Today I think even less of them, as investors have lost billions in these so-called “safe investments” – and many are set to lose more.

Let me briefly explain how structured products work, why so many of them haven’t turned out to be the safe haven investors believed they were, and how you can avoid making a similar mistake in the future…

What Are Structured Products?

Structured products are securities that are sold as an opportunity to enjoy substantial gains with full principal protection.

For example, an underwriter might offer investors the upside potential of the S&P 500 – or a substantial percentage of that upside – over a certain period of time (say, five years) while guaranteeing no less than full value of the initial investment at maturity, even if the index goes down.

(Or, instead of the S&P 500, the investment might be linked to Asian currencies, or commodities, or something else.)

How can you offer all or most of the upside of a risky investment with a principal guarantee? Well, in the early days, Wall Street would take U.S. government zero coupon bonds – which sell at a discount and pay zero interest, but gradually compound in value until they mature at $1,000 – and combine them with index options.

So, for instance, if you invested $100,000 – and investors tended to bet large since their principal was guaranteed by Uncle Sam – $80,000 might go into zero coupon bonds and most of the rest into S&P 500 call options.

Most of the rest? Well, there were Wall Street fees that had to be covered, of course.

Nothing was wrong with these early investments, really. But they were nothing more than a gimmick. You could buy the zero coupon bonds and options yourself and achieve the same thing, saving yourself the fees that Wall Street imposed when it created these products.

Unfortunately, something happened along the way that changed the game completely. Yields on government bonds came down. And the cost of buying index options went up, especially in bull markets.

Yields on U.S. Treasuries just weren’t high enough to make this game work anymore. So instead of investing most of the money in U.S. government bonds, Wall Street firms substituted their own unsecured debt instead. This was disclosed in the prospectus, of course. And it seemed like no big deal as long as these Wall Street giants remained healthy.

But they didn’t.

Structured Products Are An Investor’s Nightmare

Investors who bought structured products from Lehman Brothers, for example, are today standing in line alongside the firm’s other creditors.

These “principal-guaranteed” securities are now selling for 10 cents on the dollar, according to SecondMarket, Inc., a specialist in illiquid assets.

SecondMarket says it has already heard from investors holding more than $2 billion worth of Lehman structured products.

The firm estimates that small investors bought $34 billion of these products through October of this year alone. This surpasses the more than $33.5 billion that were bought last year.

(In truth, of course, these products are sold, not bought. No one wakes up and says “I think I’ll invest in a structured investment product today.”)

Last week The Wall Street Journal told the story of Charles Brooks, a physician in Allentown, PA:

• He put a significant sum in two Lehman structured products because he liked the idea of having some exposure to market gains along with protection from losses.
• Today he says these “protected” assets are worth approximately seven cents on the dollar. Sixty-five years old, he is now delaying his retirement planning.
• And he is angry at Wall Street. “There’s no end to things they can invent that seem to me little more than a gamble for the enjoyment of the inventors,” he says.

I don’t fault Dr. Brooks for believing that a note guaranteed by Lehman Brothers was pretty safe. Ninety-nine percent of investors would have made the same assumption 12 months ago.

Structured Products Are A Wall Street Gimmick

The shame, really, is that by buying these structured products, he was sold a Wall Street gimmick. There is nothing magical about these products that offer huge upside potential with a principal guarantee.

After all, I could take $100,000 from you, put the vast majority of it in U.S. government zero coupon bonds and use the balance to play roulette at the Bellagio for five years. If I win, you would get back a lot more than $100,000.

And if I lost everything, which of course I would, I could still guarantee the full return of your hundred grand when bonds mature.

Like I said, gimmick.

There are two lessons here for every investor:

• The first is as old as investing itself: If it sounds too good to be true, it probably is.
• Number two, however, is just as important. Whenever you hear that an investment, an insurance policy, an interest payment, a stock dividend, or a particular return is guaranteed, be sure to ask the next question: By whom?

Source:  Structured Products: Another “Safe Investment” Bites the Dust

But we have to remember that the credit crunch did not start in the banking sector. It started with housing.

After nine success quarters of expansion, the UK economy finally showed weakness in 2008.

After a twelve year bull market in housing, where average prices were £61,115 in 1995 to £198,664 in 2007, an increase of 225% we are finally seeing the housing market hit the skids.

Trend watchers would say about bloody time. ‘The climb in property was due to pop,’ clever chartists would tell you. The bull run was in its third phase, according to Dow Theory. This is where all newsflow was positive and the dumb money was piling into the investment. A sudden reversal in fortunes was, as it invariably is, on the cards.

But this is not the stock market, this is the property market and property has its own theories.

It’s called HPA, or house price affordability.

What it measures is the average earnings of UK consumers against the average price of a house. It is literally a price-to-earnings ratio for property assets.

Just like the dot-com stocks that looked overvalued in 2000, house prices are looking equally overheated today on the basis of fundamental value.

Average wages are, according to Capital Economics, approximately £30,000 a year.

Average house prices are £178,555.

178,555 / 30,000 = 6.

6 is bad. 6 is much higher than the long-term average 3.7.

Problem is that it’s even worse now. BusinessWeek claim that today the HPA ratio is now 11.

11 times your salary!? Probably overzealous from Business Week, but still pretty dire. Never fear though, as we’re alright as long as the cost of taking out mortgages is cheap.

D’oh!

The cost of borrowing has skyrocketed since the credit crunch. The nationalisations, share price capitulations and never-ending writedowns have a pretty effective way of killing the mood.

Banks have gone from lending to each other at a low of 3.4% in 2003 to around 5.8% today, even nearing 7% in late 2007.

So the banks don’t want to lend to each other, and if they do, they do so at a big premium.

So, a house buyer is between a rock and a hard place.

Houses are too expensive and debt is too expensive. Demand and supply are both, therefore, a bit limp.

If houses are too expensive you need to borrow a lot of money. If the amount of money you are borrowing is set at too costly a rate, you’re only likely to take the loan if you believe house prices are still going up.

And this is where sentiment comes into the mix.

“The Memetic Theory of House Prices”

Richard Dawkins, the famous atheist, has a theory explaining sentiment in the housing (or any) market that is very well presented, funnily enough, by the End Poverty pressure group.

“[Memes] are anything, any message sent from one person to another. It spreads much like a virus until it reaches the whole of society and forms a consensus.

“In the housing market, memes propagate of the overall state of the market. System-wide memes say whether the market is thriving or in recession spread. At times the housing market is in boom, thus the boom meme is dominant. At other times it is the slump meme that forms the consensus.”

What this is saying is house prices rose because people believed they would rise. Now, we can see, they are falling, in part, because people believe they would fall.

Now it’s not all mania and panic, there are fundamental justifications both on the up- and down-side, but it is certainly part of the process and that part is sentiment.

You have only to look at the doom and gloom headlines being generated by the mainstream press to see the pendulum has swung decisively against property.

So, housing has lost the hearts and minds. Every part of every framework, from the mathematical to the touchy-feely is shouting out GO SHORT HOUSING!

How Low Will It Go?

OK. Now we’ve got the basics we can produce an estimate.

Firstly, looking at house price affordability, our housing P/E ratio. The long-term average is 3.7.

If prices are going to ‘revert to the mean’ this implies a fall of 30%. Why not more? Because year-on-year earnings growth is also thrown into the mix. So, on fundamental grounds, we’ve got good reason to be bearish on UK property.

Then we factor in the popular sentiment, or ‘memetic’ momentum.

This could swing things even further as a market in the throes of panic is likely to over-sell and push prices as artificially low as it pushed things artificially high.

However, two considerations.

Markets do not always fall back to their historic averages. Trends can shift and that means that the ‘crash’ could be less than our antiquated metrics allow us to anticipate.

Also, sentiment can change. If popular opinion goes back the other way, and everyone decides that the 5% or so of price decline is quite enough it may prompt a turnaround, an artificial turnaround, but something that will re-light the fire that is imbedded in every British citizen.

A belief that amuses many of our foreign neighbours.

It is the belief that owning a house is a god-given right. The inbuilt desire to buy houses has not completely gone away, and once the press find a new theme that fire can be rekindled. This may be the x-factor that is shifting the trend upwards.

The 30% call is complex, there are so many variables and considerations in housing that can shift our projections a few ticks higher or a few ticks lower. In either case, our position is clear. Go short housing… any way you cut it, the market looks broke.

Theo Casey

Source: House Price Affordability