Tuesday, May 25, 2010

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. 



J said...

I also don't see the convolution. The snipped from the nyt though discloses nothing about what happens if Lehman goes bankrupt. I would have taken this to mean that it was somehow guaranteed and I guess they did too.

EconomicDisconnect said...

Good catch on this one. It smacks of the Bernie Madoff folks wanting to be made whole again.

Kid Dynamite said...

GYC - just to clarify, i'm not saying that it doesn't suck that people lost their money in this supposedly safe product - but i am saying that Morgenson deliberately strayed into the "brokers selling complex products to rubes" territory to gussy up her story... and that is utter crap.

SoxLover said...

The only thread to her stories is that banks are evil. They may be,
but the woman is third rate hack, an embarrassment. I cannot remember a story she wrote that was worth the typeface. She repeatedly fails basic logic and fact checking, the first (but not the last) writer to cause me to lose all respect for ability of the New York Times to report on financial matters.

EconomicDisconnect said...

I gotcha, that part was clear.

Sam said...

She does get stuff wrong sometimes and goes overboard but hey, we need rabble rousers like her and Taibbi to counteract the Pisanis and Jim Goldmans in the MSM.

If anything her prolific output gets my grudging respect.

Anonymous said...

Sam, she does no one any favours with her junk. Is anything she writing going to stop these people losing money again? Is it going to make the financial system more stable? Is it even going to get people to ask the write questions to acheive the above?

All she is going to do is whip up some fake outage and a story that manages to be even more simple-minded than she is.


Jon said...

The problem with rabble rousing is it doesn't help solve the real problems. Instead you end up with all this anger and misguided efforts that don't address the real issues. It's as if we're ok with blindly hacking away with an axe because to heal a sick person.

I don't understand why people are so OK with others being wrong. It's especially bad when it comes to journalists, officials and individuals producing facts or guiding decision making. Making shit up is bad regardless of which side of an argument you're on.

Transor Z said...

If you were going to make this generation's version of "All the President's Men," the extra wrinkle would be that the investigative journalists don't know how to think or write. Or jeopardize their celebrity access by saying anything too critical about their sources.

So it would be kind of like "Dumb & Dumber" -- but with a newspaper.

Now. A journalistic thriller about a talented former NYC trader-turned-NH farmer/anonymous blogger who can't shake his past so he stays in touch with The Game by blogging about it but accidentally discovers a frightening global conspiracy to rig markets -- that I'd definitely pay to see!


Kid Dynamite said...

Transor - so funny you should mention that, because i thought i actually DID uncover a massive conspiracy regarding the Lehman bankruptcy and final days. and guess what - you're not going to believe this - i tried to give the story to the NY TImes's Louise Story, figuring that she'd have more resources than me. I gave it to her on a silver platter, with the relevant filings and everything. of course, she gave up after about 15 minutes.

Transor Z said...

Kid, that's awesome. And giving the story gift-wrapped to a NYT reporter is a perfect jumping-off point for the movie. Working title: "Crowd Source."

Action-packed climax could be "Witness" meets "Revenge of the Nerds." I think there's even room for cameos by the dogs. We can take some creative liberties and merge your story with the WikiLeaks guy who moves every 6 weeks.

This would totally work.

Orion said...

As a person who has sold these in the past i think she completely misses the point. Any time I see note I get worried because of the ramifications that it carries if the company who has them has problems. Notes are backed by the company who issues them and have nothing to do with what they may be "linked" to. This very thing happened with reverse convertible notes backed by lehman as well, even though the securities they were made to mimic had no problems...good catch

Anonymous said...

I agree with Orion: the whole problem with these products is that they are marketed as investments in whatever they are linked to, whereas in fact they are most accurately described as unsecured loans with peculiar repayment terms.

The reason for not describing these products honestly as loans is obvious: it would result in lower sales. But that is exactly what should happen.

BTW, even experts can be fooled if they read only the marketing and not the prospectus. Someone I know was called in to clean up in the aftermath of one of these issuers blowing up. His initial reaction was, what's to clean up? Having never bought or sold the products, he was thinking of PPN 1.0, which were segregated investments, consisting of just futures + zero coupon treasury.

Anonymous said...

Anon, I don't think they were "loans" in the normal sense of the word, just that with LEH sitting in the middle there was credit exposure to LEH. Just like when you buy a holiday and the operator goes belly up.