Monday, September 29, 2008

MiniBond- Allocation of Responsibility

I have gathered a couple of news articles from Hong Kong which give better perspective of the whole issue.

What is MiniBond in the very first place? The picture above is a simple illustration I gather from Hong Kong Economics Daily newspaper. Yes, it is written in Traditional Chinese and I hope you could read it well.

Anyway, in short, the whole Minibond instrument comprises two parts:

1) The AA or AAA bonds as the basis of the structure (Right side of the diagram)
2) The Credit Risks Swap which involves a Vehicle (in this case, Lehman Brother's collective of financial bonds and instruments).

The first part (right part of the diagram) of the instrument is easy to understand. The money paid by the investors are used to buy AA or better rated bonds. The coupon rate or interest payment by the bonds are given to the investors on an annual basis.

However, to increase the returns of this instrument, the bonds are used as the basis to provide "insurance" for the other vehicle, like a collection of bonds or derivatives or financial entities. In this case, Lehman Brothers' collection of financial instruments. It means that Lehman Brothers will give the bond holders a certain percentage of premium to exchange for protection of its own credit risks. This is what Credit Risks Swap all about.

Literally, it means that Lehman Brothers, as an financial institution, needs to insure its own credit risk of honoring all the bonds or financial derivatives it sold in the market. Instead of buying financial insurance from a insurance company (or reassurance companies), it chose to pay a risk premium to Minibonds holders in return for an insurance against any of its losses in the event of credit events that it suffers.

Why would Lehman Brothers pay a risk premium to Minibonds holders for such Credit Risks Swap rather than buying insurance from a insurance company? Most probably it is much cheaper to do a Credit Risks Swap than paying hefty insurance premiums for its own credit risks.

The amount of "additional returns" that a Minibond provides for its investors depends on who or what the Credit Risks Swap is done with. If the Credit Risks Swap involves a collection of Junk Bonds, then naturally, due to the higher risks of Junk Bonds, the return would be higher. In this case, prior to the collapse of Lehman Brothers, it was considered as a relatively "low risk" financial entity by virtue of the facts that it was the 4th largest Investment Bank in USA. Thus the overall return of Lehman Brothers Minibonds is relatively low.

Well, if everything goes well and there is no credit issues or events for Lehman Brothers' collection of financial instruments, the investors could get all the interests paid plus the AA bonds they paid for when the Minibonds matured. But if there is anything happen to Lehman Brothers, then they could have to compensate Lehman Brothers for its loss due to these credit events like bankruptcy or inability to fulfill its financial liabilities. i.e. The Minibonds holders are required under the agreement, to act as an insurer of Lehman Brothers. It means that the AA bonds that are bought under the Minibond agreement would be cashed out and used as a compensation to Lehman Brothers to fulfill the obligation of the Credit Risks Swap.

This is the interesting part, small investors acting as insurer of a big investment bank!

The various articles have suggested that the regulators have not taken a pro-active stand in regulating the sales of these financial instruments. In the mini-bond issue, the returns are "improved" by virtue of the credit risks swap taken up by the financial instruments. In this case, Lehman Brothers bond is the vehicle that the bonds has taken up the risks swap. Yes, nobody would consider Lehman Brothers as a "high risk" financial entity but that is also why the returns is just 5.1%. If the vehicle involves consist of junk bonds, then one would expect a higher return.

The crux of the matter is whether investors are being misled in the whole dealings. But I guess the contract or agreement they have signed would have a clause that says the investors are briefed and understood the product, including all the risks involved. This is where the banks or financial institutions have covered their backsides. But the contract would most probably be very vague on what kind of risks they have explained to the investors. This is where improvement on regulation could be made. SPECIFIC risks and possibilities must be stated CLEARLY in BOLD, not in fine prints.

Even if the regulators come up with the requirement of putting different categories on the different financial instruments being sold, it is difficult to classify Mini-Bonds which involves two parts of financial structures: Bonds + Credit Risks Swap. Unless the regulations include the declaration of all possibilities of defaults and risks involves, I would say that no matter how good the products are marketed and sold, there will always be investors who will claim ignorance. Where does it end?

While I empathize with many aunty and uncle investors, but the point is, if they are not sure about what they are buying, they should not buy it in the very first place. If all investment decision in any instruments is solely based on the returns alone, then I would say that our investors, including aunties and uncles, will not evolve smarter at all. That is why I feel that we need to strengthen investors education. The plight of these aunty uncle investors is really sympathetic but they could not avoid their part of responsibility. If they chose to invest blindly, then they will have to bear the consequences. Very sad but this is basically how capitalist system works. Unless they could prove that they are being misled with clear evidence of mis-selling or misrepresentation by the institutions.

From the legislative perspective, there are rules could be set to avoid such chaos and disputes. For example, if the financial institutions that sold the financial products did not list out in BOLD of the various risks and possibilities within the marketing tools, contracts and agreements, then if one of the unlisted possibilities occurred and losses are incurred, then the investors should have the right to claim compensations from the financial institutions that sold them the products. For example, in this case, if the contract did not list the possibility of Lehman Brothers being bankrupted and the implications behind it, then the consumers have the right to claim compensations from the financial Institutions for their losses.

This will shift the burden of legal responsibilities of clear representation of risks to the financial institutions. If their presentation of risks is not all inclusive, then they will have to bear the risks of taking losses.

But I bet even with that legislation, there will always be investors that would claim ignorance. I mean, how would one measure the risk of Lehman Brothers being bankrupted at that point of time when it was the 4th largest investment bank in USA? It has no end. One has to learn that near zero possibility is NOT IMPOSSIBLE. However small the risk and possibility it is, there is still risks involved.

In the case of Hong Kong handling the issue of this MiniBond saga, the main argument is that those front line sales personnels are hardly trained and knowledgeable about this product that they were selling. I mean, this is a VERY COMPLEX derivative product that involves very abstract concept of credit risks swap. I would say that if the investors want to fight their case, they would have to provide all the marketing brochures and such, to show that the financial institutions did not explain or show clearly what a credit risks swap is all about. Then they could argue that the contract they have signed with that clause of claiming the investors have understood the product and all the risks involved, are totally invalid because due to this missing part of explaining credit risks swap.

This is the only plausible legal point that grievance investors could bring up against the financial institutions.

In my view, the regulatory body, MAS must bear part of the responsibility too. If any financially trained individuals would have difficulty in understand what a Minibond is all about at first sight, I wonder why MAS would allow it to be sold by banks to layman in the very first place. There is a clear lack of regulatory requirement or directions or guidelines to make stringent demands on the marketing effort of such complex financial instruments.

Furthermore, I think for banks that use their front line tellers to push sales of Minibonds is very irresponsible. I really doubt the front line tellers really know what Credit Risks Swap is all about and least, have the ability to explain clearly the risks involved in Credit Risks Swap to the customers, especially to the less educated aunties and uncles. This is both the lapse of MAS regulatory role as well as the banks' irresponsible moves as well.

Most customers would trust the banks as a more credible financial entity than an insurance agent or so call "financial consultant". This is the psychological effect of any normal persons. If one could entrust his money in this bank, naturally there is a level of trust on the credibility of the banks. Thus, most of the time, consumers would buy such "high return" financial instruments by virtue of basic trust on the banks' credibility, even though the banks' front line sales personnels may not be able to explain in full what the products entailed.

MAS should stop this practice by the banks, by means of regulation. Banks cannot sell complex structured financial instruments via its front line tellers. In fact, in USA, there is a strict distinction between Commercial Banks vs Investment Banks. Commercial Banks could only earn their keeps by taking in deposits and loaning them out. They are strictly regulated and disallowed to get involved in dealings with financial instruments with high leverage. Invest Banks are those who created all these mess with their financial innovations on derivatives.

I would suggest MAS to put a stop to such practice by banks in dealing with high leverage financial instruments by putting up categorization of each and every financial instruments approved for sales in Singapore. For example, if the financial instruments have a category of C, it means that it is a high risk, high return and high leverage financial instruments. Commercial Banks should be banned from selling or dealing with such financial instruments. Category A would be Government or Commercial bonds with AA or AAA ratings. This would be allowed for commercial banks... so on and so forth.

In my view, although the investors should bear bigger responsibility in taking up investment decisions, but MAS and the banks selling these Minibonds or High Notes could be totally excused from their part of responsibilities. MAS has failed miserably as a regulator in providing a clear guidelines in the sales of such financial instruments to the public.

If the PAP government could order cigarette packaging to bear big warning of lung cancer as well as tax-paid labels, I wonder why MAS has not taken similar steps in requesting financial institutions to put up BOLD and clear representation of ALL risks and possibilities involved in investing in any financial instruments. Furthermore, MAS should have prevented banks from selling complex structured, high leverage or risky instruments to layman. This should only be done by professional financial consultants instead.

And last but not least, I think the banks that sold these Minibonds would have to bear a level of responsibility in pushing the sales of such complex instruments when even their front line sales personnels may have limited knowledge about it. In fact, I would think that their credibility in the eyes of the public would be badly tarnished if nothing is done to compensate for their inconsiderate sales of such instruments to less educated aunties and uncles.

As for the investors, I could only say that if you want to prove their case against mis-selling, you would have to gather all marketing tools and materials to show that those sales personnels did not explain clearly what Credit Risks Swap is all about. Its not going to be an easy task to fight such cases against strong, big and mighty but I guess if all of you could unite and come together to go for class actions against irresponsibility sales of such instruments, you may have the chance to prove your case that even if you have signed that contractual agreement that says you have understood all about the product, but in fact, you have not been told about what the heck is Credit Risks Swap.

But ultimately, every potential investors in any financial instruments, even for investment related life insurance, we should be responsible enough to find out more about all these products before we commit our hard earned money into them.

Good Luck to you guys.

Goh Meng Seng


The Void Deck said...

Hi Meng Seng

A balanced observation on shared responsibility when everyone is jumping up and down to say the investors are blameless.

Goh Meng Seng said...

Hi Brother,

Long time never see you here! ;)

Yes, it is sad that many people are jumping up and down, starts to pointing fingers all over.

Yes, emotionally, we are touched by elderly people who lost their life long earnings in this minibond issues.

But the truth is, if we do not nab the bug at its root, there will be many repeated cases in future to come.

I hope this article could provide some balanced rationality into the whole issue and MAS should learn from its mistake.

Goh Meng Seng

Kee Hong said...

Hi MS,

Good points raised, as usual.

I especially liked the suggestion that tellers should keep to their job of daily bank transactions, instead of acting as "introducers" or "referrals" - it will make the queue shorter as well.

And yes, you are right, the sale of investment products should be done at investment banks, in the right environment. Not during lunch time, where an aunty or uncle just wanted to deposit $50,000 fixed deposit and get talked into putting their hard-earn cash into something they don't understand and have no time to find out more. There could be another infrastrucure for DBS/UOB/OCBC Investment Bank, for example.

Besides investor education, MAS also need to need raise the bar for financial advisors. I suggest minimum standard CFP or equivalent levels. While this may not prevent similar mis-selling in the future, it would reduce the occurrence.

Jennifer said...

yes, you may say that the investors of mini bond were blind....
however, how could you explain the overgraded AAA for this risky structure?
it has been misleading from the beginning before it was sold to anyone ...... fraud may not be heavy to describe it at all.

LuckySingaporean said...

Goh Meng Seng,

I think MAS will never put a clasification to say if a product is risk or not. If they say it is not risky, then if it fail everyone will be coming after them.

I think structured products that are that complex should banned from sales to retailers altogether because:

1. If it is so complex, it can never be understood no matter how much it is explained. GMS, how long did it take you to figure out the minibonds - I'm sure people selling couldn't have understood.

2. If the retail customer cannot understand, the only way to sell it to him is through misinformation and mis-selling.

There are many other things wrong with these products - it allows risk to be hidden and banks to hide their profits from the sale.

The Lehman minibonds (which are not bonds) are bad....but the DBS High Note 5 is just a horrible that is not simply fit for consumption ...worse than financial malamine.

Goh Meng Seng said...

Dear Kee Hong & Lucky Tan,

Kee Hong my friend, how's your business? Has such confidence crisis hit your sales? I believe you could ride the tide well.

And yes, such complex financial instruments should not be allowed to be marketed by unqualified financial advisers, least bank tellers.

Lucky Tan, the categorization of financial instruments is not meant to attribute risks level to those financial products, but rather, to categorize the complexity of these products.

I mean, even pure bonds itself has very wide spectrum of risks attribution, from junk bonds to AAA ratings. This categorization is for MAS, as a regulator, to determine what kinds of financial products could be sold by commercial banks.

And I agree with you totally. The complexity of these minibonds or structured financial products is not easy to understand at all. As a person trained in financial economics which includes financial derivatives, with honours degree in that, I have to spend half a day just to understand the mechanism of this minibond.

On top of that, I have just found out that I have not fully understood what Lehman Minibond entails until I have further discussion with others.

I have just noted that, ironically, the collateral of financial assets are of more risky assets which include CDOs and they are using it to "insure" the higher rating reference assets which include all the biggest banks in the whole world!

I mean, would you ask a guy living in poverty to be the guarantor of the filthy rich guy's multi millions loans? It is really amusing and ridiculous!

If anyone of the biggest banks fall, do anyone with a rational mind would think that those lower rated bonds and assets could escape the financial brunt at all? This is totally ridiculous. In a financial run down, the smaller financial entities and their related bonds and derivatives would be the first to go. Then the big boys will fall.

Thus, such minibonds arrangement is structurally unsound. Someone in MAS should get the kick to approve such financial instruments to be sold to the publice.

Goh Meng Seng

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