Some wag once said Wall Street’s goal is to part investors from their money. He wasn’t kidding.
The latest gambit to come to light was reported recently by Wall Street Journal columnist Jason Zweig. Several large brokerage firms, including JPMorgan Chase, Morgan Stanley, Barclays and UBS Financial Services, have sold approximately $1.66 billion of “structured notes,” with a payoff linked to the performance of Apple stock. Using the lure of apparently juicy interest rates in an ultra-low interest rate environment, these “notes” have names such as: “Reverse Exchangeable Notes,” “Buffered Equity Notes,” “STEP Income Securities” and “Return Optimization Securities.” None of these names fairly describes what these securities effectively are, which is put options.
A put option is a contract between two parties that requires the seller (called the “writer” in option jargon) to purchase from the buyer a given quantity of a stock at a given price over a particular time period. Suppose you own Apple stock when it’s trading at $700 and want to protect yourself in case the stock falls, but want to hold on if the stock continues to go up. You can purchase a put option that gives you the right to sell your Apple shares should the price fall to, say, $600. In that event, the writer of the put option is obligated to purchase the shares from you at that price. For his trouble, you pay the writer a premium to induce him to enter into the contract. Should Apple stock remain at $600 or more, you keep your stock and the writer pockets the premium.
The amount of the option premium is determined by three factors: first, the difference between the current price and the option price; second, the volatility of the price of the underlying security; and third, the length of time the option contract runs. Why are these notes linked to Apple stock? Because it’s been increasingly volatile, and the average retail investor underestimates that volatility.
For the most part, options trading is suitable only for the most savvy investors. In particular, writing put options can be a risky strategy. And that’s what the victims, er, customers, of these big brokerage firms were doing. Writing naked puts (those not accompanied by some other risk-controlling options) exposes the writer to large potential losses while generating limited potential returns.
An example Zweig gives are the “Trigger Yield Optimization Notes” issued by UBS last September 26. Issued at a price of $700 per note, these notes will pay interest at an annual rate of 8.03 percent, or approximately $56 over the note’s one-year life. Sounds great, doesn’t it? However, if the price of Apple stock on September 23, 2013, closes below $595, the purchaser doesn’t receive back the face value of $700 at issuance—he gets the value of a share of Apple stock instead.
As I write this, Apple is trading around $445 per share. To avoid the trigger, the Apple share price must rise 33 percent in the next seven months. Maybe it will, maybe it won’t. Should the price remain as it is now, the suckers who purchased these notes will experience a 28 percent loss on their one-year investment instead of the 8 percent interest they thought they were getting.
Now that Apple stock is trading below the trigger price and given how these notes are structured, the notes are even more volatile than the underlying stock. In its report on these UBS Apple notes, the Securities Litigation and Consulting Group of Fairfax, Va., points out that, while Apple’s stock declined 12 percent after reporting disappointing earnings on January 23, the value of these notes declined 18 percent. Based on its analysis, these notes are virtually certain to finish below the trigger price, leading to significant losses for those who purchased them.
So where are the regulators who are supposed to prevent such shenanigans? In a statement issued by the Financial Industry Regulatory Authority (FINRA), a spokesman said: “FINRA is especially focused on complex structured products sold to retail investors. When we find instances of unsuitable sales of reverse convertibles to investors, we take action.” Right. Just like Finra stopped Bernie Madoff in his tracks before he was able to make off with his customers’ funds. Ooops!
If FINRA was really looking out for the average investor, the CEOs of the big brokerage firms who sold these products would be helping Bernie Madoff pound rocks at the federal correctional center in Butner, North Carolina.
In my view, it’s the job of anyone upon whom retail investors rely for investment advice to prevent Wall Street from succeeding in its relentless efforts to part investors from their money. No adviser who stands in a fiduciary relationship with his client could, without violating his duty to the client, sell such a product to his client where the adviser or his firm stood to gain from the client’s loss.
As these Apple-linked structured notes mature over the next year or so, expect to see lawsuits filed against the issuing firms. I’m not much of a fan of securities class actions. But you shouldn’t have a hard time guessing where my sympathies lie in this situation.
