Questions to HKMA and Legco Lehman Incidence Investigation Committee

 Dear Legco Member, Dear HKMA Officers,

We are writing to you to express our questions and disagreements on the “Report of the HKMA on Issues Concerning The Distribution of Structured Products” (“the HKMA Report”). We respectfully request that Legco Lehman Incidence Investigation Committee (“the Legco Committee”) investigates questions below regarding Banks’ wrong-doing in conjunction with the sale of minibond to retail investors, and moves towards proper compensation for minibond victims. We also respectfully request that HKMA addresses each question below to the Legco Committee and to the public.

The key issue with Minibond is not about weather it declared “principal protected” or not. It is about the flagrant and recurring misrepresentation and omission of its true nature and risk. Lehman bankruptcy was only a trigger, to make the public realize the undisclosed nature and risk of the minibond.

Minibond Brief

1. Minibond is “Secured collateral and Swap” per SFC summary.
- Minibond collateral was mostly AAA-rated (Synthetic) CDO that is different from AAA-rated conventional bond.
- On the surface, Minibond included 5-7 Credit Default Swap (CDS) with 5-7 well-known A/AA-rated companies as reference entities.
- In the Minibond collateral, there were more than 100 CDS with more than 100 reference entities whose credit ratings were in categories ranging from AA to sub-investment grade. For example, collateral of Series #19 included 125 CDS with 125 reference entities and would lose 100% principal upon the 10th credit event in respect of reference entities. Collateral of Series #27 included 155 CDS with 155 reference entities of which 25 were sub-investment grade.
- Reference: The structure of Minibond Series 19 and collateral information:
http://chukwokhung.mysinablog.com/index.php?op=ViewArticle&articleId=1634112.


Conduct at Point of Sale

The HKMA Report Section 3.11-3.18 “Conduct at Point of Sale” listed responsibilities that financial intermediaries or HKMA/SFC registered staffs should follow.

2. The HKMA Report omitted the fact that banks consistently failed to offer collateral information to minibond buyers. Although banks are required to ensure adequate disclosure of relevant material information on the minibond.

The Minibond was in fact credit-linked to “7+125” reference entities (Series 19), instead of credit-linked to just 7 well-known companies. Information regarding the hidden 125 CDS in collateral, i.e. the CDO collateral information (transaction document), holds the most important elements necessary to correctly assess the true risk of the Minibond. Information regarding the undisclosed 125 reference entities (in collateral) obviously carried far more risk than the 7 well-known reference entities.

Banks gave clients prospectuses that dedicated many pages on the rating and risk of the 7 well-known reference entities and the impact of any default event. But banks never offered clients CDO collateral information containing details regarding the number / name / rating of reference entities and the impact that their default would have on the Minibonds collateral.

The true risk of the minibond greatly depended on the number / name / rating of the reference entities in the collateral and the rules regarding their default event. For example, for the 125 reference entities in the collateral, the rule on the default event was: “the 10th default event would result in 100% principal loss”. If the rule were “the 110th default event would lead to the 100% principal loss”, the risk level of the minibond would be significantly changed. However, all the rules on the default event and the numbers / names / rating of the reference entities was never discussed to minibond buyers.

No professional intermediary could have valued the Minibond using only the information provided in prospectuses. Why did banks consistently fail to offer and/or discuss CDO collateral information to buyers over the past few years? Did banks fear that the details in collateral would scare retail clients away? Did banks consider the CDO collateral information as irrelevant to the true risk of the Minibond?

- Why did the HKMA Report omit the importance of CDO collateral?
- Why did the HKMA Report fail to identify such a flagrant and recurring mistake (on CDO collateral) committed by banks?
- Did the HKMA Report consider the collateral information as immaterial?
- Did the HKMA Report consider that the CDS information detail in the CDO collateral was immaterial, as long as the credit-linked to 7 well-known Reference being explained?
- Did the HKMA Report consider that the historical default rate of AAA-rated conventional bond over the past 25 years 1981-2007 could be used as reference for the default rate of AAA-rated (Synthetic) CDO?


3. The HKMA Report failed to identify that Banks’ due diligence was insufficiently thorough over the past few years’ minibond sale. Evidence includes:

- Banks never cautioned clients that minibond was not invested into any debt / bonds issued by any of the 7 reference entities.
- Banks never cautioned clients that AAA-rated securities/or AAA-rated CDO is not the same as AAA-rated conventional bond. Banks never cautioned clients about the risk related to CDO collateral.
- And, banks never mentioned to clients that minibond was, in fact, not only credit linked with the 7 reference entities, but also credit-linked with over 100 reference entities in the collateral. For those reference entities in the CDO collateral, Banks never cautioned clients that some of them could be at sub-investment grade and a 8%-10% default rate (in the reference entities) would result in 100% principal loss in collateral.

Why did the HKMA Report fail to find the (systematic) insufficient due diligence by banks?

Product Information

4. The HKMA Report Section 3.8 failed to notice obvious misleading statements in the prospectuses.

The HKMA Report defended the issuer by quoting “Our Notes are not principal protected; you could lose part, and possibly all, of your investment” and “The Notes are not principal protected” from Issue Prospectuses.  The language “not principal protected” intended to suggest caution but it is unreliable because it is by definition true of any debt obligation that is not cash collateralized.

However, the HKMA Report failed to notice the following misleading statement in the Issue Prospectuses.
(i) In the page 9 of Issue Prospectuses: “Are our Notes principal protected?
Our Notes are not principal protected: if a credit event happens to any one of the 7 reference entities before the maturity date, you will lose part, and possibly all, of your investment”.
(ii) In the page 10 (Series #27) of Issue Prospectuses:
“Who should buy our Notes? Are they suitable for everyone?
Our Notes are not suitable for everyone. (…).
Our Notes are only suitable for investors who are:
looking for fixed rate quarterly interest income (…),
confident that none of the 7 named reference entities will be affected by a credit event. (….)”.

Both statements in plain English clearly and effectively suggested that: (a) the “not principal protected” was conditioning on the credit event of 7 reference entities;
And (b) if you were confident on the 7 reference entities, the Notes was for you.

Banks staff confirmed such understanding, either due to their lack of knowledge on the true risk of minibond, or due to their fraudulent intention. Although the truth is that the minibond was affected by the credit event of “7+125” reference entities (Series #19).

Why did the HKMA Report fail to notice above misleading statements?
What was the HKMA Report’s finding on the reasons that banks staff did not advise their clients on the true risk of minibond?


5. The HKMA Report failed to find that many Banks downplayed minibond risk level.

Banks such as Shanghai Commercial bank / Wing Hang Bank /etc, rated most (if not all) minibond series as “Medium Risk Investment”, considerably downplaying the product’s risk level. Banks either did not understand the true risk of minibond or intentionally tried to downplay the minibond’s true risk level, for the sale of minibond.

Why did the HKMA Report fail to notice such systematic mistake by banks?

6. Did HKMA consider a complex credit derivative product like minibond as suitable for retail banks to understand and able to brief the true nature and risk correctly to retail clients?

If yes, to what extent, was this demonstrated by HKMA’s investigation?


7. What were conclusions of HKMA Report’s investigation for the following respect?

(7.1) What kind of training and training material did banks receive (from Lehman or related marketing agency/ etc.) prior to deciding minibond sale?

(7.2) What kind of training & training material, and minibond sale procedure guideline did banks give to their staff on such complex credit derivative products?

(7.3) Banks staff were required to passing the Program & Issue Prospectuses to clients, and telling clients about the risk of “credit-linked to 7 well know reference entities”. Was that all a bank staff required to advise a client at the point of sale? If not, what was other advises that banks staff were required to give to clients regarding s the minibond’s true nature and risk?

(7.4) What kind of information did banks consider as minibond relevant material information? Did banks consider collateral information (collateral transaction document) as immaterial to the true risk of minibond?

(7.5) Did the HKMA’s investigation demonstrate that all the minibond distributors/banks shared the similar view as Sun Hung Kai Financial (who was co-distributor for minibond) as in the minibond news release below?

(i) Quotes from Sun Hung Kai News Release on Minibond Series#28 (Oct.2006)
[ Mr. Francis Wong, Head of Structured Products Distribution of SHK Securities Limited, said, “Minibond Series 28 is the ideal choice for investors who desire to yield a stable income in view of the interest rate trends that may fluctuate. Being linked to a basket of shares of high-quality international financial institutions, this minibond series renders to investors potential total returns of as high as 51.50%, provided that no credit event arises during the period. Investors could secure assured positive returns in the subsequent years when the interest rates are predicted to be on the downturn”. ]
http://www.strategic.com.hk/files.news/minibond%2028%20-%20press%20release%20_eng_final.pdf

(ii) Quotes from Sun Hung Kai News Release on Minibond Series#29 (Nov. 2006)
[According to the SFC research titled "Retail Structured Notes Market in Hong Kong amid a Rate HikeCycle", credit-linked notes are among the most popular structures, taking up 42% of the market for structured products. A 100% year-on-year growth for credit-linked notes has been recorded for two consecutive years in the local market, especially with those that are linked to well-known entities. (…) Branding is also a key consideration to be successful in retail structured product market.
(….)
Mr. Francis Wong, Head of Structured Products Distribution of Sun Hung Kai Financial, said, "The constantly growing investors' demand for a stable source of income explains the expanding appetite for credit-linked products. The simple yet flexible structures the various Minibond Series offered are well-liked over the years. Investors are entitled to rosy potential returns of 48.00% in Minibond Series 29, given that no credit event occurs. ]
http://www.strategic.com.hk/files.news/minibond%2029%20-%20press%20release%20_english.pdf

(iii) Quotes from “The Standard Finance” (13 Aug. 2007)
[ (……) (Zoe Leung, deputy head of structured products distribution at Sun Hung Kai Financial) Leung (……). "Our product is linked to high investment grade financial institutions like Merrill Lynch, Morgan Stanley and Goldman Sachs," she (Zoe Leung) says.
The spread on bonds issued by these investment banks are seen to be volatile lately, but this has had no impact on their fundamentals, Leung points out. (…...)
"The product appeals to those who like time deposits”, Leung says. ]
http://finance.thestandard.com.hk/chi/money_news_view.asp?aid=51085



Respectfully yours,