Principal Protected Notes: Heads Wall Street Wins, Tails Investors Lose

It’s often said that no one buys structured products, but rather they are sold to individual investors. A rational investor would never seek to buy a risky and costly derivative security with limited upside potential and lots of downside risk. Most investors prefer to buy relatively risk-free stocks based on a fundamentally simple investment principal, “Buy low, sell high.” Unfortunately, brokers earn paltry commissions buying and selling stocks. Hence they prefer to sell products that line their pockets, not their clients.

And therein was the rationale for the creation of highly toxic securities known as “Principal Protected Notes.”

Principal Protected Notes were structured securities concocted by Lehman Brothers, Morgan Stanley, Merrill Lynch, Goldman Sachs, and other Wall Street firms that supposedly allowed investors to get above-average market returns tied to the performance of an underlying index such as the S&P 500. Investors were led to believe these securities were virtually risk-free as their principal was always “protected” and would be returned when the notes matured. The closest thing to a sure thing, you might say.

But as always is the case with Wall Street’s dubious structured products, the risk is always buried in the fine print. For starters, investors who bought principal protected notes were limited to how much upside return they could realize. The return on the index of stocks they purchased was based on the value of the index, not the index’s total return, which would include incurred dividends. Experts I’ve spoken with insist that in terms of upside return, investors would almost always do considerably better simply buying a low-cost index fund rather than buying a principal protected note, which — Surprise! Surprise! - paid a lucrative broker’s commission.

Here is some of the fine print that investors were never warned about. In the event the underlying index declined before maturity, the value of the underlying note fell accordingly. The biggest attraction of structured notes was the supposed assurance that investors would receive their entire principal back once the notes matured. But there were a host of hidden conditions attached to these obligations, such as a requirement that if the index fell below a certain level, investors were required to double up on their investment in order to get their principal back.

Lehman Brothers was the biggest seller of structured notes and investors who bought the bankrupt firm’s paper have lost all their money. Had these investors simply bought the S&P index, they would be bruised but not financially annihilated. Buyers who bought the structured notes of the other Wall Street firms are faring better, but regardless they, too, were unquestionably exploited by their brokers.

Wall Street benefited mightily from peddling structured notes. Issuing these dubious securities allowed them to raise non-secured capital from their own customers. The firm underwriting the notes was typically paid an investment banking fee of about six percent. And the brokers who unloaded the notes on their unwitting customers were rewarded with hefty commissions. A good and lucrative time was had by all - except the customers who bought the notes!

I never cease being amazed how Wall Street firms systematically rip-off their customers.