Keep the gains, sell the risks

Bloomberg.com: Exclusive

“Bankruptcy risk is inherent in any investment involving a corporate entity in the U.S.,” Styrcula said. “If you don’t understand that it’s a note, and you’re not reading the prospectus, then that’s a buyer-beware scenario.”

Lipner, the Garden City lawyer who’s also a law professor at Baruch College in New York, said one of his clients bought Lehman notes issued in February that came with a brochure promising that “at maturity, you will receive a cash payment equal to at least 100 percent of your principal.” The last in a list of 13 risk factors was: “An investment in the notes will be subject to the credit risk of Lehman Brothers.”

That first paragraph seems to display a stunning ignorance of the existence of credit-default swaps, i.e. the whole business that got Lehman in such trouble in the first place. What we’ve seen is that banks and investment houses with entire departments of analysts devoted to figuring these things out got suckered, so it’s really no surprise that ordinary investors reading about guaranteed return of principal would imagine that Lehman had insured the risk of its own notes with someone before selling them as “guaranteed”. In fact, that last risk factor, read along with the “at least 100 percent of principal” seems to me very much like a representation that the risk has been insured: the total return will depend on a bunch of things, including the credit risk of the underwriting company, but the principal is safe. That’s the same way that I know when I invest in an FDIC-insured bank I’ll get my money back, but I may get a miserable or zero interest rate if they’re in the process of going under.

Of course the other difference between the banks with all their analysts and the individual investors relying on the representations made by sales reps is that the financial industry is widely agreed that the banks should get bailed out of their losing positions, but the individual investors shouldn’t.

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