Investing Guide at Deep Blue Group Publications LLC Tokyo: Why You Should Avoid Zombie Structured Notes

Occasionally I see financial products spring from the dead to devour investor dollars. One such product is called a “structured note.”

I first wrote about these vehicles more than three years ago for AARP Magazine, The New York Times, Reuters and Morningstar.com. Here’s the warning the SEC and FINRA issued after I wrote the pieces.

Structured notes are like bonds, only linked to derivatives. Brokers sell them to mostly older, yield-hungry investors. They are dangerous because they are almost universally backed by the credit of a bank — they are not federally insured — and promise a healthy yield during low-yield times.

I don’t recommend these products because of the risks and costs. They can certainly lose money and reap huge commissions for the brokers selling them. Many of them are labeled “principal protected.”

No one quite knows how these notes will perform in a prolonged bear market, but we have a clue. Lehman Brothers sold billions of them prior to the 2008 crash and investors got their shirts handed to them.

UBS, the Swiss bank and one of the biggest brokers of the Lehman products, agreed to pay investors $120 million to settle a lawsuit over the Lehman notes last year. UBS spokeswoman Megan Stinson told Reuters the Swiss bank was “pleased with the settlement, saying it avoided the cost and uncertainty of litigation, and had set aside reserves to cover it.” The bank did not admit wrongdoing in agreeing to settle.

As stock-market volatility soared in the past month, though, brokers have seized the opportunity to sell even more structured products. The Wall Street Journal’s Jason Zweig was on top of the sales surge:

“Over the two weeks that ended October 10, 343 structured notes totaling $2.17 billion were issued by various investment banks. That’s more than three times the amount of deals issued over the same time last year,” reported Zweig, who cited research by Exceed Investments in his report.

“These short-term bonds are typically structured to limit or eliminate your exposure to losses while giving you a stake in potential gains, making them especially alluring in weeks like the one we just had, when stocks were glowing red,” Zweig reported. “But whether you should buy them depends on the exact terms of each note-and on whether you can trust your advisor when he says he understands them.”

Jacob Zamansky, a New York-based lawyer who also represents individual investors, also has this warning:

"While some deals work the way they are designed, other structured notes have caused thousands of investors harm, all the while drawing the scrutiny of securities fraud attorneys. UBS (NYSE:UBS) and other brokerages sold structured notes in 2008, and many of those deals were issued by the now defunct Lehman Brothers. After Lehman filed for bankruptcy, the structured notes were worthless. The spate of lawsuits by customers and regulatory actions that followed underscored the complex and opaque nature of these critters and how investors were misled by their advisors.

Should the structured note sales boom continue, it is essential that brokers and investment banks make full and clear risk disclosure to investors. We are not predicting a Lehman-like collapse that would create panic and havoc in the broad market and also wipe out a swath of structured note holders, however, each deal is complex and laden with risk. Stay away if you don’t understand the devastating losses structured notes could create in your retirement savings.”

In short, structured notes are complex investments. Brokers selling them may not fully understand how they will perform under adverse market conditions, so avoid them.