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Structured wisdom

Date: Monday, September 21, 2009
Author: Tay Han Chong, Biz.thestar.online.com

“WHEN an old man dies, a library burns down.” A client, Mr C had attributed this to an old Kenyan saying. It refers to the wealth of experience, knowledge, skills and wisdom that is lost when an elder dies.

Of course, if the elder had been passing on his learning to the younger generation, then the death of his wisdom need not follow with his passing. Is this too idealistic? Perhaps, but many who have had the opportunity to learn from good mentors would agree that wisdom can be “inherited”.

Experience and learning can be imparted, but they have to be “updated” to be relevant with modern times. It is not about blind learning from the past, nor a total rejection of past experiences.

From the aches of the current financial crisis, many lessons will be learnt. One such important lesson is in the context of financial products – complex structured products.

Goldman Sachs chief executive Lloyd Blankfein said this recently – “The industry let the growth and complexity in new instrument outstrip their economic and social utility as well as the operational capacity to manage them.”

But are all structured products “bad”?

Let me share a personal experience, one which relates to learning from a mentor, about deriving a particular wisdom concerning structured investments.

Between 2003 and 2005, I was holding the appointment of head of investments and treasury business for a consumer bank in Singapore.

My mentor, who was my boss’ boss and the head of Global Investments Business, is a distinguished elderly gentleman, Kenneth Dowd Jr.

I remember distinctively on one occasion when we had a face-to-face meeting with about 6-8 persons.

The topic of CDO (Collateralised Debt Obligations) came up. In a sudden change of mood from relative cordial to one of suppressed anger, he uttered something along the lines of, “in Asia there are about a dozen people who truly understand the risks of CDOs, and half of them are in this room. I will never approve such a product for retail distribution, PERIOD!”

I am sure he was being sarcastic and definitely by exaggerating the situation, he was making an important point – never peddle or buy a product you cannot understand!

This wisdom goes beyond CDO, it covers all investments products.

In this crisis, structured products took a beating but the reality is, not all structured products are bad.

The lesson to be learnt is the need to identify and weed out bad apples, rather than throwing out a whole barrel of good ones because of a few rotten fruits!

Fundamentally, it is about fully understanding the products that we, the Bank, are approving for retail distribution, and also about the ability to educate clients so that they too understand the products.

This is the collective responsibility of our profession. His wisdom had been very clear to me, and has since been a guiding beacon in my professional life.

First and foremost, do we understand the risks of the products? If we don’t, then we have no business doing that business.

And even if we understood the risks, we must be able to explain it in equally comprehensive terms to the end investors.

I am proud that I have never supported or approved any CDO underlying structured investment products.

This, despite many investments bankers having put forth good strong arguments to support the CDO-backed products. I could not launch a product which, I felt, cannot be easily explained to the retail investors.

We should not let products’ complexity outstrip their economic and social utility.

With this statement, I support “going back to basic”, particularly on Structured Products.

It is not about more regulations, but about greater transparency and clarity.

The hallmark to a good structured product is to keep it as simple and concise as possible.

Below, a simple guide if you are investing in structured products:

> You must know exactly how you are going to get the returns. Generally, a structured product would have a transparent payout formula and your banker should explain how this is computed. If you are not clear or do not understand, seek clarification until you do.

> You must know exactly the risks and trade-offs. Structured products are about trade-offs and there is no free lunch. For example, where there is more principal protection, there will most likely be less exposure to the market and vice versa. Understand that there will be limitations; principal protection is usually provided if you hold till maturity but not during the tenure. There will also be costs including fees payable to the product manufacturers and distributors.

I do see reasonable value in structured products in the realm of wealth management.

Well-structured products do have the flexibility to achieve desired outcomes. In my personal investing, I too invest in a couple of structured products where they provide access to investments that I am unlikely to have direct access to such as Berkshire Hathaway and China-A Shares, while protecting my principals.

Just this week, we mark the first “death” anniversary of Lehman Brothers on Sept 15. With the 158-year-old organisation’s passing, we need to ensure its wisdom is kept alive. And we should also not forget Lehman Brothers’ cause of death and how it triggered a global crisis.

Tay is senior vice-president and senior head of UOB’s personal financial services division