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.
Continue reading "A Pig in a Poke" »
