Wednesday, January 4, 2012

What are 'structured products', anyway?

By Tim Husson, PhD

We've done a lot of work on structured products.  And I mean a lot.  In addition to our research on valuation and suitability issues, we've devoted a section of our website to informing investors about different types of products, as well as Tear Sheets evaluating several thousand structured products released over the past couple years.  We have found that most structured products are issued at a substantial premium, and that many investors (especially retail investors) do not fully understand these products, which very often wind up in FINRA arbitrations or worse.

But you might be wondering, what exactly is a structured product? or, how could such a complex investment be available to retail investors?  The answer--like the product--is complex.

Structured products are ultimately corporate debt.  Each structured product is treated as a corporate bond, with a specific stated maturity and payoff, for regulatory purposes.  Banks that issue structured products submit a the same registration form (Form 424B2) to the SEC as they would for other forms of corporate debt, and are ultimately responsible for the promised payouts in the same way as they are responsible to common debt holders.

[Interestingly, many exchange-traded products are also structured as corporate debt, and are typically referred to as Exchange-Traded Notes (ETNs) as opposed to Exchange-Traded Funds (ETFs).]

This simple point actually reveals an important factor that is often overlooked by investors.  The value of structured products is strongly affected by the credit risk of the issuing bank.  If a bank (let's call it 'Lehman Brothers') issues a wide array of structured products at a particular point in time (say, 2007-2008), then the value of those structured products depends on the probability that that bank will not be able to pay its obligations as they fall due.  It is very important that structured product valuations include this credit risk adjustment, because the many investors who bought Lehman's structured products in 2008 received almost nothing when that bank went bankrupt and the probability of that default was high when the products were issued.

Since structured products are just corporate debt, they can have almost any arbitrary payoff function.  Typically banks issue products which are easily hedged, such as simple combinations of equity and derivatives, but can also link payoffs to interest rates, commodities, and other asset classes.  Also, because of their status as debt and their SEC filings, they can be purchased by retail investors and sold through brokers.

Structured products have become a huge market (despite the financial crisis) and many educational resources are available in addition to our preferred source.  Bloomberg subscribers have access to the Bloomberg Structured Notes Brief, which is a weekly source of objective news and analysis based on Bloomberg's extensive database of products both in the US and abroad.  More from the financial industry's point of view, Risk.net publishes a magazine devoted to structured products (aptly named Structured Products), and the Structured Products Association has an informative website.

Our longstanding and ongoing research demonstrates that structured products are highly complex and often overpriced, and we believe investors should very carefully consider a wide variety of factors (and alternatives) before purchasing these types of products.  However, we encourage you to peruse our own and other sites' materials, as it is very important that both investors and the public become aware of this very large and very innovative market.

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