My Decade-Long Journey To Five Million

What does Lehman Brothers‘ bankruptcy have to do with wiping a huge part of Hong Kong and Singapore retirees’ life savings? Some of them may have never heard of this Lehman Brothers thing in their entire lives. For all they know, they just got sold these “safe” products that give slightly higher returns of 5% by their sweet-talking Relationship Managers. Poor aunties and uncles.

I really doubt these investors would have relinquished their life savings for buying these things if they had really known how these credit linked notes actually work. In fact, I won’t be surprised if the Relationship Managers didn’t fully understand these products either! It’s hard to parse through all those jargons by reading the prospectuses to find out what these things actually do.

So how does these things work, really? Read on and find out!

In the beginning, there were bonds

Bonds, Credit Default Swap (CDS), and Credit Linked Note (CLN) are closely related to one another, so let’s begin by a short recap of bonds first. 

What are bonds really? Why do the U.S. Treasury (and other countries’ equivalents) and corporates issue them? The short and somewhat simplistic answer is they do that to borrow money that they probably can’t borrow from banks otherwise.  

When an average person’s income is not enough to cover her expenses, she’ll probably borrow some money through various means, such as credit cards, personal loans, etc. 

But when it’s the U.S. government we’re talking about, then we have a rather ginormous problem called budget deficit, which, for 2008, is projected to be somewhere around US$400 billion. Borrowing US$400bn from banks is kinda… hard.

So the U.S. Treasury has to raise money in other ways, one of which is to sell bonds, notes, and bills to the public. (Bonds, notes, and bills are principally the same. They only differ in terms of maturity and the way the interest is paid.) 

When you buy these U.S. Treasury notes, you’re lending your money to the U.S. government for a predetermined amount of time. In return, the U.S. government agrees to pay you a fixed interest every 6 months as long as you’re holding the notes, and return to you–or whoever is holding the notes by then, since the notes can be resold–the face value of the notes when it’s payback time. (I said return the “face value” instead of “your money”, because the actual price of of the notes fluctuates–the amount you paid to get the notes can be different from the face value.)

Now, the interest that we get out of lending the U.S. government our money is not very high. This is because it’s virtually risk-free: the probability that the U.S. government will not pay our money back is very small.

On the other hand, corporate bonds pay higher interest, since, unlike the U.S. government, corporations come and go all the time. There’s a higher risk of us not getting back the money we’re lending them. Obviously the riskier the bonds are, the higher the interest has to be, or else nobody would bother to take on the risk of lending them the money in the first place. The bonds with the highest returns are even called junk bonds to reflect how risky these things are!

(By the way, who gets to decide how risky these corporate bonds are, exactly? It’s usually done by third party credit rating agencies, the most well-known of which are Moody’s and Standard and Poor’s. They rate these bonds, starting from the highest AAA/Aaa (the least risk), to C or even D–meaning bankruptcy is very likely.) 

Credit Default Swap

So the conclusion is that we can get higher returns on the money we’re lending… in exchange for the higher probability of us losing that money.

How do we typically protect ourselves against an unfortunate event that may or may not occur? Typically, we buy insurance, right? We buy insurance policies from insurance companies, and pay them premiums, so that they will compensate us when the unfortunate events covered by the plans actually occur. 

Now, what happens when the unfortunate event is not death or critical illness, but a company (whose bonds we own) is filing for bankruptcy? Are there insurance policies for this kind of thing? Sure there are. And here’s how it works. Let’s say we’re buying this policy from an imaginary insurance company called GIA. The policy would be something like this:

1. I buy 10 million dollar’s worth of 5-year Namhel Sisters corporate bonds, in effect lending them my money. 
2. If over during that 5-year period a credit event happens, say, by Namhel Sisters filing for bankruptcy, I want GIA to compensate me for any resulting loss. GIA can do this either by (a) buying my Namhel Sisters bonds (which after Namhel Sisters’s bankruptcy will of course be a lot less valuable than 10 million) for 10 million, or (b) write me a cheque to pay for the difference between 10 million and the post-credit event value of the bonds. 
3. To compensate GIA for taking on this risk, I will pay GIA annual insurance premiums of 1% of the value of the bonds, that is, US$100k every year, for 5 years.

Namhel Sisters in this agreement is called a reference entity. See the diagram below for a depiction of this arrangement.

 

So this is the Credit Default Swap (CDS). Profitable for the insurance seller when the reference entity is doing fine, but potentially disastrous if the insurance seller has sold a lot of protection policies, and suddenly the reference entity goes bankrupt. (For the Lehman Brothers’ bankruptcy case alone, the payouts these insurance sellers will have to make are estimated at around US$350 billion.)

There are three important differences between CDS and “normal” insurance, however:

1. You don’t have to own the bond to buy a CDS on it. You can buy a CDS without owning the bond, effectively placing a bet on whether the bond will fail or not. (In the “normal” insurance world, this is like buying life insurance policy on a guy whom you think will die rather soon, so you can collect if he actually dies.) This way, CDS gives people a relatively cheap way of betting on any credit event. In effect, credit default swaps became the world’s largest unregulated casino. The market size is estimated at around US$55 trillion.
2. Anybody can sell CDS. Consider this. At the time of this writing, my net worth is close to half a million Singapore dollars. Would you buy from me if I try to sell you life insurance, insuring you for S$200k if you die? You’ll think that I’m crazy, right? Yet this is what many small, unregulated, offshore hedge funds, with not enough cash to pay up if credit events do happen, are selling. And big banks like Citibank are actually buying! 
3. Unlike deaths or critical illnesses, credit events affect one another. Generally speaking, people die independently of one another. That is, if my neighbour dies (I hope not, I love my neighbour), it doesn’t make it any more likely for me to die too. But if a company goes bankrupt because an industry sector isn’t doing well, does it make it more likely for others in the same sector to go bankrupt as well? You betcha! AIG did the mistake of thinking that CDS are just like insurance, so it sold a LOT of these. Look where it is now.

This whole multitrillion-dollars CDS thing is like a huge, scary domino effect, and nobody knows when it ends. Who insures the insurer? What happens when the insurer’s insurer goes bankrupt? The chain reaction goes like that and more than a few think that it’ll go nuclear.

But anyway. Sorry. I wanted to write this to discuss how Lehman Brothers’ bankruptcy depleted the life savings of retirees in Singapore and Hong Kong. To find out how, we must discuss the third financial vehicle: the Credit Linked Note.

Credit Linked Note: where the insurer uses YOUR money to pay up

Credit Linked Note (CLN) is very much like the CDS. The difference is that the money that the insurer needs to pay up in case of a credit event comes from the so-called investors. So, expanding from our CDS example above:

 

 

So, as you can see, there’s no difference, really. The only addition to the picture is the investors, who buys the Credit Linked Notes issued by the insurance seller to raise money. If a credit event occurs, the investors’ money will be used to compensate the insurance buyer. 

Similarly, in the case of DBS High Notes 5 (pdf) in Singapore, DBS promises higher interest to people who bought the product. However, if a credit event occurs (which it did), then the investors will lose some or even all of their money, because DBS will use that money to compensate whoever buys the CDS (insurance) it was selling, with Lehman Brothers as one of the reference entities. 

Conclusion

Personally, I understand that higher returns obviously require higher risks. But did these uncles and aunties know what they were getting into? Would they commit their life savings to it if they knew that they could lose up to 100% of their investment? 

And most importantly, did the salespeople/relationship managers even know these products themselves? CDS and CLN are actually quite straightforward, but I haven’t been impressed with the level of financial knowledge of the relationship managers I’ve met so far.

(Images–except for the Word drawings–courtesy of manitou2121 @ flickr, sachab @ flickr, and Malkav @ flickr)

October 6th, 2008 | Tags: Business, derivatives, financial crisis | Category: Business | Subscribe to comments | Leave a comment | Trackback URL