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:

Image 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