LOSSES in structured products fall into two categories: Small money and big money.

TNP PHOTO ILLUSTRATION: SIMON ANG

Small money

The banks have made a big show of solving the small-money cases.

Hong Leong Finance said it will compensate investors with a primary school education and aged 62 or older at the time of purchase. The company did not say how many of its customers fall into this narrow category.

DBS issued $100 million of High Notes 5 that are now worthless.

It will pay out $70 to $80 million to compensate customers for its mis-selling.

The $70m to $80m also includes customers in Hong Kong.

Hong Kong sales include products like Minibonds which a bank could buy back, hold to maturity and redeem at or near full value. It would cost the bank little or nothing.

DBS can't do that with the $100 million in the High Notes 5 it sold here because those have defaulted. Their value is zero.

I asked DBS about the split between its Singapore and HK payments. It told me: 'As a matter of policy, we do not discuss individual cases and thus will not divulge how much will be paid to investors in each country.'

Big money

All the losses have been in a popular type of structured product called credit and equity-linked notes.

I call them 'linked notes' for short.

In brief: High Notes 5 and Jubilee 3 have no value.

There is hope for all the others, including Minibonds.

Many now trade at only 10 to 20 per cent of cost, but they could mature at or near full value.

The three Lehman-linked notes account for $500 million of sales here. Add other linked notes and the total is in the billions.

Why did we buy so many? Are the issuing banks and distributors to blame?

Probably. Here is why: Linked notes invest in a 10/90 per cent mix of stock options and risky bonds called CDOs (collateralised debt obligations).

Most of the options are now worthless because of the stock market's fall. Many of the CDOs could also default.

The important issue, I think, is whether ALL investors were mis-advised because of omissions from the prospectus.

If so, it could constitute grounds for invalidating the linked-note contracts and returning the money to investors.

It would be similar to the repurchase of $55 billion of auction-rate notes and $522 million in fines of global banks for mis-selling them.

Hidden risks in prospectuses

THERE are three important errors of omission in the prospectuses of linked notes. These do not apply to other structured products like structured deposits.

1) The issuers took money from customers in five ways: (i) mark-ups in the initial pricing, (ii) early surrender charges, (iii) market-making margins, (iv) initial commissions and (v) management fees.

How high were the charges? No one knows. They were not disclosed in the prospectus.

Key question: Would disclosure have made a difference in the purchase decision?

2) Risk of the reference entity defaulting:

Take DBS' High Notes 5. Its prospectus shows that one reference entity, like Lehman Brothers, has a 0.75 chance of defaulting during the product's five-year life.

The proper way to evaluate the risk, however, is to add default risk for all 8 reference entities. I did. It becomes a whopping 7.9 per cent.

It means the risk of a total loss in High Notes 5 is nearly 8per cent.

Key question: Would investors have bought if they had known this?

3) Undisclosed risk of the underlying assets:

Linked notes invest about 90 per cent of the money in bonds, including a risky type called CDOs. The prospectus, however, says only that the issuer purchased CDOs rated AA or higher.

Nowhere does it mention that CDO ratings are unique. They are not comparable to standard credit ratings.

For example, bonds rated Baa have an average default rate of 2.2 per cent. CDO bonds with the same Baa rating have a 24 per cent default rate.

Key question: Would disclosure have made a difference in the purchase decision?

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