Lehman Minibonds

Over the past week I’ve been sort of semi-obsessed with following up on news on the whole financial mess thats going around the world (who isn’t?). One topic very close to home would be the Lehman Minibombs (sic) that’s gotten lots of Singaporeans into trouble.

I tried reading the Business Times but it only got me more confused. I found the Den of the Lion Investor website which had a slightly better explanation but was still confused by the terminology so turned to the actual prospectus, with reference to my handy Fabozzi fixed income textbook for more information (Bond Markets, Analysis, and Strategies, 6th Edition). I think I’ve finally somewhat understood the idea behind the Lehman minibonds, so I’m going to document what I understand for future reference.

Note: This article is going to change as my understanding deepens so it’s somewhat a work in progress.

Essentially, the Lehman Minibond is is a synthetic CDO, specifically a credit default swap (CDS). Let’s see how this CDS is structured:

Lehman MinibondImage taken from the Lehman Minibond prospectus

From the picture, it can been seen that there four major parties:
1) The Swap Counterparty (Lehman) (actually there is also a Swap Guarantor but in this case they’re both owned by Lehman)
2) The Issuer (Minibond Ltd). The issuer in this case is a Special Purpose Vehicle (SPV), a separate company that is set up to isolate financial risk from the sponsor that sets the company up.
3) The Noteholders (investors of the minibonds)
4) The Underlying Securities (not really a party, but they could be any type of cash flow generating security)

There is one more party missing from the picture:
5) The Refererence Entities. It must be emphasised that the Reference Entities have nothing to do with the AA-rated Underlying Securities. This is where I think most investors were misled.

The Reference Entities are linked to Lehman (note that I didn’t use “Swap Counterparty” because I want to emphasise how Lehman removes risk by becoming a Swap Counterparty, more on that later). Lehman owns securities within the Reference Entities. In the case of Minibonds 2, this are mostly subordinated notes. Subordinated notes are risker than than senior notes: If the reference entity defaults, it would have to pay off its senior obligations before the subordinated obligations. So clearly, even though the reference entities are AA rated, the notes owned by Lehman have higher risk because they are subordinated. For whatever reason, Lehman wants to remove this credit risk from its balance sheet by participating in a credit default swap that behaves like an insurance policy.

In the credit default swap agreement, Lehman is the Swap Counterparty to Minibond Ltd. Lehman pays a premium to Minibond Ltd for the guarantee that Minibond Ltd will take on the risk of Reference Entities defaulting. When Reference Entities default, this is known as “Credit Event” (although there are other ways a Credit Event could be triggered, such as Underlying Securities defauting). Should a Reference Entity default, Minibond Ltd. is obliged to make a payment to the Swap Counterparty in the form of the Underlying Securities and the Swap Counterparty pays a Credit Event Redemption amount to Minibond Ltd that is typically significantly lower than the par value of the original notes from the Reference Entities.

As mentioned earlier, Minibond Ltd, is a SPV. In the case of Minibond 2, it only has USD1000 in share capital. Yet from the picture it can been seen that it owns the Underlying Securities. How does this come about? Basically, Minibond Ltd. issues notes to the Noteholders and from the funds raised, it purchases the porfolio of Underlying Securities and manages this portfolio which acts as collateral for Credit Events. The cashflows generated from this portfolio are also used to fulfill an additional interest rate/currency swap agreement with Lehman. (Note that for other CDS agreements, the cashflows from the portfolio could be returned directly to investors/SPV sponsor or reinvested.)

The premium Lehman pays to Minibond Ltd comes in the form of fixed interest/principal payments. These payments are then passed back to the Noteholders. In a nutshell, the Noteholders are effectively receiving a fee for providing insurance to Lehman. The cashflows from the Notes do not have a direct relationship with the notes issued by the Reference Entities.

What’s pretty tragic about this whole fiasco is that investors were only paid a small premium (4.88% p.a) to take on quite substantial risk:
The risks include:
1) Reference Entities defaulting (only 1 RE needs to default for a credit event to occur)
2) The Swap Counterparty and Swap Guarantor going bankrupt.
3) Risks of the Underlying Securities. In this case, even though they were rated AA, they were actually synthetic CDOs in which exact knowledge of their type was not made known at point of issue.
4) Liquidity risk. According to the prospectus, the Notes did not have a liquid trading market.

What most investors had accounted for was probably Risk 1 because that was emphasised quite clearly in the prospectus. Unfortuntely, what was shocking and totally unexpected was that Risk 2 took place (to be fair though, no one would have expected Lehman Brothers to file for Chapter 11). Furthermore, many of these investors had no understanding of the actual structure of the notes and thought that they were actually buying into bonds issued by the Reference Entities. Studying this event in hindsight really makes me shiver at the lack of regulation that allowed these investors to purchase these risky instruments. Even though all these risks could actually be found in the prospectus, the structured notes were targeted towars the retail investor and it’s clear that many of them were not given the right advice by the sales staff. More needs to be done…

Subjects: Finance 経済

Tags: financial crisis


Credit Rating fiasco?

Based on my experience with these structures, credit rating is the key. I checked Lehman’s credit ratings and the best they had was A+. The reference entities are AA. This means that the reference entities are more stable than Lehman. Makes you wonder why they need protection from these. Now how can the structurer and main swap counterparty be more risky than the underlying bonds? Well that’s why they made an SPV. The SPV should theoretically have better credit rating because it’s specially made to support the structure. Failure of the swap counterparty will still enable them to pay something to the investors. But most SPV’s still fail when their parents fail.

I think the main problem why

terra's picture

I think the main problem why the investors are finding the value of the minibonds evaporating is because since the swap counterparty has disappeared, based on the terms of the contract, Minibond Ltd has to shut down the agreement and liquidate the underlying securities which have plunged in value based on current market conditions. I think if it the underlying securities still had value and were still rated AA, and it were only the swap counterparty collapsing, the investors wouldn’t have lost so much because technically, the swap counterparty collapsing doesn’t constitute a credit event, so it’s not a case of swapping the credit event redemption amount of defaulted reference obligations with the underlying securities owned by the SPV. The liquidation amount of the underlying securities in this case would still be a decent amount.

In this current fiasco, the SPV hasn’t really failed, but the diasaster is a result of the agreement being terminated at a really bad time (although I’m not sure even if Lehman had survived, the underlying securites would have much value in the first place).


The underlying CDOs are practically worthless because there are no buyers. This is what is happening around the world in which CDOs only have sellers and no buyers. That is why it becomes impossible to obtain a market value of these CDOs. The US Treasury is trying to be a market maker to buy these CDOs. If HSBC Trustee is “hardworking” enough to get a good selling price for these CDOs, it might have to use innovative ways to sell it back to the US Treasury!

the main reason

that people are losing money are actually due to the drop in value of the underlying securities. swap counterparty going bankrupt or defaulting does not actually impact the value of the minibond notes if the notes have been properly set up (legally).

the CAPTCHA decoding is even harder than posting any comments!

There might be some loss but

terra's picture

There might be still some loss but yes I agree with you that the actual value depends on the quality of the underlying securities (except the part on the legality of the notes; I think it was legal).

I’ve fixed the CAPTCHA thing so it’s hopefully easier to post now >_< The settings went awry when I upgraded the CMS and I didn’t notice it till you mentioned it.

These credit securities could not save Lehman

Apparently these securities are not all they are cracked up to be. These, along with securities tied to bad credit personal loans probably contributed to Lehman Brothers from going belly up.