During the financial crisis, Wall Street firms got a reputation for making money at their clients' expense. Yet years after the end of the crisis, Wall Street's finest are still providing their clients with access to complicated financial products, and one recent episode shows how those products can go awry for unsuspecting investors.
Late last month, Goldman Sachs (NYSE:GS) reported in a filing with the SEC that it had sold nearly $30 million in complex debt instruments called structured notes that were tied to the performance of Apple (NASDAQ:AAPL). That sale happened to come immediately before Apple released its most recent earnings report, after which the stock plunged. Although Goldman vehemently denies that it made money at the buyer's expense, various firms have sold billions of dollars in structured notes tied to Apple and other investments in the past year, and given the tech giant's losses, many of those notes have worked out badly for their buyers.
How structured notes work
Structured notes were designed to cater to the need among investors for substantial and dependable income. In general, they involve short-term bets on market benchmarks or individual stocks, offering yields well in excess of what the targeted investment offers in dividends. For instance, as Bloomberg reported, some of the notes that Goldman sold on Apple earlier in January were designed to pay a yield of more than 9% per year for as long as three years, with protection for investors' principal as long as the stock avoided losses of more than 30%.
But there's no such thing as a free lunch on Wall Street, and the lucrative income from structured notes comes with a catch. If the stock does fall below a certain threshold, then the company that sold the notes can force investors to accept shares of stock in repayment of the note rather than cash. Moreover, the notes are structured so that the amount of stock investors receive in case of a loss leaves them holding the bag for the entire amount of the loss. And to add insult to injury, after the threshold is triggered, the clock stops on any further income payments from the note, leaving investors with far less in total income than they expected when they first entered into the transaction.
A big bet
When shares don't drop, the deals can work out exceedingly well. For instance, back in September, Citigroup (NYSE:C) sold structured notes on Facebook (NASDAQ:FB) that paid a 17% yield for a one-year term, with a threshold loss of 35% below the roughly $19.35 per share price on the day of the note sale. Nearly six months later, Facebook shares have rebounded sharply, and the note buyer seems likely to get the full benefit of that 17% return.
Of course, that experience shows another trade-off of investing in structured notes: Your return is limited to the income payments. Buying shares of Facebook on that day in September would have produced total returns of 50% or more, well ahead of the 17% return on the notes. In fact, the best result for notes compared to the stock comes when the share price falls by just less than the threshold amount, allowing noteholders to get paid in full with interest and without having to accept depreciated shares as payment.
Beware of Wall Street "innovation"
The lesson here is the same as it is for all the new products that come out of Wall Street's toolbox: View any product with skepticism, especially if it has attributes that look too good to be true. Trading all your upside for current income isn't automatically a bad strategy, but it's essential to understand the risks involved, especially if you're retaining a big part of the downside exposure from a stock.
Fool contributor Dan Caplinger owns shares of Apple. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Apple, Facebook, and Goldman Sachs. The Motley Fool owns shares of Apple, Citigroup Inc , and Facebook. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.