Friday, February 15, 2013

Structured CDs: The Big Picture

By Tim Dulaney, PhD and Tim Husson, PhD

This week we have reviewed some of the issues surrounding structured certificates of deposit, giving an introduction, example offering documents (both simple and complex), the basics of FDIC insurance of these products, and a description of some of the tax implications investors should be aware of.  We hope we have conveyed our reasons for thinking that structured CDs are complex and risky investments that, like structured products, are rarely suitable for retail investors.

But there is a bigger picture to consider as well.  We've described structured CDs that are similar to principal protected notes (equity-linked CDs) and interest rate linked structured products (range accruals).  Some structured CDs, such as this example from Union Bank, have equity exposure subject to quarterly caps and a minimum return, similar to equity-indexed annuities.  It is no coincidence that these very different products offer the same basic types of payoffs.  Banks have determined what types of exposure they can profitably offer investors, and can offer it any of several different packages.

Importantly, each type of product has very different regulatory treatment, even if it offers the same or similar exposure as another class of investment.  Structured products, being debt securities, are registered with the SEC and subject to its regulatory oversight.  Indexed and fixed annuities, being insurance products, are subject to more state-level regulation.  Structured CDs, as bank deposits, are under the FDIC's jurisdiction.  Each of these regulatory frameworks has different disclosure requirements, limitations, and investor protections, but in each of these cases, the issuer takes a position that it can profitably hedge--that is, a position that it can purchase cheaper in derivatives markets.

So while low interest rates may have made traditional CDs and other 'vanilla' investments seem unsatisfying, we would caution investors from aiming at higher returns via structured CDs.  The underlying risks, including the information asymmetry that exists between banks and retail investors, can mean investors may be getting less in expected value than they put in.

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