Friday, July 4, 2008


Today we are going to talk about how the challenges of today will inspire the financial wizkids of tomorrow! Most recently we have felt the impact of the "skill" or perhaps more appropriately, the "cunning" of financial engineering. The increase in "structured" solutions has come at a tremendous cost as we have all seen with the Sub Prime situation and ABCP fiasco.

While rationale minds might think that would lead to the sale of more "vanilla" securities like stocks and bonds and Index funds, that is not likely to happen any time soon. Financial engineering is "industry speak" for hiding the fees behind the concept. So whats coming next.....

What will actually happen is that the financial "engineers" will construct more of the same structured stuff that got us into trouble today! If real engineers and construction firms worked the same way as financial engineers, houses would be falling down all around us as I write. But one needs to assume we are not crazy enough to buy the same risky securities as the ABCP and bad mortgage products we bought; so this time around the engineers will have a whole new approach to the products. Look for the word "GUARANTEED" to become prevalent in the sale of the "new" structured products! Having just been burned they know we are all looking for a "sure thing" before we dip our investing toe back into the shark tank.

How will they manage this engineering feat? Think of a rundown dilapidated house, but with a new coat of paint and new vinyl siding! The risks and future repairs are hidden by the cheap covering to provide a sense of quality that is not there.

Securities are actually quite basic. They are investments upon which you earn a rate of return determined by rent and risk.
Rent is the return you could get from a zero risk investment such as a short term government guaranteed treasury bill. That is known as the "risk free rate of return".
The "risk" portion is the additional return you get for accepting volatility and some amount of uncertainty in your return. As an example with bonds that risk portion would be the credit risk of the issuer and the impact of interest rate changes on the bond value.

So, if somebody is offering you returns above the risk free rate, and suggesting you have a guarantee, then where did the risk end up? The return over and above the T-Bill rate means there is risk, but the guarantee means somebody else is taking the risk for you! Sounds great! So, just one question(?) what are they getting in return?

Well, for the most part they are getting a significant chunk of the return you might think you will be getting! The neat thing, for the engineers, is you are the only one putting money into the proposition! They are taking a per cent of your positive returns and none of the negative returns because the guarantee is paid for from your deposit. Perhaps now you can see where the cunning comes into the equation!Perhaps these products need to come with a warning on the label:

CAUTION: Guarantees may significantly reduce the value of your investment while drastically increasing your costs!

While that is never likely to happen, the real disgrace is that these products will be sold to those seeking the least risk and who can often least afford the costs.

So what should you be watching for:

Guarantees: Unless you are buying a bank GIC with CDIC coverage or a short term Government Bond, do NOT ever trust a guarantee.

GaffleGab: If you do not understand a product, do NOT think it is because you are stupid. There is a great chance the confusion is intentional and a pretty good chance your advisor does not really understand it either.

Fees: Structured products are often designed to hide fees. Ask for a clear description of all fees in writing from your advisor along with comparable fees without the guarantee. In fact ask your advisor why they can not create the same product for you from standard easy to understand securities.

The attached leads to a great Ken Hawkins article on structured products for those wanting to learn more!

sois mike

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