Morgenson Misses the Mark

I read Gretchen Morgenson's recent NY Times piece : "Principal-Protected Notes Aren't as Safe As They Sound," and something about it has been bugging me ever since.  Morgenson writes:

"Questions about how Wall Street marketed yet another complex product, sold as solid and secure, are now emerging in investor arbitration cases. The instrument is named, inaptly as it turns out, “100 percent principal protected absolute return barrier notes.” 

These securities are essentially zero-coupon notes sweetened by tying the return, in part, to the performance of an equity index, like the Standard & Poor’s 500 or the Russell 2000. The securities promise to return an investor’s principal, typically at the end of 18 months, with the added gain from the index’s performance if that index trades within a certain range. Brokerage firms often issued these securities. 

For an investor in one of these notes to earn the return of the index as well as get the principal back, the index cannot fall 25.5 percent or more from its level at the date of issuance. Neither can it rise more than 27.5 percent above that level. If the index exceeds those levels during the holding period, the investors receive only their principal back.

Convoluted enough for you?"

Well, no, Gretchen, it's not convoluted enough for me, and by talking about the "complexity" of the product, you're dragging a massive red herring through your own story.  Morgenson continues, talking about the investors who bought this product:

"Yet, these securities appear to have been sold to conservative individuals whose financial market forays were usually limited to certificates of deposit. Many of these investors, to their great misfortune, bought principal-protected notes issued by Lehman Brothers. They are now worth pennies on the dollar."

She goes on to recount a sad story of an unsophisticated couple who lost a lot of money buying these notes.

There's a major point of clarification that's needed here, though, and which Morgenson ignores:  The losses suffered by investors on these notes have absolutely NOTHING to do with the notes being "convoluted" or unsuitable for unsophisticated investors.  I'll make it really clear:  The reason investors suffered losses on these notes is because Lehman Brothers went bankrupt.  That's it. It's not because of confusing derivatives, complex structures, or anything of the sort - it's because the notes were obligations of Lehman Brothers.  Is it possible that the UBS brokers selling the product failed to explain this, and to stress that Lehman Brothers' credit was not quite as good as that of the U.S. Government?  Absolutely.  In fact, it's likely - but that's a very different issue from the complexity of the product.

To put this another way, the unsophisticated couple in the article may very well have been interested in a very simple hypothetical product that stipulated "As long as the sun rises in the East and sets in the West, this note will return 6% per year."  That's pretty simple.  They'd probably understand that.  And you know what?   Those hypothetical Sunrise Notes would also be worth "pennies on the dollar" if they were issued by Lehman Brothers.  THAT is the point.  Sophistication has nothing to do with it. 

-KD