Lehman collapse dents confidence

Lehman Brothers’ bankruptcy in September last year is still affecting thousands of UK investors, who are awaiting news of compensation for being missold products backed by the bank. But the events of 2008 seem likely to have a more lasting effect on the future of investing in complex derivatives.

Around 6,000 investors put a total of £200m into structured products reliant on Lehmans’ bonds, according to a House of Commons motion tabled earlier this year, only to lose it all when the US bank filed for bankruptcy protection. “Capital protected” products issued in the UK by NDFA, DRL, Meteor and Arc were among those that had used Lehmans as a “counterparty” – buying into the bank’s bonds to provide their investors with a return of capital on maturity.

Last week, the Financial Services Authority (FSA) said it would take action against a number of companies for the misselling of these Lehman-backed structured products as low-risk investments. The regulator also said it would lift the moratorium on the Financial Ombudsman Service, which handles complaints from private investors, and allow it to deal with individual cases.

For investors, Lehmans’ collapse has drained confidence in products that offer capital protection. Peter Howard, who formed the Structured Products Investors Recovery & Information Team (Spirit) to campaign for compensation, says: “We want people to realise there are still victims of Lehmans, where the issues of their structured products have not been resolved a year on.”

Only a minority of UK structured products used Lehmans as the counterparty – most involved banks with stronger credit ratings. But all are reliant on that counterparty to provide the return of capital. Typically, a structured product provider will put most, but not all, of investors’ money into a zero-coupon bond issued by the counterparty, which will have a redemption value equivalent to the total amount invested. This bond provides the capital protection at the end of the term. Then, the provider will use the amount left over to trade derivatives on an underlying market index. These derivatives provide the potential upside: either participation in any rise in the index, or an income payment if the index hasn’t fallen.

Capital protection is therefore not guaranteed, but dependent on the zero-coupon bond being redeemed in full. “When applied to structures backed by bonds, we think the word ‘guaranteed’ can be misleading,” says Marc Chamberlain, executive director for structured products at Morgan Stanley. “Investors need to remember that the guarantee is only as good as the counterparty providing it.”

Some exchange traded funds (ETFs) also rely on counterparties, even though they are simple index trackers – something that few UK investors knew until AIG nearly collapsed in the same week as Lehmans. At the time, trading in commodity funds issued by ETF Securities had to be suspended because they relied on AIG index swaps – another type of derivative.

Some in the industry suggest independent financial advisers (IFAs) must take much of the blame for failing to quantify the risk and communicate it to clients. “It is always easy to blame the provider in order to cover up the basic lack of understanding of investors and their advisers,” says Mike Hollings, chief investment officer of Matrix Investment Management. “The simple rule should be: if I can’t explain this to a non-professional investor, I shouldn’t be making the investment myself.”

“Investors and advisers perhaps became a little blasé,” says Chamberlain. “No-one thought a major bank like Lehmans would collapse. I wouldn’t say that they failed to grasp the risk, but perhaps they under-estimated the potential impact a credit event would have on these products.”

Now, with 90 per cent of IFAs still recommending capital protected products – according to Structured Products magazine – mandatory risk warnings look likely. “I do believe that the FSA will want counterparty risk and complexity risk in any rating that advisers do from now on,” says Declan Sheehan, chief executive of HSBC Private Bank UK. “I mean complexity as in ‘can you really understand what you’re buying’.”

Some structured product providers have already rewritten their plans. In February, Morgan Stanley issued the first structured products backed by AAA-rated government bonds. “Not only is there much more clarity and transparency in the marketing literature so that investors can grasp the risk associated with an investment, but, also, there is now more choice over the level of risk inherent in the product,” explains Chamberlain. “A year ago, capital protection was mainly provided by financial institutions issuing bonds. Today, there are many more options with clients able to choose from a variety of bond issuers to match their risk profile.”

Investors in Lehmans-backed products, meanwhile, await news of any kind of return.