Structured notes have been around since the 1980s, but for years sales were restricted to institutional investors. With the recent surge in sales to retail investors, the SEC is demanding more transparency. According to American Banker, over the past twelve months, the SEC’s Office of Capital Market Trends has been trying to obtain information from Citigroup, Bank of America, JPMorgan Chase, and other structured note issuers about their pricing practices and risk warnings for these products.
The question is whether it is even possible to make structured notes transparent.
Structured notes come in many forms, including the reverse convertibles that are the subject of our December 19, 2012 article. These products are so complex and variable that it is difficult to come up with a single definition that applies to every type of structured note. In their most basic form, they are unsecured loans that – instead of paying interest like regular notes and bonds – pay returns based on a derivative tied to an index, equity, or fund. Like any debt security, structured notes are subject to the credit risk of the issuer. However, that risk is often not made clear to retail customers. The SEC is asking that sellers provide prominent warnings about credit risk.
Structured notes are being marketed to investors as attractive alternatives to bonds in the low-yield environment that currently exists. However, the pricing of structured notes is not at all the same as the pricing of bonds. The SEC is concerned that issuers and financial advisors are not adequately explaining those crucial differences to investors.
Structured products are difficult to value since they are illiquid securities that often reference hard-to-value derivatives. Furthermore, the issuer often adds inadequately disclosed fees that add to the cost to the customer. The absence of an active secondary market for structured notes can hide both the inflated valuations and the added costs.
It is common practice for issuers to estimate the value based on the prices of other bonds and derivatives that are traded more often. This practice can lead to estimated valuations that are not just inaccurate; they can be misleading.
In a letter to JPMorgan quoted in American Banker, SEC Office of Capital markets Chief Amy Starr expressed concern about using more widely traded derivatives to arrive at these estimates (called “mid-market inputs”). “If you do not use mid-market inputs, we believe you should disclose this fact, describe what you use, and the risk that the embedded derivative is being valued differently than other similar derivatives.”
Of even more concern, is the possibility that the issuers’ valuations may purposely be inflated. Sometimes multiple, inconsistent values are placed on the same product. The American Banker reports that the SEC is also questioning banks’ practice of providing customers with valuations for the notes that are higher than their own internal evaluations.
Can the SEC make structured notes transparent enough for the average investor to understand their value and their risks? Not according to Norway. In 2008, the Norwegian government made it unlawful to sell structured notes to retail investors. Five years later, the SEC is still trying to put duct tape on a product that may very well be unfixable.