A year ago, I wrote a post dissecting Morgan Stanley’s Pinnacle Notes Series 9 and 10 – a structured product that abruptly imploded at the peak of last year’s financial crisis. It’s the most popular JRE post ever, and it was even picked up by the Financial Times (hi Alphaville!).
The notes blew up not because they hit their stated default triggers, but because the underlying collateral – an ugly low tranche of an ugly synthetic CDO – completely evaporated. The investors – most of whom had bought the product because they’d been told it was low risk and just like a term deposit – were understandably pissed. There were even protests at Singapore’s designated protesting zone (no, really) in Hong Lim Park.
At the time, the FT’s Sam Jones rightly wrote:
The bottom line though, is that this kind of product should never have been made available to retail investors, and no sane regulatory authority would have allowed it to have been.
…but instead of cracking down on banks selling gnarly structured credit products to aunty-and-uncle retail investors, the MAS crawled into their shell and said “it’s not our problem”.
And surprise, surprise – the exact same thing has happened again. The culprit, once again, is the Pinnacle Notes – this time, it’s Series 3, which launched a few months before the already-exploded Series 9 notes. Here’s the prospectus cover (which repeats the theme of “cute kids doing cute things” that we saw in the Series 9 prospectus, but at least it doesn’t use random Comic Sans):
(At this point, you might want to re-read the original post – it’s a bit long and nerdy, but it explains how these exploding structured notes worked and why they blew up.)
Like the Series 9 notes that exploded last year, Series 3 is a first-to-default credit basket – so if one of the reference entities blows up, you lose all your money. And like the series 9 notes, none of the reference entities were anywhere near blowing up. The underlyings were a collection of banks – Stanchart, HSBC, Bank of China, KDB, Maybank, DBS and UOB – which fared surprisingly well through last year’s turmoil.
And once again, it was the collateral that blew up.
The underlying collateral was a CDO – a higher tranche than the one backing the Series 9 notes, so it lasted a lot longer before exploding, and absorbed more defaults (exactly what it was supposed to do). The CDO tranche backing the Series 3 notes was fairly low down the waterfall – a 6.2% to 6.95% tranche. With 121 companies in the CDO, you could probably expect about 12 defaults before things started to get hairy; the standard assumption was that each default would have about a 40% recovery rate, so a default in this CDO would knock out about 0.5% of the principal, and 12 or 13 default would start to eat into this tranche.
But this CDO – the ACES 2007-5 CDO, with a 128-page offer doc right here – referenced most of the big corporate defaults of the last two years: Fannie Mae; Freddie Mac; all three Icelandic banks; Abitibi and Bowater; Chemtura; Syncora (the old XL Capital); Thomson; and CIT, the final default that destroyed the collateral behind the Pinnacle Notes.
So for the second time in two years, Singaporean retail investors have been blown up by a risk that was never properly explained to them. I think it’s safe to say that the MAS’s caveat emptor style of regulation isn’t working quite to plan.