SINGAPORE banks and brokers admit to selling risky structured products as safe to uneducated investors.

Text/Graphics: Larry Haverkamp and Maroo

You think that's bad? Hong Kong's monetary authority disclosed that its banks sold them to - get this - the mentally ill. How low can you go?

On the bright side, Hong Kong's largest broker - Sun Hung Kai - has paid back all the money to all investors who bought Minibonds from them. It is the most complete compensation so far.

Our banks and brokers are also paying vulnerable investors, but they won't disclose the total payments or tell how they define vulnerable.

Credit and equity-linked notes are the structured products at the centre of the storm.

Did any of your friends buy Minibonds issued by Lehman Brothers? More than $500 million worth were sold before Lehman went broke. It placed the investment in jeopardy, although Minibonds still have value.

Other structured products have been total write-offs like Morgan Stanley Pinnacle Notes 9 and 10, Merrill Lynch Jubilee Notes 3 and the granddaddy of them all: DBS High Notes 5, which cost investors $103 million.

We invested billions in structured products but have little idea how the money is invested. Is it in bonds paying a safe 5 per cent or a risky 15 per cent?

Incredibly, banks refuse to disclose this basic information. They are under little pressure to do so and the Monetary Authority of Singapore's new Guidelines for Financial Institutions do not require it.

The issuing banks hide structured product risks well.

When assessing risk, it is best to take Minister Mentor Lee Kuan Yew's advice.

At a Tanjong Pagar talk in November last year, he explained that high returns provide a good clue that risks must also be high.

Unfortunately, the issuing banks conceal the high returns by first subtracting fees and expenses, leaving only the net returns. Of course, those are lower and make the investment look safer than it really is.

How they do it

The structuring is done in five easy steps.

Step 1: Investors' money goes into risky bonds like collateralised debt obligations (CDOs) with yields as high as 15 per cent.

Step 2: After deducting fees and expenses, the net return is much less, like 5 per cent. The brochure, fact sheet, prospectus and pricing statement show only the net return which looks low, conservative and safe.

Step 3: If an issuing bank puts investors' money into a low-risk bond paying 6 per cent, it must pay 5 per cent to investors, leaving just 1 per cent for the bank.

A risky bond that pays 15 per cent, however, earns the bank a whopping 15 - 5 = 10 per cent. You get the picture. Issuing banks can earn more when they use investors' money to buy risky investments with high yields.

Step 4: There is an even bigger conflict: Issuing banks earn the most when bonds default.

A typical structure requires that investors lose all their money when 15 of 150 bonds default.

The remaining 135 'good' bonds must then be forfeited to a counterparty which - you guessed it - is the issuing bank. The investor's pain has become the bank's gain.

Step 5: A second way to lose it all is a 'credit event in a reference entity'.

A default here also results in all investors' money being forfeited to the issuing bank.

When Lehman Brothers collapsed, it triggered a 'reference entity credit event' in DBS High Notes 5, causing all the investors' money - $103 million - to be lost.

While investors lost everything, DBS claims to have sold its right to the proceeds, so it did not gain from the High Notes 5 credit trigger.

But it declines to say (i) when it sold, (ii) how much it received or (iii) whether the sale was to an affiliated party.

DOC MONEY'S QUICK QUOTE

'It's morally wrong to allow a sucker to keep his money.'

- W C Fields, American humourist, 1880 - 1946

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