The value of structured products that are set up to protect clients’ capital have been thrown into serious doubt after the shock bankruptcy of Lehman Brothers and turmoil in financial markets, say figures in the banking industry.

These products have often been marketed to private banks, brokers and advisors. Prominent manufacturers of such products include Société Genérale and Morgan Stanley. Typically, an investor is promised that all, or a very large proportion of, initial capital will returned so long as the product is held for its agreed maturity term, say five years, and the holder normally forsakes some of a market’s upside as part of the cost.

The stunning collapse of Lehman – parts of which UK bank Barclays has agreed to buy – has cast a pall over structured products, since investment banks typically assemble and can also stand behind the capital protections that go with them.

An example of a Lehman structured product is a 100 per cent capital-protected note linked to the Dow Jones Industrial Average Index, with returns capped at 135 per cent, with a 25 January, 2011 redemption date. (The Bloomberg code for this product is INDU Index). The fine print says Lehman is the lead manager and guarantor of the product. In its footnotes on this product, it adds that the clients are "exposed to the credit risk of the issuer and guarantor".

When a client buys such a product, they are effectively in the position of lending money to its issuer for an agreed period. Up until the Lehman bankruptcy, it may not have crossed clients’ minds that the products’ capital pledges were at risk, said a senior structured product financier at a large bank in

London, who declined to be named because of the sensitivity of the issue.

“There is a lot of nervousness around investors about these products. Until now, it has not been considered an issue but it is very sensitive right now,” the banker told WealthBriefing.

Much depends on the fine print of a product and how the capital protection is provided. If the protection is backed by a private sector bank rather than hedged via rock-solid government debt such as US Treasuries, for example, the client is in the position of a senior, but unsecured creditor, potentially losing everything, the banker said.

For clients with big portfolios held in structured products, say of $50 million or more, they should contact their banks to check terms and see if they can repackage their deals, using higher-quality collateral if necessary to stand behind any capital guarantees, the banker continued.

“That’s the kind of conversation we are already having with private banks and their clients,” the banker added.

Lawyers too are expressing concerns. "I would say that clients should be worried," Baker & McKenzie's Philip Marcovici told WealthBriefing. "To understand how safe a guarantee is requires an understanding of the structured product, and sadly many who sell these products understand more about the commissions and fees involved than how the products actually work."

Structured products may use cutting-edge derivative strategies to manage returns, but they are by no means a novelty. Earlier this decade, holders of so-called “precipice bonds” lost all, or some of their money as markets tumbled at the end of the ‘90s dotcom boom. These bonds were linked to derivatives on underlyings such as the performance of an index like the FTSE 100 benchmark of blue-chip

UK stocks. Under the terms of these bonds, all capital was wiped out if markets fell by a certain percentage, hence the term “precipice”.

The precipice bond collapse was a mis-selling scandal at the time, leading to regulatory fines. Questioned by WealthBriefing on whether structured products could suffer a similar fate, the Financial Services Authority, the

UK financial regulator, declined to comment.

A number of private bankers and wealth managers told WealthBriefing that the structured products sector was a worry. “These things are only as good as the [investment] house that is protecting them, unless you have some sort of mechanism that stands on its own,” said Justin Urquhart-Stewart, marketing director of Seven Investment Management, a

UK firm.

Mr Urquhart-Stewart said his firm does not use structured products unless it can have a complete view of what the products contain and how they work.

Brian Rout, head of investments at Arbuthnot Latham, the

UK wealth manager, said his firm had only a modest exposure to these products. He added: “There is no such thing as a guaranteed product unless it is underpinned by some kind of government [bond] issue.”

A New York-related analyst, who also asked not to be named, pointed out that some worries about structured products’ value may be misplaced because banks such as Lehman typically would hedge out the cost of any capital-protection pledge by buying investment grade bonds. Also, the assets used to underpin the capital promises of such products were segregated from an issuer’s accounts, which protected capital.

In the past, structured products, which cover a bewilderingly vast range of markets, have been criticised for being opaque in design and for being driven by a desire by investment banks to earn quick fees. Also, as Barclays Capital argued in its annual Equity Gilt study last year, the cost of hedging against losses by such products typically comes at a high cost of reduced potential returns, without necessarily reducing volatility by a great degree.