Retail and high-net-worth investors who have bought into instruments tied to single stocks may face losing significant chunks of capital invested. The structures, known as reverse convertibles, pay out high coupons and have been snapped up particularly by U.S. investors. But investors may forfeit capital if the underlying stock drops by a certain amount, usually 10-30%, or face being 'put' into stocks that have fallen in value.
Dealers are afraid losses on structured products that retail clients have invested in could attract the attention of regulators. "This is top of my worry-list right now," said one structured salesman in New York.
The National Association of Securities Dealers in October issued a notice to members reminding dealers to ensure investors understand the risks involved in principal-at-risk products (DW, 9/16) and suggesting these should not be sold to investors not eligible to trade options. The notice was not enforced by any regulation, but one product structurer said his concern is that if there are losses, the NASD may take the warning further. The structurer added that if losses are on a small scale and there are complaints from investors, dealers may decide to settle independently with clients. NASD officials did not respond to calls by press time.
Reverse convertibles generate high coupons by selling put options and tend to be structured on volatile stock in order to get high option premiums. Energy, commodities and technology stocks have been favored. The notes are not listed, so it is hard to estimate how many notes may have been affected by falling stock prices. But notes have been written on stocks such as Google, down 11% year-to-date or SanDisk Corp. down 15.5% year-to-date, and can be bought for around USD1,000 making them accessible to retail clients. To avoid the investor being put into stocks, or losing capital, firms such as Royal Bank of Canada have been tweaking structures (see story, page 4).
Capital-at-risk warnings on reverse convertible documentation may also support dealers should there be losses. One salesman, however, noted that regulators tend to disregard the value of these warnings if widows and orphans are losing money and this could prove the incentive to introduce new restrictions on what instruments may be sold to retail investors.
