Like any investment you’ll make, Structured Products carry a certain amount of risk. This is dependent upon the type of plan you choose to invest in, so it’s important to know where your money’s going and how it’ll be invested before going ahead.
There are a number of risks inherent to Structured Product investments, such as that posed by the counterparties, but the first distinction to make in Structured Product investments is between Structured Investments and Structured Deposits.
Structured Investments
A Structured Investment is most often found available from banks or insurers, and your money will be used to buy two underlying investments – one to provide protection of your original capital, and the other to create returns. The returns you receive will be dependent upon the performance of one or more stock market index – when all the necessary measures are met, this type of investment could produce potential gross annual returns of anything around 30% of your original investment. However, if the index doesn’t do well over the period of your investment then there’s the potential that you could lose some or even all of your original money invested.
Structured Deposits
A Structured Deposit differs in that it’s more often likened to a savings account. The rate of interest you receive from your original investment will be dependent upon the performance of the stock market index specified in the plan. If that index performs badly then you may not receive any returns on your investment, but – crucially – your original capital will be protected. This means that you should always come away with at least the same amount you put in to begin with. That is, unless there’s an issue with the counterparty.
Counterparty Risk
Whilst some Structured Deposit plans will be able to guarantee the return of your original capital, what they can’t protect against is the default of the counterparty. This is something that Structured Investment plans will also be at risk of.
Counterparties are companies which your provider has chosen to place your money with in the form of investments. This acts as a means to share the risk of holding investors money, and your plan could involve one or more counterparties – spreading the risk out across a number of companies can be beneficial, as it’s far less likely for multiple companies to become insolvent at the same time.
However, the risk to your investment these counterparties pose will still be dependent on the financial stability of that company. This is why there are a number of credit rating systems around to help you gauge the reliability of a firm, the three main ones being Moody’s, Fitch Ratings and Standard & Poor’s. You may have to make an account to use one of these sites, but the extra information they’ll send you can actually be quite beneficial, especially if you’re trying to become more well-versed in investments.
Counterparty in Collapse: Lehman Brothers Holdings Inc.
An infamous example of the risk counterparties can cause to Structured Product investors appears with the collapse of Lehman Brothers Holdings Inc in 2008. The fourth-largest investment bank in the US at the time, its closure marked the biggest filing for bankruptcy in history – the firm was a monstrous $619 billion in debt.
Prior to this point, Lehman Brothers had managed to pull through a number of other crashes and crises, not least of all the Great Depression and two world wars. During the housing boom of 2003-4, Lehman sold a vast number of mortgages, but this overexposure ultimately led to their demise when the market slumped in 2007-8. Sectors of the company were bought out by Barclays and Nomura Holdings, but the collapse still left around half of Lehman’s original 25,000-strong staff fending for themselves.
The sheer size and scope of Lehman Brothers Holdings whilst at its height meant that the group was a counterparty for numerous Structured Products. They backed products from such companies as Legal & General, Meteor Asset Management and Arc Capital & Income, but their collapse caused significant problems for these firms, even forcing Arc Capital & Income into administration. This was due to the level of claims coming in from advisers and investors, who had not been made aware that Lehman were the bank backing the plans, leaving them unable to assess the counterparty risk of the investment.
A Watershed
This moment in time marked a watershed for Structured Product investment. Nowadays, all Structured Product investment plans will make it clear who the counterparty or counterparties are backing the plan, giving advisers and investors enough information to clearly judge the risk they may be placing their money in.
Some products will offer protection of your investment under the scheme provided by the Federal Deposit Insurance Corporation. The UK equivalent to this is the Financial Services Compensation Scheme, and these programmes minimise the chance of firms collapsing under claims by providing compensation to customers where it is needed. So just like the credit rating of a company, it’s important to check your plan to see if it provides any protection of your investment.
Awesome overview here. It’s so important that people wanting to get into investing understand structured products like this. Thanks so much for sharing this!