Five years later, what has the mini-bond scandal taught us?
While rules for sale of complex products have been tightened, the same forces are at work that saw investors ramp up risks for better returns
It took a few days for Hong Kong to realise that the September 2008 implosion of Lehman Brothers had created a very specific local problem.
Tens of thousands of ordinary Hong Kong savers had spent some HK$20 billion on "mini-bonds" issued by the bust investment bank. With its collapse, the value of their investments fell to zero.
Much of the following three years was taken up with bitter accusations of mis-selling and inadequate regulation.
Yet five years after Lehman's bankruptcy, with new and tighter investor protections now in place, it is questionable how much investors, bankers and regulators have really learned from the whole fiasco.
In case you've forgotten, or if you were lucky enough never to know in the first place, Lehman's mini-bonds weren't bonds at all. The name was intended to inspire confidence, but in reality they were credit-linked notes assembled using complex derivatives.
Most developed markets prohibit the sale of these notes to retail investors. But in Hong Kong's more relaxed regulatory environment, mini-bonds found willing sellers in the form of local banks and eager buyers among their customers.
The banks were certainly keen. In the early 2000s Hong Kong's sluggish economy and depressed property market saw loan demand dry up. As a result, the banks' loan-to-deposit ratios tumbled to a record low (see the first chart), brutally squeezing their interest income.
Encouraged by the Hong Kong Monetary Authority, local banks ramped up their sales of securities, pushing structured products like mini-bonds to depositors in order to capture lucrative commission income.
Their customers needed little encouragement. Thanks to the US Federal Reserve's policies, in the early 2000s Hong Kong deposit rates slumped to a fraction of their late 1990s levels (see the second chart).
Clamouring for higher yields, local savers lined up to buy mini-bonds, which typically promised a coupon of 5 per cent or more, far higher than fixed deposit rates at the time.
Many customers thought they were getting something akin to a deposit, only with a higher yield. What they were actually doing was writing insurance against defaults by a basket of companies. Worse, because the insurance was in the form of credit derivative contracts struck with Lehman Brothers, they were also getting exposure to Lehman's own creditworthiness. When the bank went bust, the value of the contracts evaporated.
Five years later, mini-bond holders have recouped most of their losses from the banks that sold them the notes. And Hong Kong's regulators have tightened the rules governing the sale of complex products, improving disclosure and requiring banks to satisfy themselves that customers understand and can accept the risks involved.
Yet it's doubtful how much anyone has really learned. With banks looking for new income sources and savers hungry for yield, it is unlikely the new regulatory measures would have deterred either the sellers or the buyers of mini-bonds had they been in force at the time.
Meanwhile, with deposit rates as low as ever, banks and their customers are as willing as before to run extra risks in the expectation of higher returns.
Mini-bonds themselves may have gone out of fashion, but both structured notes and credit derivatives still find ready markets. According to the Bank for International Settlements, the market value of outstanding credit default swaps at the end of last year came to US$848 billion, up from US$721 billion in the middle of 2007 just before the outbreak of the financial crisis.
For now the risks look moderate. But when interest rates start to rise again, legions of investors who ramped up their risk in search of returns will find themselves facing heavy losses.
It happens every time the monetary policy cycle turns. Alas, despite the lessons of the mini-bond fiasco, this time will be no different.