The New Paper:The real problem? Underwriters hiding product's risk

14 July 2009

For the first time, the Monetary Authority of Singapore has banned 10 banks and brokers from selling structured notes for six to 24 months.

The ban doesn't affect other structured products. POSB still advertises 2.78 per cent interest in the first year for its five-year structured deposit linked to four Singapore blue chip companies.

That one is safe but, as usual, it is impossible to calculate the yield you can expect after five years.

Banks won't tell what we really need to know: A history of actual versus advertised yields for structured deposits.

Banks and brokers sold us billions of dollars of structured notes. Defaults stand at $686 million. Some have become worthless, like DBS High Notes 5. Others still have value, like Minibonds.

MAS report

In the just-released 119-page MAS report, 10 banks and brokers describe how they measure customer risk attitudes. It's useful but doesn't address the real problem: Underwriters hiding the product's risk.

Structured notes promise a safe-looking yield of around 5 per cent per year. But underwriters invest your money in risky bonds that yield much more, like 15 per cent. They keep the difference of 10 per cent, which is called 'expenses'.

The problem is, they don't disclose expenses or total yield in the prospectus or anywhere else. Investors see only their 5 per cent yield, which is low enough not to trigger any alarm bells.

That is half the story. The other half is a built-in conflict: Underwriters have fixed expenses and can earn more by investing your money in high-yielding, risky bonds.

Those bonds are more likely to default but underwriters have that covered too. A typical contract is written so that investors lose everything if only 10 to 15 per cent of the bonds default.

Investors must then forfeit the remaining 85 to 90 per cent of 'good' bonds to the underwriter. An example of this is Pinnacle Notes 9 and 10.

Underwriters get an even better deal when a 'reference entity' - like Lehman Brothers - defaults. It triggers transfer of 100 per cent of investors' money to the underwriter. An example is DBS High Notes 5.

In that case, DBS said it sold its rights to the $103m of investor losses. I asked, but the bank declined to say when it sold, how much it received and whether the buyer was an affiliated company.

Next, DBS set aside $70m to refund losses here and in Hong Kong.

The 7 Jul MAS report shows DBS made refunds of $7.6m to High Notes 5 investors. That is 11 per cent of the $70m DBS allocated to reimburse Singapore and Hong Kong investors.

The low payouts here may be explained by higher payouts in Hong Kong.

Compensation by HK v S'pore banks

WE HAVE heard that 63 per cent of decided structured note cases received full or partial refunds.

That is impressive, but the number falls considerably when you look at dollars paid to all investors.

The data comes from the 7 Jul MAS report, a 26 Jun speech by Senior Minister Goh Chok Tong and losses reported for Pinnacle Notes 9 and 10.

It shows $107m out of $686m of defaulted notes - 16 per cent - was returned to investors.

Contrast that with Hong Kong banks. On 7 Jul, The Standard newspaper there reported that 16 distributors for Minibonds met with the Securities and Futures Commission on 29 Jun to indicate they would pay 60 per cent of the amount invested. A few investors - aged 65 and above - would receive 70 per cent.

To recap, our banks paid investors 16 per cent. Hong Kong banks propose paying at least 60 per cent.