Escape clauses at JPMorgan & Deutsche Bank…

September 10, 2010

untitled Love it or hate it, the Dodd-Frank Wall Street Reform and Consumer Protection Act threw a certain amount of short-term uncertainty at the lions of Wall Street. But this being Wall Street, don’t expect them to bear the consequences willingly.

This week, both Deutsche Bank (DB) and JPMorgan Chase (JPM) filed documents warning investors in complex securities that, if the bill — or legislation like it — causes them problems, well, caveat investor.

The documents are examples of the “free writing prospectus,” a sort of free-form offering document. Deutsche Bank’s FWP, filed on Wednesday, was for something called “Buffered Fixed Payment Securities Linked to the S&P GSCI Crude Oil Index Excess Return due March 15, 2011.” JPMorgan’s FWP, filed the same day, carried the cheery title of “Monthly Review Notes Linked to the S&P GSCI Excess Return Index due March 10, 2011.” (Both companies have filed previous FWPs mentioning the Dodd-Frank legislation in a similar context.)

Although these kinds of structured investments can be bewilderingly complex, similar instruments — typically promising the potential for a nice premium over the performance of an index or company share price, accompanied by a steep downside risk — have been marketed vigorously to retail brokers. This despite the fact that investment gurus call them manifestly inappropriate for the vast majority of individual investors.

The two we spotted this week are typical of the breed. Deutsche Bank’s offer a 10.7% over the face investment — if the S&P GSCI Crude Oil Excess Return Index rises over the term of the arrangement. But gains are capped at 10.7%, however much the index actually rises. By contrast, if the index falls more than 10%, your loss is magnified: You’ll lose 1.11% for every percentage-point decline beyond 10%. JPMorgan’s notes have even more tantalizing twists, at one point invoking visions of a 20% return — but a table deeper in makes clear your gains are capped at 10% and you can expect to eat losses in the applicable index at 100 cents on the dollar.

In any case, Deutsche Bank warns — in a chunky paragraph on page 4 of 13 — that the Dodd-Frank bill’s impact, like that of other regulatory change, “is impossible to predict, but could be substantial and adverse to your interest.” That makes it sound like Congress might slip investors a mickey. In fact, the next sentence makes clear that Deutsche Bank is mostly hedging its own bets:

“For example, we may become subject to position limits on certain commodities, including commodities included in the Index. Such restrictions may cause us or our affiliates to be unable to effect transactions necessary to hedge our obligations under the securities, in which case we may, in our sole and absolute discretion, accelerate the payment on the securities and pay you an amount determined in good faith and in a commercially reasonable manner by the calculation agent. “

The first sentence of JPMorgan’s Dodd-Frank disclaimer, at 50 words, is all but identical to Deutsche Bank’s, except it calls its instruments “notes” instead of “securities.” The House of Morgan then goes on to warn that future action by Congress could indirectly affect the value of the index in question, which in turn could hurt the investor’s payment. Moreover,

“we or our affiliates may be unable as a result of such restrictions to effect transactions necessary to hedge our obligations under the notes, in which case we may, in our sole and absolute discretion, accelerate the payment on your notes. If the payment on your notes is accelerated, your investment may result in a loss and you may not be able to reinvest your money in a comparable investment.”

The upshot of clauses like these: If it looks like the new regulations are going to hurt us, we have the option to clear the heck out if it’ll help us — very likely to your detriment.

In the run-up to the Wall Street reform bill, some members of Congress tried mightily to craft a bill that would give investors better odds when it came to dealing with the big banks. Clauses like this are Wall Street’s effort to make sure it keeps hold of as many cards as possible. Expect to see more of them cropping up as regulations to implement the new law are drafted.

Update: We heard back from spokespeople for both companies. The Deutsche Bank spokeswoman said the company’s filings speak for themselves. The JPMorgan spokesman declined to comment.

Image source: .faramarz via Flickr

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