Minibonds Revisited

In Investment banking, Investments on 02/01/2010 at 5:44 am

I nearly bought minibonds in 2007, and since the failure of Lehman Brothers last year, I’ve been trying to understand why I nearly bought them. It is important to me as it could help me avoid a future disaster.

I always knew why I didn’t buy — greed. Dr Money sums this greed up nicely when he wrote, “Your money gets invested in risky bonds and derivatives. It means total returns are much higher, like 13 per cent or more. But all you see is your safe-looking 5 per cent return.

‘The difference of 13 – 5 = 8 per cent goes to the deal-maker while you must take all the risks. If the bonds default, you lose.”

Then there is the issue that if interest rates collapsed, the arranger could recall the note, while if inflation went to 10% (remember the price of oil then), I’d be stuck with 5%.

But I didn’t know why I nearly bought i.e. think it was a safe product, despite being “aware” of the risk premium. This is worrying. I could misanalyse again.

I’ve very recently come to the conclusion that my mind (without me being conscious of it — mindlessness in Zen) divided the risk element into two bits.

Risk 1

I “knew” (I was relying on the ads and a BT newspaper article) that

– I was (with many others) insuring someone against the failure of one of the six entities

– the product was highly leveraged

– derivatives were being used

– the combination of the last two meant that it was likely that if one entity got into trouble I would lose my money.

(Having read the prospectus last yr, the above points were confirmed.)

Risk 2

The probability of a default by Lehman or one of the entities.

My conscious mind came to the conclusion that the probability of default by Lehman or one of the six entities was very, very low (so far none of the six entities are in trouble). Dr Money had a great take on the improbability of an LB failure. I can do no better.

The very low probability of failure must have made me conclude that it was a safe product, and that LB had found investors who had mispriced risk — willing to pay the 13% mentioned by Dr Money. Not surprising as my experience as an arbitrageur (risk and straight) had taught me that risk is usually mispriced (investors are too cautious — Yes if I were still arbitraging, my employer would have lost big time in 2008 )

What has all this to do with forcing a settlement that Tan Kin Lian and others wanted? That the MAS refused to even think about.  It told them to bugger off.

Supposing there was no mis-selling: investors in minibonds and DBS HN5 notes were told everything and I mean everything. Would investors still have bought?

I think that most would have. Of course they would deny this today. “They would, wouldn’t they?”

They would have been advised, and rightly so (at the time), that the very low probability of failure, meant that their principal was safe.

The lessons of the story- better to be lucky than smart and going for yield is dangerous.

Good 2010 and decade.

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