Good Idea of the Day: Slashing the Structured Product Investor Base

Aline van Duyn reports today that a group of A-list banks — "including JPMorgan Chase, Merrill Lynch, Citigroup, HSBC, Lehman Brothers and Morgan Stanley," we’re told, a list which is notable for the non-inclusion of Goldman Sachs — is interested in tightening up the rules on who they’re allowed to deal with.

Perhaps the most unexpected proposals involve new criteria for the “sophisticated investors” allowed to buy complex financial products. Under the plans, even pension funds and other institutional investors would no longer be automatically allowed to buy bonds backed by assets such as subprime mortgages. All but the wealthiest retail investors would be barred from buying structured products, such as auction rate securities, a $330bn market used by municipalities and student loan providers to raise funds.

I like this idea a lot. The present system for determining whether you’re sophisticated enough to play in highly complex markets basically comprises one question: "How much money do you have?". If the answer is a big enough number, then come on in, the water’s lovely!

This is not about reducing the risk that unsophisticated investors are going to be allowed to take. Any idiot can gamble their entire net worth trading in and out of penny stocks, should they be so inclined, and lose it all in a matter of weeks. Rather, this is about matching sophisticated products to sophisticated — rather than simply rich — investors. For all that it’s highly risky, a penny stock is easy to understand; a CDO-squared comprising synthetic products made up of ABX CDSs, on the other hand, is almost impossible to understand in any detail.

If this proposal goes through, then retail investors won’t be herded into auction-rate securities by fast-talking brokerage salesmen, and that’s a good thing. I have no idea how "structured products" can be defined to include ARSs, but I’m glad that someone’s been able to do it. We’ve learned the hard way, over the past year, that complexity in financial products tends to backfire. At least now we can hope that it will backfire only on those investors who only have themselves to blame.

Update: I think Aline was talking about this; Goldman is represented on the committee. I believe this is the recommendation she is talking about:

All participants in the market for high-risk complex

financial instruments should ensure that they possess the following

characteristics and make reasonable efforts to determine that their

counterparties possess them as well:

ß∑ the capability to understand the risk and return characteristics of the

specific type of financial instrument under consideration;

ß∑ the capability, or access to the capability, to price and run stress tests

on the instrument;

ß∑ the governance procedures, technology, and internal controls

necessary for trading and managing the risk of the instrument;

ß∑ the financial resources sufficient to withstand potential losses

associated with the instrument; and

ß∑ authorization to invest in high-risk complex financial instruments from

the highest level of management or, where relevant, from authorizing

bodies for the particular counterparty.

Large integrated financial intermediaries should adopt policies and procedures

to identify when it would be appropriate to seek written confirmation that the

counterparty possesses the aforementioned characteristics.

I’m not clear, however, where Aline gets the idea that ARSs are included in "high-risk complex

financial instruments".

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