(Bloomberg News) A gray-haired woman picking a flower with a young girl adorns the cover of an HSBC Holdings Plc brochure that promises investors both "the growth of the market" and "the security of FDIC Insurance."
By tying interest rates to everything from the Dow Jones Industrial Average to precious metals, the pamphlet for HSBC's Market-Linked Certificates of Deposits explains U.S. investors have the potential to earn "enhanced returns" over as long as seven years. A separate disclosure states that they also may earn zero, getting just their original principal back after the CD matures, while brokers may collect fees of 6 percent or more. Investors that need to get their money earlier must find a buyer for the CD, risking a loss.
As the Federal Reserve holds interest rates at about zero for a fourth year, Goldman Sachs Group Inc., Citigroup Inc. and the rest of Wall Street are selling record numbers of the CDs to savers seeking the chance to earn eight times what fixed-rate deposits pay, while having principal backed by the Federal Deposit Insurance Corp. Officials at the Financial Industry Regulatory Authority, or Finra, said they're looking at whether buyers understand the risks of CDs that may lock up money in derivatives bets for as long as 20 years.
'Hugely Profitable'
"They are hugely profitable for the issuers, much more profitable than typical CDs, and they are poorly understood by retail investors, who will not be able to figure out how much profit the issuers are making," said Frank Partnoy, a University of San Diego law professor and former Morgan Stanley derivatives trader. "The institutions that are selling them might as well be marketing CDs whose value depends on which team wins the Super Bowl."
Sales of the investments may total $25 billion a year, Sean Gordon, who oversees distribution of market-linked CDs in the U.S. at Barclays Plc, said in a December interview. Banks sold a record 1,271 of them last year, according to StructuredRetailProducts.com, a database used by the industry, with some offering potential annual returns of as much as 24 percent by tying rates to everything from gold to Brazil's real.
Bank revenue from the investments more than tripled to $99 per million dollars in retail deposits in October from $30 in January, according to Kehrer-LIMRA Research compiled from approximately 30 lenders, including Wells Fargo & Co. and SunTrust Banks Inc.
No License Needed
The dollar amount of so-called structured CDs sold isn't known because they aren't registered with the U.S. Securities and Exchange Commission, and the brokers that sell them aren't required to be licensed by Finra.
Four years after subprime mortgages caused the worst financial crisis since the Great Depression, the government- backed insurance pool created in 1933 is guaranteeing investments that marry derivatives with what are supposed to be the safest product offered by a bank other than savings accounts.
"When banks start doing other things with insured deposits, it veers away from the intent and purpose of the FDIC insurance," said Andrew "Skip" Hove, a former acting FDIC chairman who is now an adviser at Promontory Financial Group LLC in Washington. "The FDIC was created for depositors who wanted some security of their money, so they didn't have to worry about a bank run."
As long as a CD's principal is guaranteed at maturity and risks are disclosed to investors, it's considered a bank deposit, even if tied to a basket of stocks, commodities or other assets, said James Deveney, chief of the FDIC's deposit insurance division.
Understood By Investors
"You can tie one to how many points Kobe Bryant might score" in a Los Angeles Lakers basketball game as long as the risks are disclosed, said Robert Colvin, president of Robert Colvin Consulting LLC, who created a structured CD program for community lenders. "Banks have the ability to write those contracts any way they want."
Given the increasing complexity and lengthening maturities of the investments, Finra wants to make sure they're properly understood by investors, Maria Rabinovich, a lawyer in the watchdog's risk division, said in a Feb. 6 interview in New York.
"HSBC supports Finra's efforts to ensure financial products, including market-linked CDs, are properly understood by investors," Juanita Gutierrez, a spokeswoman for the bank, said in an e-mailed statement.
'Suitability'
The industry watchdog "continues to be focused on the creation and distribution around new products, particularly around suitability and how the products are being represented and marketed to retail investors," Michelle Ong, a Finra spokeswoman, said today in an e-mailed statement. "We cannot say that this will necessarily translate to an increased focus of exam resources, or even a special review, but there is not one now."
Goldman Sachs offered a four-year CD in December tied to the monthly returns of the Dow Jones Industrial Average. Under the best scenario, the investment would return as much as 24 percent annually. Under the worst, the CD would return the minimum 0.5 percent, less than half of what an investor might earn putting money into a traditional CD that matures one year sooner.
13 Percent Odds
To reach the maximum yield, the Dow would have to steadily gain by at least 2 percent each month over the life of the CD, according to disclosures in an offering statement. Gains higher than 2 percent aren't passed on to the CD investor.
The odds of making more than the minimum 0.5 percent may be as low as 22 percent and the chance of earning more than the current rate on a four-year, fixed-rate CD may be as low as 13 percent, according to more than 100 years of monthly Dow returns analyzed by Bloomberg.
Michael DuVally, a spokesman for Goldman Sachs in New York, declined to comment.
Structured CDs allow investors with as little as $1,000 to be involved in the derivatives market. Unlike traditional CDs, which typically have no commissions and have fixed penalties if a buyer sells before maturity, an investor exiting some structured CDs has to sell on the secondary market, meaning the amount of principal returned is subject to how much buyers are willing to pay.
Banco Popular
At Popular Inc.'s Banco Popular branch on East 116th Street in Manhattan, a window display lights up an ad for a "Performance CD," promising guaranteed principal with the possibility for returns higher than traditional certificates of deposit.
The CD is "conservative in structure" because it's linked to stocks in the Standard & Poor's 100 Index or to "blue-chip global stocks" and insured by the FDIC, Manuel Chinea, the head of U.S. retail banking for Banco Popular, said in an e-mailed statement.
United Community Banks, Inc. in Blairsville, Georgia, pitched a so-called steepener CD in November that bets on the Treasury yield curve, or the difference between short- and long- term interest rates, according to a disclosure statement. The CD matures in 20 years.
"Structured CDs are complex financial instruments that require detailed risk disclosures and special considerations with respect to investor suitability," Michael Burke, treasurer of United Community Banks, said in an e-mail. The lender "issues and distributes its structured CDs through registered broker-dealers regulated by Finra," he said.
'Plain-Vanilla'
Most of the structured CDs sold to individual investors aren't tied to such interest-rate formulas and have shorter maturities, said Tim Bonacci of CD Funding Securities LLC in Cincinnati, who has helped about 30 banks start their own businesses to sell the investments, using a competitive bid process with the longest maturity at six years.
The vast majority have maturities of five to seven years and typically are tied to a basket of stocks, he said.
"All of our clients, many of which are regional banks, are more interested in plain-vanilla, simple market-linked structures," Bonacci said in a telephone interview.
Demand for structured CDs has increased as interest-rates on traditional deposits fall to record lows and after Congress approved a permanent expansion of FDIC coverage of bank deposits to as much as $250,000, from the $100,000 limit that had been in place since 1980. The typical one-year CD is now paying an average 0.75 percent, down from 2.65 percent at the end of 2008, according to Bankrate.com.
Raise Cash
The CDs allow banks to raise cash at rates that are on average about 20 basis points, or 0.2 percentage point, less than what they pay on Federal Home Loan Bank advances, Bonacci said. To return principal on a $1,000 CD, banks may use the money raised from an investor to buy a zero-coupon bond for $880 that returns $1,000 at maturity. The remaining $120 covers commissions and the cost of the underlying derivatives.
Chase Manhattan Bank, now part of JPMorgan Chase & Co., offered the first structured CD in 1987, the "Market Index Investment Deposit Account," winning approval from the late FDIC chairman William Seidman that the investment should be insured as a deposit.
The SEC and the Office of the Comptroller of the Currency agreed they were deposits, allowing banks to forgo registering them with the securities regulator.
UBS Fined
As many as 10 states are investigating how some of the investments are being marketed, according to Ronak Patel, co- head of a working group for the North American Securities Administrators Association and director of inspections for the Texas State Securities Board.
Finra has already been investigating other types of structured products, and it has fined brokerage firms for misleading investors about the safety of "principal-protected" notes.
UBS AG, Switzerland's largest bank, was ordered to pay investors $8.25 million and fined $2.5 million over sales of Lehman Brothers Holdings Inc. securities marketed as "100% Principal-Protection Notes" that became almost worthless after Lehman filed for bankruptcy in September 2008.
The payouts of the instruments may be too difficult for many individual investors to understand and buyers might receive yields closer to those on Treasuries rather than any outsized returns, according to Steve Swidler, a professor at Auburn University in Auburn, Alabama.
'Walked Off Mars'
Some would take him several lectures to explain to his class on financial engineering, such as an HSBC 10-year CD that pays 4.5 percent for the first year and then ties the yield for the remaining nine years to leveraged bets on interest-rate swaps, he said, a so-called "steepener" because it bets on the steepness of the Treasury yield curve.
"If I mention the yield curve to your typical customer, standing in line at a bank making a $100 deposit, and I ask them, 'What do you think about 2-year and 10-year spreads?' Swidler, who's written academic papers on the products, said in a telephone interview, "They'll probably look at me like I just walked off Mars."
Wells Fargo offered a 6.5-year CD tied to the S&P 500 Index last month that pays bankers and brokers a fee of as much as 8 percent, according to the CD's disclosure statement.
The CD returns the gains of the index if it doesn't increase by more than about 62 percent from its starting level. If it breaks the so-called "barrier," investors receive 2 percent annually, which has happened about 60 percent of the time, according to an analysis of more than 80 years of S&P 500 data by Bloomberg.
'Enhance Returns'
"Our Market Linked CDs provide value to our clients and their fees are fully and clearly disclosed," Elise Wilkinson, a spokeswoman for the San Francisco-based bank, said in an e- mailed statement.
Citigroup Inc. offered a 15-year CD last month called the "Libor Inverse Floater Contingent on the S&P 500 Index Market- Linked Certificate of Deposit" that pays an initial 6.5 percent, more than eight times current one-year, fixed-rate deposits, according to a Citigroup term sheet.
After the first year, the rate is based on a formula of 1.1 times the difference between 5 percent and the three-month London interbank offered rate on days when the S&P 500 is equal to or above 75 percent of its starting value. The index closed yesterday at 1,350.50. The New York-based bank has the option to redeem the CD after the first year.
Difficult To Value
"The investment allows clients to take advantage of a view that rates will remain relatively low," Nicholas Parcharidis, managing director and the head of Americas sales for Citi Private Investor Products in New York, said in an e-mailed statement. "It gives them the opportunity to earn 6.5 percent return in year one and to potentially enhance returns above low fixed rates in subsequent years. The risk is the opportunity cost of potentially earning zero interest in subsequent years."
The derivatives and formulas make the investments difficult to value, Auburn's Swidler said.
"It is questionable whether some of these products should be sold to retail investors in the first place," said Moritz Seibert in Westport, Connecticut, the former U.S. head of equity derivatives structuring at the Royal Bank of Scotland Group Plc who's now starting an alternative investment business. "Traders at issuing banks understand the nitty-gritty pricing of those products very well. It seems that professional institutional investors would be a more suitable clientele."