As banking companies take steps to move into the forefront of investment management, some have begun offering an array of complex products for their more sophisticated affluent clients. Paul N. Watterson Jr., an attorney with the New York-based law firm of Schulte Roth & Zabel, advises a number of private banking departments as well as their well-heeled clientele about such exotica as equity and debt swaps and foreign exchange contracts. Recently, he sat down in his midtown Manhattan office and discussed issues that banks need to consider when offering complex and risky investment options.

Q.: What exactly are these new products being offered?

WATTERSON: We see quite a few private banking investors wanting to buy foreign exchange products in order to get good exposure to foreign currencies, or because they've got a business or an investment that has foreign exposure and they want to hedge the exposure. There are also high- end private banking clients who are making investments outside the U.S., in securities or in buying businesses, who need these products to obtain the currency and to protect their return against the currency risk.

And then you get the really high-end investors who want to diversify their investments into the kind of investment they often cannot acquire as an individual. They can use equity swaps and credit swaps to take a position in an investment without, for instance, owning a loan, which they couldn't do.

Q.: What is the advantage to investing in a credit swap?

WATTERSON: You may either be getting a better return or may be getting a better secured risk for the same return. It's a fixed income return, so investors are getting a return similar to the return they could get in the junk bond market.

Q.: What should banks be aware of when dealing with such sophisticated products?

WATTERSON: Banks should certainly have some kind of disclosure statement to give to customers, explaining the risk of the transaction, and getting them to acknowledge that they have evaluated it. Banks also have to take extra suitability precautions to make sure that this investment really makes sense for this investor, based on what they know about the investor. And beyond the procedural things, the bank really shouldn't engage in these transactions with the investor unless the investor is either incredibly sophisticated or has an investment adviser that is.

Q.: Who is eligible for these products?

WATTERSON: You wouldn't do any of these things with anyone who wasn't an eligible swap participant - for an individual, that means at least $10 million in personal assets. Individuals get exposure to credit derivatives either if they're doing it directly themselves or if they are buying into a mutual fund, which has bought the same derivative.

Q.: Have there been many incidents where customers have gotten burned?

WATTERSON: There is a long history of retail customers being burned by unsuitable recommendations of purchases and sales of securities. But with derivative products, there aren't many litigated cases. I also don't think there are many claims that were settled quickly and kept quiet. One of the main arguments that the industry makes is that if you look at all the incidents of alleged unsuitable recommendations by derivative dealers to the public, you are talking about a very small number of cases.

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