Sunday, September 28, 2008

Caveat Emptor - Understand What you Invest In !

With the recent bankruptcy of Lehman Brothers, there has been much controversy over the structured products which have been sold (through various financial institutions and brokerages) to retail investors. One of them is the DBS High-Notes, while another contentious product are the Lehman Brothers Mini-Bond Series. When a major event such as a credit event occurs, these products are rendered virtually useless for the retail investor and many are now questioning the amount of risk they took up (unknowingly) and whether there was any mis-representation on the part of bank officers who sold them such products.

Deep in the heart of such controversy lies the term "Caveat Emptor", which means "buyer beware" in Latin. Essentially, it means that purchasers of securities and investment products should understand what they are buying before they plunge in, or suffer the consequences of their lack of understanding. While the flip side for this argument is that the "pushers" if such securities ought to be more informed and provide better clarity on the structure of such products; the reality is that sometimes the sellers of such products themselves may not fully understand the consequences or ramifications of obscure events such as "credit events" or "default".

If sufficient appropriate disclosure of risks had been made, perhaps the issue would not have blown up in the media to the extent that it is (in Hong Kong, and now in Singapore). I have read reports that showed retirees who invested their life savings (6-digit sum) into such derivative products, believing that the risk was low and that the product was principal-guaranteed. THe 5% interest rate seemed a little too good to be true, as bank savings rate was only a paltry 0.25% ! I guess as the saying goes - if something is too good to be true, then sometimes it isn't true. Apparently, such high returns were a form of "insurance premium" which the banks paid to ensure that there was no default on any of the underlying securities; and the retail investors were the ones who had to pay out the "insurance" when one of the firms went bust. Essentially, these investors were in the dark about being used as vehicles for insurance, while the issuer of such securities paid off these premiums to them every year. Though the risk of default at the time of issuance was low, this does not preclude the fact that the product was in itself risky and complex.

The Edge Magazine's Personal Wealth section reported that even Mr. Leong Sze Hian (who is president of the Society of Financial Service Professionals in Singapore and has 4 Masters Degrees) had problems understanding the inner workings of such products. He had to read it a few times and in depth before he could unravel the risks and characteristics of such products. So the irony is that if such an accomplished and experienced professional such as Mr. Leong finds it hard to understand such products, what about the uneducated retail investor who simply seeks a safe haven to park their retirement monies ? The banks and brokerages have a fiduciary duty to the general public to ensure that ALL the risks and rewards of ALL the products they offer are clearly and explicitly stated, and not just using glossy marketing brochures to advertise the rewards in large fonts while keeping the risks portion at font size 6.

The reason why I feel strongly about this issue even though I do not know anyone personally affected by this saga is because I feel for the people who have "invested" their life savings into such risky products, all the while thinking that their retirement nest egg was safe, only to be told now that almost all their money will go up in smoke. It could happen to your parents, uncle, aunt or a relative; so imagine the number of extra years one has to slog just to make back the money - and all because of salespeople who may be pushing the wrong product and not being able to explain such products clearly enough.

I welcome comments from readers who have something to say about this saga, and to voice your opinions on how you think this can be prevented in future.


la papillion said...

Hi mw,

There are two approaches to solve this problems, I feel:

1. Buyers have to be more financially savvy. No one is more careful with your own money than yourself.

2. Sellers have to be more responsible on the things they sell. It's no good to say that everything is written in the prospectus when it is not highlighted or not explained clearly. I heard a lot more bankers preying on the older folks when they just want to do their banking.

xinhuazidian said...

To me, this problem came up because govt sold POSB. In the old POSB, good interest rate satisfy all depositors, the bank did well just thru loans and deposits. so only simple transactions done.
Now, all these normal folks get pushed all sort of nonsense by aggresive salespeople who tell only half the story to them.

nhyone said...

My guess is that there are two types of investors who got caught.

1. People who thought these have the same risks as FD. They didn't know there's a prospectus to read.

2. People who know these have some risk, but they downplay the risks. (Now they claim they were misled.)

I feel that you don't have to understand everything in the prospectus to know the risk.

I was a potential Minibond buyer, so I know what it felt like -- it was viewed as a very safe investment. I decided not to buy after reading the risk section of the prospectus.

8percentpa said...

I think DBS should do something about this. Some heads should roll, or DBS should take some money out of its own capital to repay these poor retirees.

Of course, in reality they won't pay back a single cent. This is Singapore, not a charity. The sad part is, probably no heads will roll, and the executives continue to collect their million dollar paycheck. Not sure if we can have class action suits here? If so, then the retirees should seriously consider sueing DBS.

How to prevent this from happening again? The most practical solution is to accompany your old folks to the banks every time. If got no time, then at least ask what they have been signing regularly.

The ideal solution is of course the usual tightening of compliance, risk profiling, educating financial advisers, relationship managers etc.

But when I see the parallel in property agents, insurance agents, brokers and that they have been around for years doing the same stuff with zero fiduciary resposibilities (selling things without really thinking for the clients), I think we cannot expect FAs or RMs to improve.

My partial solution, if it can ever be implemented, would be the complete revamp of the industry practices incl fees charged to clients, compensation packages based on commissions. Eg fees should not be based on how much the clients buy but maybe consultation per session (like seeing the doctor). And RMs, FAs, agents etc commission cannot be tied to how many pdts they sell but how well they serve their clients (imagine doctors who keep selling you expensive medicine!!? Well some do, but that's another story).

But easier said than done though.

musicwhiz said...

Hi La Papillion,

Yep agree with your Point 1 but for folks who are either not savvy with financial products, not good with numbers, illiterate or just plain blur, this can be a daunting task. I guess safe rather than sorry is a good option for them (i.e. to leave their money in a fixed deposit).

Sellers are compensated based on the products they sell, rather than on customer service. I guess that's where the problem lies. I think the compensation scheme should be altered to protect the consumer, rather than to benefit the seller of the products.


musicwhiz said...

Hi xinhuazidian,

I think that's probably not the only reason. Banks have "diversified" in recent years to do a lot more stuff than just loans and deposits. As you said, now they really know how to complicate things by introducing all sorts of financial products. The idea is to make $ from them and trap the unwary ! Haha.


musicwhiz said...

Hi nhyone,

I think for point 1, if an investor thinks a structured product has no prospectus, then he's not ready to invest in such products. He must be under the mistaken assumption that it is akin to a fixed deposit, while in reality the difference is like night and day !

Of the people who claim they were misled, I am sure there are some who knew all the risks but chose to dive into the deep end anyway; now they are making use of the hoo-hah to merge with the ignorant folks to claim that they had been misled. Of course, whether or not they were misled does not erase the fact that they are all going to lose a substantial portion of their investment, sad to say.


musicwhiz said...

Hi 8percentpa,

Yep I think the banks owe investors some form of explanation, though I seriously doubt too that they will act to compensate the affected parties. I personally do not have an RM (not high net worth enough haha !) but from what I hear from friends who do, the RM are quite clueless about such events and may even be blur about certain products which are not within their realm of research.

I completely agree that they should revamp the system, though I think a major overhaul will probably take much too long to implement; thus they might just tweak the current system a little. Woe betide those poor investors who did not know the term "caveat emptor" !


PanzerGrenadier said...

The problem is the aggressive sales tactics used by banks and relationship managers that may come close or perhaps even fall into the ambit of negligent misrepresentation. In law, you can sue for negligent misrepresentation for damages but it's not easy and you will need to incur legal fees whether you are awarded damages or not.

What the Association of Banks, MAS and CASE should do is to come together and hammer out the basic dislcosure information to retail buyers before they sign on dotted line.

Some questions to be asked:
1) What is the risk of losing my entire capital?

2) What is the worst case scenario for this investment (in $ terms e.g. what is the worst thing that can happen?)

Mandatory disclosure along those lines would make some investors stop and not go along.

But in reality, there is no real interest by banks to do so and consumer advocacy and protection in Singapore is still lacking.

nhyone said...

For investors whose notes encounter a credit event, they are very likely to get back very little of their capital.

Best course of action: sue the issuer for misrepresentation.

If the issuer is no longer around, the underlying securities may still have some worth. The trustee has not come out with the valuation, so it's too early to say if the distributors should compensate the investors.

For example, the trustee may let the notes run to maturity. Of course they may have to alter some of the terms, such as capital protection, interest rate and protection from misrepresentation. :)

Best course of action: pray that the underlying securities still have value.

nhyone said...

musicwhiz, some people were renewing their FDs when they were introduced these structured products.

These people are easy meat. Tell them high interest rate and capital protected, and they will accept. (Long term is not a problem because they want to generate income from their capital.)

Anonymous said...

it is just plain ignorant on the part of the buyers who should know that the only one interested in their money is nobody else other than themselves, and if they choose to part their money, they better know what and where the money is going before it become history

PanzerGrenadier said...

anonmymous October 4, 2008 5:11 PM

It's very easy to put it down just ignorance but that is only one part of the equation. The other part is consumer advocacy and basic rights of consumers when purchasing financial products and services.

Yes, before you buy a financial product, understand its risks and returns before plonking your hard-earned money. But financial institutions have a part to play in not pushing products they KNOW their clients DO NOT UNDERSTAND.

If ignorance is always the fault of the purchaser, why do we have laws against under 18s smoking and watching M18 movies? In these cases, the State deems under 18s to be incapable of informed constent in buying cigarettes or watching M18 movies. Why doesn't the State step in when it can and does to mandate 18 year old boys go to NS and die for their country?

Anonymous said...

you mentioned vices? under 18? certain cases minor needs to be protected, other cases you probably don't want to many violence/iresponsible behaviour/wasting tax payers money. a working adult who can purchase financial instruments? did the bank put a knife under the buyer's neck? if not ignorant, then greed!

musicwhiz said...

Hi Panzer,

Thanks for your comments. Yes I do agree it is up to the investor to ask the right questions, otherwise he may not know what he's getting into ! If an investor is ignorant, he can ask someone who is knowledgeable to accompany him and it must be someone he can trust.

I think MAS can do more to educate the general public. I also feel they are not doing enough. MoneySense was an important initiative back then but now it seems to have faded into the background. It's sad.


musicwhiz said...

Hi nyhone,

Yep, I would say investors in general are a gullible bunch. Perhaps they trust the banks too much. Those days are gone forever I think.....