HSBC Trust has updated their FAQ to address this:

Can you confirm the reports stating that any restructuring of the notes is not feasible for the time being?

Yes, although draft proposals have been made by interested parties the Receivers, in consultation with the independent advisers appointed by MAS in relation to the restructuring proposals, have ruled out any restructuring for the time being due to the legal complexities which are likely to be encountered in unwinding the notes and seeking to obtain control of the ultimate underlying assets. See answers to questions 14 and 19 for further details.

Can you confirm that the note trustee has received a notice from the lawyers of Lehman Brothers? What does it say and what are the implications? 

Yes, we have received a communication from Lehmans’ lawyers in the US which indicates, as a result of the Lehman bankruptcy, there could be legal challenges on behalf of Lehman relating to the documentation and the actions which need to be taken to unwind the notes both at the Minibond level and for those series in respect of which the underlying securities are underlying synthetic notes at the underlying level as well. This raises the possibility of prolonged litigation as part of the process which has to be taken by the Receivers to unwind the notes. We cannot comment further at this stage other than to say that the contingent litigation risk as referred to in the answer to paragraph 14 makes it impossible for the Receivers to make any kind of estimate of what value may ultimately be realised for noteholders and means that the overall process could take a considerable time.

Series 9 and 10 will face a less complicated process compared to the other series, as the underlying securities for these notes are corporate bonds and have no swaps. This means the ultimate collateral is more readily accessible to the Receivers and there are fewer aspects of the unwinding process which might be subject to being challenged by Lehman. Accordingly, the process may be somewhat shorter than for the other series.

Update from MAS

Fresh Woes for Minibond Holders (Today)

No Swift Solution for Lehman Minibond Holders (Channel News Asia)

Restructuring of Minibond on Hold (Business Times)

Expect 2 year Refund Delay (Straits Time)

Dear Martin,

I am enquiring on behalf of my father who has been approached by an insurance agent in signing up an Endowment Plan.

The amount is $50,000 is single premium for 5 years term. The insured amount is $62,500. The part that I am uncertain is on the Projected at 2.80% and 4.30% on investment return (which both are non-guaranteed) described.

The agent explained that it is based on compound interest 0f 2.997% upon 5 years maturity. She also explained that the non-guaranteed investment return is required by MAS to provided.

Appreciate if you can advise on:-

1. Can I deemed the compound interest as 2.997% as the guaranted interest rate? Cos I have some concerns on the so-called non-guaranted is like too good to be that attractive.

2. Is this endowment plan similar to a fixed deposit? Which one would be a safer option, this or the recent fixed deposit with BEA over 2.125%?

Thank you for your time in reading and hope to hear from you soon!

My reply:

First of all, you might want to refer to my earlier post on participating funds.

In this case, the insurer is showing you the projected returns based on the figure of 2.8%pa and 4.3%pa for their par funds.

If their funds managed to achieve a 2.8% p.a. return, you will get back $54530 on maturity. This works out to be an annualised return of 1.75% p.a. On the other hand, if they can achieve 4.3% p.a., then your annualised returns works out to be 2.997% p.a. as correctly pointed out by your agent.

As you probably realised by now, this 2.997% return is not guaranteed. The only guaranteed portion is the return of $50000 on the maturity of the plan. Your actual returns might be higher or lower depending on the performance of the par fund.

Your benefit illustration will show you the track record of the par fund for the last three years as well as their asset allocation.

Insurers also usually practice a concept of “smoothing” to spread out the gains/losses evenly to policy holders. In layman terms, this means keeping some buffer (when they declare bonus) during good years to make up for bad years.

Lastly, an endowment plan is not the same as a fixed deposit. There is always a trade-off between risk and return. With an endowment plan, you stand a decent chance of getting a better return than a fixed deposit but you bear the risk of the par fund underforming. You also bear the liquidity risk (funds locked up for five years). 

Ultimately, it is up to you dad to decide which are the risks he wants to get paid for because ultimately that is what investment is - understanding the risks and being paid for those risks you are willing to take.

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Complex issues of US bankruptcy law have been raised.

Article in Hong Kong on this issue

HSBC Institutional Trust Services (Singapore), the trustee for minibonds sold in Singapore, also received legal notice from Lehman Brothers attorneys on Wednesday that any termination of swap agreements underlying the Singapore minibonds would be deemed illegal.

Version 9 of the HSBC FAQ (dated 25 Nov) makes no mention of this yet. Paragraph 18 takes about the legal implications of transfering swaps, but is not exactly the same issue of swap termination.

On 13 November 2008, Lehman Brothers Holdings Inc. and its affiliated debtors in chapter 11 proceedings in New York filed a motion seeking an order that would (a) allow them to assume, sell and assign executory, derivative contracts that have not yet been terminated and (b) permit them to enter into settlement agreements with counterparties under terminated derivative contracts without further approval from the United States courts.

For each series of the Minibond notes, Minibond Limited entered into swap agreements with Lehman Brothers Special Financing Inc.

If a United States court order is granted in connection with the motion above, Lehman Brothers Special Financing Inc. will be allowed, as a matter of United States law, to transfer any open swaps to third parties who wish to acquire them without the need to seek the consent of the swap counterparty.

The swap agreements entered into in connection with the Minibond notes are governed by Singapore law and are subject to the exclusive jurisdiction of the Singapore courts. The trustee understands from its legal advisers that it is highly unlikely that the unilateral transfer of swaps (under any order made pursuant to the motion referred to above) by Lehman Brothers Special Financing Inc without consent from Minibond Limited, would be recognised and enforced as a matter of Singapore law. If this is correct, even if the order was made, noteholders would still have the opportunity to reject any transfer purported to be made under it as and when the transferee sought to assert any rights in relation to the swaps under Singapore law. It is however emphasised that the trustee cannot give legal or other professional advice to the noteholders on this or any other issue and noteholders cannot rely on advice obtained by the trustee. Noteholders may therefore wish to seek independent professional advice with respect to their own positions.

We will have to wait and see how all these unfolds.

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Tan Kian Lian (Part 1)

Tan Kian Lian (Part 2)

Tan Kian Lian (Mandarin Transalation Part 1)

Date: 4 December 2008 (Thursday)

Time: 7-9pm

Venue: SGX Auditorium, #02-02 Podium, SGX Centre 1, 2 Shenton Way

RSVP by Monday 1 December to Jennifer Yap at 62312769. Seats limited to 160 participants only. Light refreshments will be provided.

Meeting Agenda

1. See your MP
2. Misrepresentation in prospectus
3. Ask for information in writing
4. Experience with FIDREC
5. Mental health concerns
6. Class action
7. Special meeting on Sat 6 December 08

An extension to a single CDS is a credit linked note (CLN) that has a basket of entities as the reference entities. In this case, a default will occur when the first entity in the basket defaults.

The noteholder becomes the insurer while the CLN issuer takes on the role of the insurance buyer. Retail investors have to put up the principal in case there are credit events.

The principal is then used to buy some underlying securities. In the good old days, the underlying securities could be government bonds.

This first-to-default structure means that the more entities there are in the basket, the higher the probability that a default will occur. This makes it more risky for the noteholder.

But wait, shouldn’t more entities mean more diversification? Let us look at the difference between holding normal bonds and a CLN setup.

Portfolio of Bonds

$5 million in capital is used to buy $1 million bonds from five different companies. Should there be a default, $1 million could be lost. Having more companies in the portfolio of bonds diversifies the risk. 

Credit Linked Note

$5 million is provided by the note buyer. A CDS of $5 million each is written on five different companies. Total insurance written is therefore $25 million. In the event of a default by one company, up to $5 million would have to be paid out to the swap counter party. In addition, all the other 4 CDS positions will also have to be unwound.

Therefore, the more companies there are in the portfolio, the riskier the note is.

If the CLN has been structured with $1 million CDS each written on five companies (total insurance of $5 million), then it would have been similiar to the normal bond portfolio. But then, the profit to the note issuer would be much lower.

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The High Notes 10 FAQ highlights the risk of this product. The capital of investors will be severely affected should something (along the likes of bankruptcy) happens to one of these two companies:

• DBS
• CapitaLand

The buyback price of High Notes 10 can be found on the DBS website. This mark-to-market price is quoted on a daily basis and is affected by a few factors, including:

• interest rates
• exchange rates
• credit spreads of CapitaLand

Redemption of High Notes 10 is available on a daily basis until further notice.

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Minibond Series 9 noteholders will receive an amount based on an interest rate of 3.6383917% p.a. This works out to be $90.91(3 months period) for every $10,000 invested.

Minibond Series 10 noteholders will receive an amount based on an interest rate of 3.3234799% p.a. This works out to be $83.09 for every $10,000 invested.

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In this post, I will give a brief introduction to credit default swaps. 

But first, we need to know what a bond is. A bond is simply a debt obligation of a company.

For example, if you use $100,000 to buy a 5-year bond from SPH, you are essentially lending $100,000 to SPH. In return for the loan, SPH agrees to pay you a coupon (or interest rate) of say 4.5% p.a.

In the event that SPH goes bankrupt, you will lose a huge part of your principal. The amount you get back will depend on the recovery rate. If the recovery rate is 40%, you will get back $40,000 of your capital. 

To mitigate the risk of a SPH failure on your SPH bond, you can buy a credit default swap (CDS) on SPH. This is like buying an insurance plan that pays you if SPH defaults on your loan. The cost of this insurance premium might be about a couple of percentage points every year but will depend on a few factors including:

• Credit rating of SPH
• Market conditions
• Government risk free interest rate

Using our earlier example of a SPH failure, the seller of the CDS (which acts as the insurance company), will have to pay you $60,000, which is the amount you lost based on a recovery rate of 40%.

If SPH does not default on their bond for the duration of the CDS, the CDS seller happily pockets the premium.

The thing about CDS is that anyone can purchase it without the need for owning the underlying debt. If I feel that SPH is going to fail soon, I can buy a CDS on their default even though I might not hold any SPH bonds.

Conversely, almost anyone might sell a CDS without the need for showing that they can handle the payouts in the event of a default.

In the search for greater yield, this “free for all” mentality in a largely unregulated environment has led to an explosion in the CDS market. So much so until no one really knows what the size of everyone’s else CDS exposure is. And whether they can pay the liabilities in the event of defaults. Furthermore, it is clear now that some institutions have underpriced the CDS that they sold.

This is also the instrument that single-handedly bought down AIG.

And when someone talks about unwinding a CDS position, it simply means cancelling this “insurance contract”. There’s a cost (or profit) to this of course. This will depend on the market rate of the CDS at the point when the position is unwinded.

Let’s say you sold CDS for SPH at a 2% premium. If the current CDS rate for SPH is at 1%, you can buy your own SPH CDS at 1% and transfer away the risk of SPH defaulting (assuming no counter-party risk). Then, you would have made 1%. However, if the market rate for a SPH CDS is at 4%, you would have lost 2% in order to transfer this risk away.

The mathematics would be similar for the cancellation of any credit default swap between the swap parties.

The cost of CDS has increased significantly since the collapse of Lehman Brothers. Thus, most unwinding of CDS positions would have resulted in losses for the original seller.

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