'Derivatives don't kill people; people kill people'

Did you know...? Private investors like you can make 230% of emerging Asia’s super-soar-away gains between now and 2014.You’re only tied in for three years. An early exit will return 130% of your initial investment. And yes – it really does sound just too good to be true.

"Citigroup said these products should be for sophisticated investors only. But the municipalities were definitely not sophisticated investors..."

So says Eystein Kleven of the Financial Supervisory Authority in Norway, speaking this week to The Guardian newspaper. He’s investigating the collapse of public funds in Narvik, a small town of 18,000 people some 140 miles north of the Arctic Circle.

"Terra Securities misled them," Kleven goes on. The municipality lost $35 million on high-risk US mortgage-backed investments. Seven other small Norwegian towns were also hit, apparently.

Why? Terra got busy selling Citigroup-issued derivatives to profit-hungry public investors. But it failed to explain that if their market price fell below 55% of face value, the products would be forcibly redeemed, leaving small towns like Narvik with an instant loss of 45 cents in the dollar or more.

Which is just what happened last summer, of course. Yet Narvik opted to pump fresh funds into these products, hoping they’d come back in due course. So now the same dumb investment has made the town’s fund managers look stupid twice.

"Terra Securities did not disclose this mechanism to the municipalities," says Kleven in mitigation. "We are not sure whether the broker understood the mechanism himself." But so what? A lack of understanding should never get in the way of making an investment. Or so you’d guess from the professional market.

According to a survey released this week by The Economist and KPMG:

One-in-five asset managers worldwide lacks the staff needed to understand their more complex investments;
One-in-four hedge funds admits the same;
All told, one-in-three institutions now holding collateralized debt or structured products has "no in-house expertise" in understanding them.
Just 42% of fund managers reckon they can quantify their true exposure to complex investments.

Interviewing more than 330 professionals in 57 countries worldwide – and with one-third of respondents based in the United States – Beyond the Credit Crisis also found that the blow-up in credit and debt derivatives has directly dented returns at 60% of investment funds. And as a result, a huge 70% of institutional investors now want to cut their exposure to derivatives and "other complex financial products".

Yet of those managers running $10bn-plus, three-in-four say their use of such instruments is growing regardless!

Of course, "Derivatives don’t kill people; people kill people," as Frank Partnoy quotes a fellow Morgan Stanley salesman from the early ’90s in his classic book F.I.A.S.C.O. Yet even now, more than 15 years after Orange County blew up, people wielding derivatives continue to "go postal" every so often.

Just take a look at the carnage amongst under-informed, over-reaching investment funds.

"Staff skill sets have struggled to keep up with the growing sophistication of the industry," says Tom Brown, head of KPMG’s investment management division in Europe. "These firms cannot afford to continue flying blind." Flying blind worked up to summer ’07; it’s also much cheaper than training or hiring qualified staff. Quicker, too. Time is money when structured products with hidden clauses are waiting to get triggered.

But "if the fund management industry is to retain the trust of investors," reckons the KPMG-Economist survey, "it would seem imperative for it to both develop the necessary skills and then offer these skills to investors."If only! Investors right down to the retail level are going need all the same "necessary skills" they can get. Because trigger-happy derivatives are heading your way, and they’ve got a big fat marketing budget – plus the entire financial media – queued up right behind them.

"Groups are continuing to flood the market with structured products as investors seek safety from volatile markets," reports IFAonline here in the UK, a website aimed at financial advisors. Originally offering zero downside – so-called capital protection – structured products on stocks, bonds and property now come with such juicy options as:

"10 times the upside in the index with a cap at 70%..."
"positive returns even if the index falls by 35%..."
"100% of any growth between 65% of the initial reading and the closing level..."
"one-for-one downside with no guarantees or protection but an uncapped geared return of 170% of growth..."
"the greater of 0.24 times initial capital or 0.75 times the growth of the index..."

Got that? Whatever you used to think investing should taste like, it no longer needs to just come in vanilla. Starbucks’ menu of frappuccino flavorings has got nothing on Wall Street, La Defense and the City of London.

Which brings us back to multiplying Asia’s stock market gains by 230%, courtesy of Morgan Stanley UK. There’s no fee for investing in the bank’s new Asia ex-Japan Protected Growth Plan 5. (We guess here at BullionVault that means there are already four in issue.) And with the exception of a transfer charge of £100 plus VAT (approx. $230), "all other charges are taken into account in setting the terms offered," says the brochure.

Nor could you ask for better timing. The Hang Seng in Hong Kong – one half of Morgan Stanley’s basket in this plan (which then only runs to Taiwan in offering "Asia ex-Japan") – just suffered its worst month since, umm...well, since February in fact. Losing 10% of its value during the worst June in 19 years, the Hang Seng just put in its worst half-year since 2001.

That will go towards cutting your purchase price by one-fifth from New Year’s ’08. And seeing how the Hang Seng has still doubled inside five years, it’s only heading one way long term, you might guess.

But if that were the case, why on earth would Morgan Stanley want to offer you 230% of the next six years’ of growth?

"The Early Exit Basket Level is the official closing level of the Basket on 1st September 2011," explains the brochure. If this level is 30% or more above the initial starting level of Sept. ’08, then the Early Exit will be triggered and "you will be able to elect to receive an amount equal to 130% of your Initial Investment."

Bully for you! Thirty per cent up in three years, regardless of any extra gains above that level which Asia stocks might deliver. Nor did you get any capital protection in between. And if you now neglect to quit the scheme, then 30% is all you’ll get after the following three years as well.

Your growth is protected, in short, but not your capital and certainly not your upside exposure if the Early Exit is triggered. So the last thing investors in Morgan Stanley’s new Asia ex-Japan Protected Growth Plan 5 actually want is a quick bounce in Asian stocks. To get a shot at making 230% of Asia’s gains to 2014 instead, they’ll actually need sub-30% gains between now and 2011. Which might be just what they get, of course. We have nothing against Morgan Stanley’s new offer, nor the terms on which it’s made. But we are getting a head-ache trying to figure out why anyone might buy this structured product.

Like all structured investment offers, it’s clearly built from a fistful of complex derivative contracts which Morgan Stanley has bought. At least, we hope Morgans have laid off their risk with derivatives contracts...) Squeezing the new retail market for structured products ever tighter, Morgans have even raised that six-year gearing from the 200% recently offered in ex-Asia Growth Plan 4.

More gearing for you equals more risk for somebody, somewhere...and the brochure from Morgan Stanley UK is bold enough to re-state the facts more than once.

"Your money will be invested in securities issued by financial institutions with a credit rating, at the time of publication of this brochure, of A+ or better by Standard & Poor’s...In the event of these financial institutions going into liquidation or failing to comply with the terms of the securities, you may not receive the anticipated returns on your investment and you may lose all or part of the money you originally invested.

"The Plan is not a guaranteed investment," in short, which is just as it should be. Nothing is certain, least of all in investment. But you’d do well to acknowledge your counter-party and trigger risks next time you find 230% gearing attractive. Either that, or put a little of your wealth into something simple, stupid and brutally blunt.

Buying Gold doesn’t offer to pay three times Fed funds minus your sister-in-law’s birthday divided by the number you first thought of. But Gold owned outright is at least sure to sit free of counterparty and trigger risk. And that’s got to be worth buying as banks fight to bamboozle investors with a new raft of complex derivatives...even as the last derivatives bubble continues to blow up.

By arrangement wiith: www.bullionvault.com