The derivatives your bank is selling are not 'safe and sound'
You walk into a bank looking for a decent return on your money, maybe with one of those high-yield CDs you've heard about.
A well-dressed "personal banker" shuttles you to his cubicle and instead suggests something called a derivative that could earn 5% annually.
Impressed, you agree -- and live to regret it.
Unlike high-yield or indexed CDs, derivatives are complex, highly risky stock market investments that have absolutely no federal backing -- or a legitimate place in most people's portfolios.
With a CD, you may not earn much these days, but at least you'll always get out of it what you put into it, meaning your principal (minus fees and penalties for early withdrawal, of course).
That's because CDs are backed by the U.S. government, either through the Federal Deposit Insurance Corp. for bank CDs or the National Credit Union Administration for CDs purchased through a credit union.
With a derivative, you're completely uninsured, meaning you could lose your entire investment.
Derivatives aren't some evil scam -- well, not exactly. As their name implies, these complex legal contracts derive their value from the performance of an underlying stock, bond, commodity or currency.
Think of a derivative as a bet that the value of what's underneath it will rise or fall within a given time frame. Some win, some lose, but there's no guarantee you'll get a dime back.
What is an evil scam is the way derivatives have been aggressively marketed to American seniors as a quick fix for their flagging nest eggs. Those who take the bait are often unaware that they're jeopardizing their life savings.
Demos, a nonpartisan public policy research and advocacy group, recently teamed with The Nation Institute, a nonprofit media center, to publish a new study, How Safe Are Your Savings? How Complex Derivative Products Imperil Seniors' Retirement Security.
The study found that banks and brokers sold more than $52 billion of these products last year, despite the fact that they are blatantly inappropriate for most investors' portfolios, regardless of age. Seniors on fixed incomes are most at risk, however, because they have neither the time nor the income to recover from a financial collapse.
"For far too long, brokers have been selling their older clients these complex investments that are so risky and so costly in fees that some of them are almost sure money losers," says John Wasik, author of the study.
The study also found that brokerage firms mislead investors by characterizing their derivative offerings as "principal-protected" and "safe and sound" investments.
Chris Vernon, founding partner of the Naples, Fla., law firm Vernon Healy, specializes in suing what he calls "high-pressure derivative mills" on behalf of devastated investors.
"I've seen (derivative) cases where they say, 'Oh, we've got you one that tracks the S&P 500, one that tracks an Asian currency basket, one that tracks a bond index – you're completely diversified!' when they're all unsecured notes issued by financial companies," he says.
So much for that "principal-protected" whopper.
As for "safe and sound," you may recall that derivatives contributed to the economic collapse of 2008, the seeds of which were planted in the late 1990s when these risky products were made exempt from federal regulation.
That widespread financial disaster prompted Congress to rein in derivatives in its sweeping Dodd-Frank financial reform package.
The plan calls for derivatives to be placed under the regulatory control of the Commodities Futures Trading Commission, which oversees futures and commodities, and the Securities and Exchange Commission, which oversees securities.
That's a move that is long overdue, according to Barbara Roper, director of investor protection for the Consumer Federation of America, which has been lobbying hard to regulate derivatives.
"Derivatives aren't inherently bad in the sense that they can serve useful economic purposes. You can create a derivative to do pretty much anything," Roper says. "But because they are opaque, because they are unregulated, they lend themselves to abuse -- to where they're basically little more than gambling."
Roper says that the very argument that the derivatives industry used to duck regulation a decade ago -- "that everyone who participates in this market is a sophisticated investor who knows the risks" -- has allowed it to ransack the retirement nest eggs of older Americans.
"The only thing the average person needs to know about investing in derivatives is, don't do it," Roper says. "It's not remotely appropriate for the vast majority of investors."