First-to-default notes a blast from the past

PUBLISHED : Monday, 12 December, 2011, 12:00am
UPDATED : Monday, 12 December, 2011, 12:00am

American comedian Will Rogers observed: 'You can't say civilisation don't advance ... in every war they kill you in a new way.'

Having barely survived the implosion of minibonds, Asian investors are now being tempted by 'new' similarly structured products.

They are known as first-to-default (FtD) credit-linked notes and give investors a yield boost by linking to a basket of credits. If one credit in the basket defaults, then the investor takes a loss.

The pitch is that all the credits in the basket are of a very sound rating, so a default is unlikely.

FtD notes share much in common with minibonds, not least because minibonds were often based on FtD swap contracts.

With minibonds, investors purchased notes issued by a Cayman Islands special purpose vehicle (SPV) that invested the money in AAA-rated securities - initially, investments in money market funds.

The investment secured a credit derivative contract, known as an FtD swap, where the investor assumed the risk that any one of, say, seven or eight entities might default on their obligation during the life of the note.

An annual fee payable for the FtD swap together with the interest on the money invested gave the investors a higher return than comparable bank deposits.

The investors risked the loss of their investment principal if any one of the specified firms defaulted.

Over time, instead of placing the investor's money in money market funds, it went into collateralised debt obligations (CDOs) arranged and sold by Lehman Brothers.

FtD notes are similar. Investors take a risk on the first to default in a portfolio of entities. The differences are that the issuers of the notes are banks and dealers rather than an SPV and that the underlying investment does not include structured securities such as CDOs.

In both generations of product, the companies in the FtD basket are solid, well-known Asian or global institutions. The sales literature highlights the good credit rating (generally investment grade) of the individual companies, emphasising that the risk of loss is remote.

But investors are taking two distinct risks: the chance of any of the firms in the FtD basket defaulting, and default correlation risk (the likelihood of one reference entity defaulting if another entity defaults). The risk of any one entity within a basket of eight well-rated firms defaulting is much higher than for any single entity defaulting.

The credit rating or default risk of the companies within the basket is one element of the structure. But it is the risk that matters. If the note itself were rated, then it might not be an investment-grade credit risk.

In practice, precisely for this reason, the notes themselves are rarely rated. The rate paid does not compensate for the true risk once this adjustment is made.

Because FtD notes and minibonds share the same basic structure, their risks overlap.

Both carry counterparty risk. As Lehman was the counterparty to the many swap contracts in the minibonds, the investment was essentially worthless when Lehman went bankrupt. FtD notes are also vulnerable to the default of a key counterparty.

Both share documentary and legal issues. Because multiple legal jurisdictions are involved, there may be different interpretations of key provisions by different courts.

In Asia, minibonds and the newer products are marketed as simple high-interest bonds. In fact the higher returns involve complex risks.

Financial innovation can create wider investment opportunities. But it can also produce complicated products, incomprehensible structures and sharp sales practices.

Investors in Asia seem intent on corroborating the German philosopher Hegel's observation that the only lesson of history is that no one learns the lessons of history.

Satyajit Das is the author of Extreme Money: The Masters of the Universe and the Cult of Risk



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