A Pig in a Poke

Buying a pig in a poke, colloquially, is to buy something risky without examining it beforehand. The phrase arose in the middle ages, when confidence tricksters would offer to sell a pig in a sack – but when the customer opened the sack, they’d find they’d bought a nice juicy cat. Or rabbit.

These days, the pig in the poke is more likely to be a nice juicy “risk-free” yield on a structured deposit. And the cat is the credit risk, or equity default risk, or short option, or some other undisclosed risk that you’ve taken on to juice those “risk-free” returns.

In Singapore, one of those juicy structured deposits has just blown up in an unexpected way, on a risk that you’d never have thought about when the clueless teller sold you the deposit over the bank counter.

Here’s the pricing statement for Morgan Stanley’s Pinnacle Notes Series 9 and 10. Flick through to page 4 of the PDF to see the advertisement, but here’s the copy (random font sizes, random boldfacing, and random Comic Sans all sic):

Profit from bull and bear markets

5.00% p.a. PLUS a potential

Equity Bonus Coupon

of up to
4.00% p.a.

over 5.5 years

Then down the bottom:

Credit linked to these Reference Entities:

Australia • Hong Kong • Singapore • Singtel • Temasek

And then lots of footnotes, including one that says “Each Series of Notes will be secured by, amongst other assets, US Dollar denominated Synthetic CDO Securities that are rated at least AA on the date of investment therein”. Keep that one in mind, it’s important.

If this all sounds a bit complicated, don’t worry – the note works just like this:

* You invest your money with these blokes for 5.5 years;

* If none of the five “reference entities” default or restructure their debt during that time, you get 5% p.a. interest;

* If the price of a basket of six unrelated shares goes up or down by a certain percentage, you get an extra 4% p.a interest (the equity bonus coupon);

* If any of those five companies does default during the life of the deposit, you immediately lose substantially all of your money. (Not necessarily the whole lot – it depends on the amount recovered from the company that goes bankrupt – but you can assume that it’ll be the whole lot.)

That last bullet point is the risk you take – you’re selling insurance on any one of those five companies going toes up. It’s called a “first-to-default basket” in the trade, and these were massively, massively popular among structured note issuers and gullible customers.

Oh, and the other nice bit? Buried in the fine print of the Summary of Terms on page 5, you’ll see that the notes are “callable” – at any time after the six-month mark, if the notes start to look expensive, the issuer can buy them back at the face value.

So if things stay calm for six months, and the insurance that you’ve sold becomes cheaper, the issuer will buy the notes back and only give you the face value (plus any accrued interest) – but if the market suddenly turns wild, they won’t buy the notes back, and you’ll be left facing an ugly pack of default risks with your own money on the line. NO UPSIDE FOR YOU.

(Incidentally, the “issuer call” interacts amusingly with the Equity Bonus Coupon. The basket of stocks has to rise 15% for the bonus coupon to kick in – but in a calm market, stocks aren’t likely to spike 15% in six months. So if the market stays calm, you’ll never see a dime of that juicy 4% extra coupon, because the note will be called well before one year, where the bonus coupon starts to kick in. To be fair, there’s a small downside equity bonus coupon as well, if stocks drop by 15% – so it’s not a totally dud feature.)

But in return for all this malarkey, you get a nice high yield.

And it was a very high yield – a 5-year term deposit back in late 2007, when this product was launched, would’ve yielded about 2% p.a. So a lot of customers said to themselves, “a three percent yield pickup for writing insurance on five rock-solid companies like that? Sign me up!”.

Keep that three percent yield pickup in mind, it’s also important.

Now, eight months have passed since the launch of this product. None of the five credits in the basket have defaulted – the three governments are all rock solid, and the two corporates are backed by the Singaporean government, so they ain’t goin’ nowhere.

But these Pinnacle Notes spectacularly blew up this week, and the aggrieved customers will receive none of their cash back. Not a dime. Not a farthing. Not an Icelandic krona.

How did this happen?

Turns out that there was a second, major set of risks – one that you would’ve missed if you’d just looked at the ad copy. Read on to find out how this product carried exposures to to Fannie Mae, Lehman Brothers, and Kaupthing Bank – and how those three companies, along with a rogue’s gallery of other corporate collapses, cost investors all of their money.

Now, when you invest in one of these notes, two things happen. Firstly, you sell the credit default swap, the “insurance contract” if you like – because this is a swap, it’s not like buying a bond or a share: you don’t have to pay any money up front. The cashflows come later in the trade’s life; in the meantime, the actual cash that you’ve invested is put on deposit as collateral against any losses that you might incur.

Now, the sensible thing to do would be to stick this cash somewhere safe, so that it’s there if you need it.

Remember that first footnote in the advertising copy, the one about “secured by US Dollar denominated Synthetic CDO Securities”? That means that instead of sticking the cash in a bank account or something like that, Morg Stan can go and stick it in another credit-linked structure – one that works quite similarly to the one you’ve just invested in.

And that’s what they did. They stuck it in the little gem listed under the “Underlying Assets” section on this information pagethe ACES 2007-41 synthetic CDO.

(As a side note: because it’s a “synthetic” CDO, the ACES CDO has to do the same thing, and stick its money somewhere else again. If you rummage through that statement linked above, you’ll find that the cash ultimately ends up in the Capital One Multi-Asset Execution Trusta credit-card debt securitisation. Did you see anything on the ad copy about investing in American credit-card debt?)

So let’s take a look at the Private Placement Memorandum Supplement for this ACES 2007-41 thingamajig. Don’t worry, you don’t have to read through all 317 pages – just skip to page 19 of that PDF. Look at the “margin” for a moment – this extra investment pays 1.30% over LIBOR (a market base rate).

Now this is interesting.

Remember how the total structure gives the investor about a 3% yield pickup over the “base” deposit rate? We’ve just found where 1.3% of that yield pickup comes from.

(Now, this is a bit rough and ready – but very roughly, you can swap that 1.3% premium over LIBOR, which is denominated in USD, to a 1.3% premium over the SGD base rate – which would give you the same yield pickup, but in Sing dollars instead of US dollars. If any SGD basis swap traders know what the premium/discount was back in Dec 07, or if I’ve totally screwed this up, drop me a line.)

So you might think that if this second layer of risk contributes half of the extra return of the total structure, it must contribute half of the extra risk, surely? Risk and return go together and all that?

You’re right.

The structure of a synthetic CDO is subtly different from the original structure, though. Unlike a first-to-default basket, where the whole thing blows up if one company goes bust, a synthetic CDO only loses part of its value if a company goes bust. Say there are 100 reference companies (as there are in this one); if one reference entity goes bust, and there’s no cash recoverable, the whole CDO will lose 1% of its value.

But CDOs have this little thing called “tranching”. They issue lots of different classes of securities, and some classes take losses before other classes – in return, the classes that take the early losses have a much higher yield. Risk and return again.

So in our example with one company going bust – the so-called 0-1% tranche of the CDO would take the entire loss, while the tranches above it would be unaffected. But the 1-2% tranche (or the 1-3% tranche, or the 1-5% tranche or whatever) would suddenly have no protection from losses, and if any more defaults occurred, it would start rapidly losing value.

Now, 1.30% is a big yield pickup. You can’t get that from investing in the high tranches – typically, anything above a 20% attachment level (that is, it starts taking losses if 20% of the portfolio is written off) only yields a few hundredths of a percentage point. So to juice up the yields enough to make the Pinnacle Notes look good, Morg Stan invested in a very low-ranked tranche – with an attachment point of 2.67%, and a detachment point of 3.67% (page 77 of the PPMS).

So, if 2.67% of the CDO portfolio is written off, the investors in the Pinnacle Notes will start losing their cash – even though none of Australia, Hong Kong, Singapore, Singtel or Temasek are necessarily in any danger of default. And if 3.67% of the CDO portfolio is written off, the investors will lose all of their money.

So let’s have a look at the names in this portfolio. Surely they would’ve picked a good set of names, one that isn’t likely to suffer the three to six defaults that would wipe out the Pinnacle Notes investors’ cash?

MBIA. RBS. Barclays. Freddie Mac. Fannie Mae. Kaupthing. AIG. Bear Stearns. Landsbanki. HBOS. Lehman Brothers. Wachovia. XL Capital. The Republic of Iceland.

Oh dear.

There are five defaults already in that portfolio (three of which – Lehman, Landsbanki, and Kaupthing – saw virtually zero recovery rates; there goes 3% of your CDO right there), and the other nine names are on various forms of life support. And those are just the worst offenders – there’re also a handful of ailing emerging-market banks, battered property trusts, and precarious energy companies in the list.

The 2.7-3.7% tranche of this CDO is well and truly wiped out.

And with it goes the Pinnacle Notes.

Even though none of the five reference entities ever came near defaulting.


There might have been a genuine pig in this poke when it was sold to investors. If markets had stabilised back in December, they’d have had their money back now thanks to the issuer call, plus a quick 2.5% bonus interest (no, no equity bonus coupon). But with markets collapsing, a second-order risk – an unwise choice of collateral, driven by customers’ desire for juiced-up returns and the issuer’s desire for a second layer of fees – has turned the pig into a particularly angry cat.

And now the MAS (the banking regulator in Singapore) has washed its hands of the Pinnacle Notes affair, telling customers to talk directly to their banks if they claim they’ve been misled and want compensation.

The crowds are forming at Speakers’ Corner.

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8 Responses to A Pig in a Poke

  1. simplysi says:

    Thanks Josh, this is an excellent explanation.

  2. Middle East PE guy says:

    wonderful article

  3. Ben says:

    That was well written and I enjoyed it. I gather you are not local – certainly don’t sound like one.

  4. Anonymous says:

    Thank you for a great exposition.
    Just a thought. There’s something else fishy about this deal: Who bought the swaps on Australia, HK, Singapore, Singtel, Temasek? Since the deposits are gone the swap’s worth nothing. Why would anyone agree to pay for a swap that was secured in Nov 07, no less, by such a risky investment — i.e. the synthetic CDO?

  5. Steven says:

    Great article. Thanks a lot! =)

  6. Lim says:

    Mr Josh….can you please let us know how to contact you – your email please. We need your help .

  7. JR says:

    Josh, any chance for a 2nd review? Something in the order of “where are they now?”
    I notice the link under “The crowds are forming at Speakers’ Corner.” is no longer available.
    Also, do you ever research the legal phrase “Fraud in the Inducement,” or Fraud in the Factum?”
    Also there is:
    Fraudulent Conversion
    Constructive Fraud and
    Breach of Duty
    With regard to ethics there is:
    Higher Standard of Professional Conduct.
    Suppose to apply to people who take big retainers, salaries or lofty hourly fees. They are by all professional standards in their industry, suppose to raise the level of professional conduct high above those who cannot charge as much, and are bound by their oath at point of being licensed to broker such things and offer them.
    There is this higher standard memorandum, commensurate with pay – principal. Otherwise there is NO justification for charging clients such high fees.
    They HAVE to also offer a higher standard to go with that. Otherwise they are complicit, by default @ omission, and negligence: dereliction. Failure to uphold the higher standard principal commensurate with pay.

  8. JR says:

    When I read this review you have put together, it seems what is modelled at the executive level is a low standard of professional conduct or non-existent standard (what some call “substandard” work product or conduct unbecoming a corporate officer in a professional capacity). There is this ranking of corporate officers, and this too is commensurate with rate of pay. The higher the rank the higher is their obligation to model a high standard; the highest standard possible because they make the most.
    As you describe what occurred, a non-existent standard or substandard of performance, seems to go in a triangular pattern from the executives at Pinnacle to Morgan Stanley, and then back to MAS (the banking regulator in Singapore).
    The banking regulator cannot wash their hands.
    The regulator has the obligation to imprison or sanction the executives who used the deception at point of sale.
    All that is needed is the testimony of two people who were deceived in the same way. This testimony in a court of law becomes evidence. And it is sufficient evidence as can serve to support a criminal allegation of Fraud in the Inducement.
    Add to that hundreds of others who will also have very similar experience to put into evidence. They were defrauded. It is the regulators obligation to record each incident and develop a profile of the executives in question. Weighing in the testimony of clients who say they were deceived is one of the main ways they have, to develop the profile of the firm and executives in question.
    Once in a Court of Law, the defendents cannot use the deceptive defense, “they were greedy.” (this is really a non-defense) If the buyers have testified they were deceived early on by the seller, the argument “they were greedy” only works in blog land and with reporters who are naive about English law in question; relating fraud or concepts like “Fraud in the Inducement.”
    In a court of law, since the allegation is “fraud in the inducement,” and the accused are being accused of using deception in language, during a business negotiation, a fraudulent actor who is accused of fraud and who is testified against in such way as reveals the fraud, cannot then make a fraudulent reply “they were greedy” in hopes of being considered innocent.
    The Judge and Court would laugh at them if they tried that. And then convict them of the fraud.
    So the regulator being a guard has the duty to uphold the higher standard principal. They cannot default on this mission and duty, or they also default as protector and giver, of the ethics guide.

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