Business Times: Look at pricing structure, risk disclosure too

11 Nov 2008
By OH BOON PING

LAST month, DBS Bank agreed to return up to $80 million to investors who were mis-sold the DBS High Notes 5 series - a welcome move by many. But as the saga continues, public attention should be paid not just to the way products were mis-sold, but also the pricing structure and risk disclosures involved.

To recap, the note is a 5.5 year credit-linked series that pays 5 per cent annual premium on the Singdollar tranche with an underlying 'default' basket of eight securities including the now collapsed Lehman Brothers. If either of the reference entities undergoes a credit event - such as bankruptcy, this means that investors who bought the notes will receive only the net market value of only the underlying securities tied to the defaulting entity.

In a sense, they have become insurers against the total credit risks of the underlying basket in exchange for 5 per cent premium each year on the Singdollar tranche.

And this raises the question: is the interest payment fair given the types of risks involved? Indeed, if we assume that the chances of entities hitting a 'credit' event are mutually independent and equal, this means that investors are paid 5 per cent annually to insure against a total credit risk that is eight times that of one reference entity - scant compensation by any measure.

Yes, all the entities had strong ratings of between BBB+ and AA- when the notes were structured, and the issuer can point to those ratings as evidence that a low interest payout is fair.

Identical insurance
However, it is conceivable that the long counterparty may have to cough out a lot more in premiums if he had bought an identical insurance from general insurance firms with diversified portfolios of insurance assets.

A second issue concerns the level of professionalism among the relationship managers. Not only was product structure not properly explained to some investors, but the investments were sometimes sold to clients who did not have the risk appetite for them.

This is clear from the several cases of mis-selling, where High Notes 5 were sold to 'low-risk tolerance' investors who should not have bought the product in the first place.

In some cases, even the relationship managers did not understand the products but continued to market them to clients, according to some reports.

This is a serious breach of professional conduct since industry best practices dictate that those providing client advisory services have a duty of ensuring that only suitable investment products are recommended to clients, and related information should be transmitted accurately.
What the episode illustrates is that financial advisory standards still leave much to be desired among some local banks and brokers.

A third issue relates to the disclosure of market information on those structured products. Unlike stocks, structured products are not openly traded in a liquid secondary market and investors have no means of getting the latest market data or information except by calling their relationship managers.

The result? Investors have no means of making timely investment decisions, and this may hurt them in volatile market conditions like now.

For example, a check on the Bloomberg showed that spreads on Lehman's five-year senior credit default swap in US dollars had risen rapidly to a few hundred basis points in recent months, while credit spreads widened steadily over the same horizon.

Amending the rules
However, as most investors did not have access to such information, they may end up holding on to a depreciating asset instead of cutting losses.

Therefore, financial regulators may wish to consider amending the rules to require issuers to release such vital market information.

Already, the push for more disclosure in gaining momentum elsewhere, like when the Depository Trust & Clearing Corp said it will now release weekly credit-default-swap data, and similar moves should also be made in Singapore.

Institutional issuers have a duty of ensuring greater transparency, as individual investors deserve no less.