It is easy to be cheated (3) - Credit linked notes

Many retail investors have lost large sums of money by investing in the credit linked notes, such as the minibonds, pinnacle notes, high notes and the jubilee notes. 

Several financial institutions sold these credit-linked notes to their customers. The customers were told that their monies were invested in a basket of bonds issued by highed rated companies. The chance of failure of any of these reference entities was small, and even if it materialises, their loss will only be a proportion of the invested capital, due to the diversification of the risk.

This turned out to be an incorrect description of the actual nature of the notes. The invested capital was actually used to provide the security for credit default swaps on the reference entities. If any of these entities failed, the entire capital would be lost. Instead of diversifying the risk of failure, they are taking six to eight times of the risk of failure of any single entity.

The capital was actually invested in other assets that carry their own credit risk. This adds to the total risk of loss of the capital.

The actual structure of these notes were contained in several hundred of pages of a prospectus and pricing statments. The documentation was not clear, even to knowledgeable financial experts who spent many hours to read them. Many people feel that these documents are written to conceal the real nature of the structured products.

The actual return received by the product issuer was considerably higher (due to the extremely high risk) than the yield of 5% given to the retail investors. These excess gain was earned by the issuers but was not disclosed in any documentation. There were several devices created to hide or siphon off these profits.

Due to the global recession, many credit linked notes failed, causing severe losses to the retail investors. The dishonest act was in the creation of these products, attempts made to hide the true nature of the risks and to siphon off the excess return to the product issuer.

Most distributors of these products were not aware about the true nature of the products and had negligently misrepresent the products as being safe for retail investors. They were only focused on generating large volume of sales to earn an attractive rate of commission. 

To avoid being cheated, it is important for retail investors to avoid all types of structured products, especially in an regulatory environment that is weak in protecting retail investors. 

Tan Kin Lian