Market-Linked CDs: A Rigged Game
I have often said that while innovation is beneficial in most fields of endeavor, the one glaring exception is finance. All investors would do well to remember that when Wall Street creates a new product or a new “enhancement” to an existing product, it is for Wall Street’s benefit only. Anyone who doubts this should consider the last decade when Wall Street’s furious pace of innovations gave us such abominations as the “CDO-Squared”, and we know how that ended. The one great innovation that I wrote about last week (indexing) was more a rebellion against Wall Street than anything else.
The Wall Street Journal of 9/7/2016 carried a cogent reminder of this idea. The article titled “Wall Street Remakes the CD, Hitting Yields” delved into some horrific client experiences with market-linked or structured CDs. These are products whose returns depend on the performance of a basket of stocks, commodities, currencies, or other assets instead of a flat interest rate. They are a close cousin of the equity-indexed annuity, which we will leave for another day. As with most investment products, they are sold rather than bought—nobody walks into a bank thinking they need a market-linked CD. Instead, a broker at the bank “upsells” them from an ordinary CD because the broker stands to make a nice commission from the sale. The bank itself is not taking any real risk because the guaranteed payments can be covered with options and other financial instruments. The customer essentially gives up liquidity until the expiration of the contract.
Where it gets interesting (and distressing) for the hapless customers is the calculation of their interest payments. The FDIC warns investors, “With market-linked CDs, the formula for calculating the return may be extremely complex.” The WSJ article reveals just how badly the game is rigged. Even I was surprised, and here I thought Wall Street was out of surprises for me. How silly of me! For example, one series of CDs from HSBC called “Industry Titans” pegs its returns to a collection of ten stocks. From the inception of the contract in 2012 through July, 2016, the stocks were up by 46%. Now you may think that a holder of an Industry Titans CD would be quite happy, but you would be wrong because HSBC put a 6% cap on the winners and a minus 30% floor on the losers! The fact that there were two big losers among the ten means that the investors have not made a penny of interest. All I can say is wow, just wow! In my opinion, there is no way that the buyers of this piece of Wall Street dreck understood what they were getting themselves into.
Of course, this is but one example, and unfortunately we don’t have the data on all the market-linked CDs, but we do have some of them, and it’s not a pretty picture. Of the 118 Barclays CDs issued at least three years ago, only 37 have posted returns of more than 1% per year, while the average conventional CD earned 1.2%. One quarter of them, like the HSBC Industry Titans debacle, have produced zero returns. Well, at least the brokers made out—like the genius broker from Fifth Third Securities who advised an 88-year-old customer put the bulk of his retirement money (about $200,000) into market-linked CDs. This was an especially horrid idea because the customer was required to meet Uncle Sam’s IRA required minimum distributions which means he got eaten alive by the early surrender charges.
The lesson for investors is simple: Don’t invest with companies that are not acting as your fiduciary. In Clarity’s view, Investments should not be “sold” like appliances. Lastly, if a proposed investment appears unnecessarily complex and difficult to understand, just walk away! Remember the sage words of Warren Buffett: “Wall Street is a place where anything that can be sold will be sold.”