Published September 19, 2008

Should Minibond Series 3 have taken the retail route?

By R SIVANITHY
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IF YOU want a front-row lesson in first-class financial obfuscation for structured products, then look no further than the way the recently collapsed Minibond Series 3 notes was packaged and marketed.

Lehman structured a synthetic derivative product to hedge its exposure to various instruments and linked it to the default likelihood of six major banks.

Up to $200 million of these notes were sold to a gullible retail public who probably thought they were buying a five-year bond issued by six leading banks that paid a 5 per cent coupon per year but were in reality, not only exposed to the US housing market but also to a complex credit default swap arrangement whose substantive party was the now-bankrupt Lehman Brothers.

The cover of the Pricing Document prominently stated that the issue was credit-linked to six financial institutions, namely Barclays Bank, Citigroup, Deutsche Bank, Goldman Sachs, UBS and UOB - these banks being defined as Reference Entities or REs.

Much was made of the fact that the viability of the notes depended on whether these six banks or REs would go bankrupt and there are repeated warnings to this effect throughout the document. Investors were given plenty of information on the credit ratings of these six REs and links to their websites while Lehman is listed only as the Arranger in small print.

The fine print at the bottom of the cover, however, states that Lehman is also Swap Counterparty, besides being the arranger. Not many retail investors would have seen this, and if they had, few would probably have understood the importance of this information. More on this later.

Investors, however, were urged to read the Base Prospectus in conjunction with the Pricing Statement. In the former's page 24, it is stated that 'the Notes are intended to provide investors with a coupon for assuming exposure to the credit risks of companies or of sovereign states, that is, the Reference Entities'.

'By acquiring the Notes, investors can gain exposure to the credit risks of the REs without directly holding debt obligations of the REs, for example, bonds issued by the REs.'

Note that the language used creates the impression that gaining exposure to the credit risks of the six REs is something desirable - and, by extension, this suggests that the notes are good investments - when in reality, the key to the whole issue is in the words 'without directly holding debt obligations' of the REs.

In other words, the six REs are not participants in the notes, receive no money from the issue and are not issuers of the notes. Instead, the next sentence reveals all: 'This (exposure) is achieved by linking payment of the principal and/or interest on the Notes to an RE's default.'

Who provides this link? In all the documents, this is given as Minibond Ltd but this is a special purpose vehicle with only US$1,000 in capital. The substantive party behind Minibond Ltd is most likely Lehman Brothers. Here's how it works.

Lehman most probably owned securities in the six REs. In order to hedge itself against a default by any of these REs, it set up Minibond to offer notes to the public. Minibond offered these notes with attractive terms and because of clever marketing and pricing, collects a certain amount of cash from retail investors.

This money is then used to buy securities - in the case of Series 3, it was collateralised debt obligations (CDOs), most probably on US mortgage instruments. Minibond then collects the cash flows from these CDOs. In order to pay investors the quarterly coupon and to ensure no problems with currency/interest rate fluctuations, it swaps these cash flows with a counterparty, which is Lehman. It is stated elsewhere that if the swap deals fail in addition to an RE default, the whole issue will be terminated. Thus, since Lehman has failed, so has the issue.

The crux of the entire deal appears on page 17 under Credit Default Swap where it is stated that Minibond has an agreement with Lehman in which Lehman pays Minibond a premium for insuring Lehman against credit losses on the REs.

In effect, the money that Singapore retail investors exchanged for the notes were not for any bonds issued by the six names that appeared on the cover of the prospectus but instead, went towards insuring Lehman against losses in its portfolio.

The quarterly coupon investors received was not interest from the six REs but instead, Lehman paying an insurance premium, partly financed by cash obtained from CDOs.

In short, Lehman structured a synthetic derivative product to hedge its own exposure to various instruments and linked it to the default likelihood of six major banks.

Should the true nature of the instrument have been disclosed upfront? Yes, especially since it was marketed to retail investors - though it has to be said that many other notes and products have been sold in a similar manner and the only reason that the poor disclosure of this particular series of notes surfaced is that Lehman went bust. Had it not, or had it been rescued, the coupon payments would have continued as per normal and no one would have been the wiser.

Moreover, while it is possible to piece together the actual substance of these notes from the documents available, it is a tedious process and arguably not within the ability of the average retail investor.

There are many issues also unresolved - for one thing, how many other similar products are out there? How could the authorities allow the conflicts of interest inherent in one party from being the arranger, issuer and swap counterparty?

How is it that, if Lehman alone performed all these functions, there was virtually no disclosure of Lehman's financial position or credit rating? Instead, investors' attention was focused on the six REs - wrongly, as it turned out.

Finally, if disclosure was weak, then so was knowledge among distributors. Some brokers did not understand the true nature of the instrument and sold it as a bond. Maybe the name had something to do with it, though as investors have now found out painfully, what they had bought was not a bond but a convoluted swap-based instrument.

Thus, should such products be allowed to continue to come into the retail market?