"客戶所須簽訂的銷售文件無可挑剔" is NOT true

From News....


[.... 公民黨余若薇反映，不少個案都是客戶所須簽訂的銷售文件無可挑剔，但銀行口頭上未有解釋清楚]

The "客戶所須簽訂的銷售文件無可挑剔" is a myth that HKMA and banks try to let everyone believe. "客戶所須簽訂的銷售文件無可挑剔" is NOT true because banks omitted material information. Banks never gave clients Minibond's (Synthetic CDO) Collateral Information which is material information to the true nature & risks of Minibond. No professional intermediary could have valued the Minibond using only the information provided in Program Prospectus & Issue Prospectus & marketing material.

Banks and HKMA have been silence on the "collateral information" from day 0.

Why was Minibond Collateral information material information?

or: Why did banks consider Collateral Information as immaterial information?

1. First, let's take a look at the now well-exposed Minibond structure (e.g. Series 19-36, and earlier ones with Synthetic CDO Collateral):
(i) Minibond had CDS with 7 well-known reference entities;
and:
(ii) Minibond CDO Colalteral had CDS with over 100 reference entities (some were at sub-investment grade).
The Bank passed us the Program Prospectus & Issue Prospectus that dedicated many pages on the “credit-linked to 7 well-reference entities”, the 7 reference entities’ ratings, and the impact of any default event related to the 7 well-known reference entities.

What kind of collateral information was disclosed in the Issue Prospectus? It was described as AAA-rated CDO, or: AAA-rated Synthetic CDO to be exact.

1. Does the AAA rating suggest that the collateral would be at low default rate and thus no need for disclosure?

The Issue Prospectus provided default rate based on historic data from 1981-2004. However, such data does not provide any meaningful reference for the AAA-rated synthetic CDO collateral. Because the default rate data was based on AAA/AA/A/BBB-rated bond that is very different from Synthetic CDO (whose history is shorter than 20 years).

2. Does CDO information needs to be disclosed?

Regardless if CDO information needs to be disclosed or not, the CDO collateral selected by Minibond (arranger) was in fact Synthetic CDO, as stated in the "selection of collateral" (of Issue Prospectus). That is, the Minibond collateral is not a 'conventional' CDO (without CDS), it is a Synthetic CDO (i.e. comprised with CDS).

3. What was the most important feature of Synthetic CDO?

Synthetic CDO may not invest into any debt/loan/bond at all. Its value is decided by the credit risk of its portfolio holding. Thus, the collateral is credit-linked to portfolio of reference entities. (sounds familiar?)

3. For Minibond Series 19:
The collateral was credit-linked to 125 reference entities. The collateral would loose 100% principal on the 10th default event out of the 125 reference entities, That is, a mere 8% of default rate (out of the reference entities portfolio) would result in collateral 100% principal loss! (On the Minibond top layer, minibond could lose principal on the first default event, i.e. 1 out 7, which is over 14% default rate. Although the chance of hitting the 8% default rate seems to be higher than the 14% of default rate. That is, Minibond top layer started to crack, there is better chance to lose the collateral principal value which requires 8% of default rate of the collateral reference entities pool. ).

The CDS in the CDO collateral synthetically transferred the credit risk of 125 reference entities to Minibond holders. Therefore, the value of minibond was not only affected by the credit-event with the 7 well-known companies, but also was greatly affected by the credit events related to the 125 reference entities in the CDO collateral.

4. If the fact that Minibond was credit-linked to 7 well-known companies was important and was material information to the Minibond's true feature and risks,

we can CONCLUDE that the risks of the Minibond also greatly depended on the information regarding number / name / rating of the reference entities & reference obligations in the (synthetic) CDO collateral and the rules regarding their default event. The risk of minibond would vary greatly If collateral were credit-linked with 7 or 50 or 125 or 155 reference entities. The risk of minibond would vary greatly if collateral would lose 100% principal upon the 10th or 50th or 100th or 125th default event out of the 125 reference entities.

5. Our questions are:

why did banks consider collateral informations such as number of reference entities / their credit-rating / default impact to the collateral principal (loss) as immaterial ?

Why the above collateral information was never discussed / disclosed to clients?

and:

How many people would be interested in buying the minibond (for the same term & return rate) if they were told/given the collateral information ?

Lehman could argue that the Program Prospectus and Issue Prospectus touched every aspects (in a selective in-balanced way). However, regardless what Lehman provided or not-provided as mandatory documents (or display documents), regardless what was or was not disclosed in the Issuer Prospectus, banks are not no-brainer minibond-sellers (HKMA or banks can correct me if I were wrong about this). Banks are regulated financial intermediaries by SFC Code of Conduct which requires that "Intermediaries were still under an obligation pursuant to the Code of Conduct to explain the nature and risks of the product they were selling", and "make adequate disclosure of relevant material information".

Therefore, banks should understand the product (per Code of Conduct), after exercising reasonable due diligence. Banks should have realized that the collateral information is part of material information for clients to understand the true feature and risks of minibond. Banks should have requested such information for their clients. Banks should have provided and/or discussed with clients on the collateral information. Because we bought minibond from banks, not from Lehman.

You can suggest banks to provide evidence of institutional buyers that bought Synthetic CDO without Synthetic CDO documents. Would "AAA rating" be sufficient information for Synthetic-CDO ? Would they need to have document/information describing the number of reference entities / reference entities' rating /reference entities industry range / impact of default rate (e.g. 8% or 20% default event would lead to 100% principal loss)/etc.

My guess is that, Minibond (and DBS Constellation) were probably the only examples that banks can find.
Because banks (as selling-agent) were in fact willing to collaborate, I would suggest fraudulently, with Lehman, to hide the information and risks of synthetic CDO from the Bank's retail clients, with the objective of increasing the sale of the Minibonds. For a product like synthetic-CDO / CDS, how many people in HK really know ?

I am sure when banks selling CDS or buying CDS, they knew exactly how many reference entities are associated with the CDS or Synthetic CDO. Like group insurance for a company, it makes difference to insure a company that has 10 or 50 or 100 or 150 employee. The Insurance company needs to know the rough range of employee number.

"Mahogany Notes" is a Credit-Linked Notes sold in Australia by a Lehman entity, arranged by Lehman Asia (the same department that arranged Minibond in HK and Singapore). It was summarized in the web page below:
http://minibondvictim.blogspot.com/2009/01/austalia-mahogany-notes-prospectus.html