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

Earn
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.

Epilogue

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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