 1995 Senate Bank Committee hearing on derivatives regulation,  Fed Chairman Alan Greenspan said unequivocally that the Bankers Trust agreement should not be construed as setting general guidelines for the industry.

2. The person in charge of the CFTC in the 90s during the first structured product investigations was none other than Mary Schapiro, the SEC’s current chairperson.

Happy Trading!


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