Octave Notes a leap into the unknown for investors

Octave Notes a leap into the unknown for investors

Once again, bank clients had no idea of risks they took on

Last October, Wang Wu, a 58-year-old Hong Kong housewife, had a stroke. A few weeks earlier, US investment bank Lehman Brothers had collapsed, taking US$90,000 of the Wang family's life savings down with it. The irony was that the Wangs never invested in Lehman Brothers, not even in the bank's now-infamous minibonds.

Instead, in 2006 they bought Octave Notes, fiendishly complex structured products designed by another US investment bank, Morgan Stanley, and marketed as a high-income product to retail investors by 17 local banks.

Mr Wang claims he and his wife had no idea the future of the couple's retirement income had anything to do with Lehman Brothers. But lurking under the bonnet of the Octave Note the Wangs bought from Citic Ka Wah Bank was a complicated credit derivative that effectively ruled that if Lehman Brothers went bust, investors' money would disappear. Mr Wang says he found out in late September that all the money was gone.

"I cannot say [the stroke] was totally due to this incident," he said of his wife's condition, which has left her unable to speak. "But she was worrying about the money [she lost] all the time."

A Citic Ka Wah spokesman said the bank could not comment on individual cases.

Mr Wang is one of 400 outraged retail investors who have lodged grievances with the Hong Kong Monetary Authority about Octave Notes. Investors poured more than HK$2 billion into the products. Most have lost almost all their investment.

Advertisements for the note the Wangs bought promised annual interest of up to 7.5 per cent. According to Mr Wang, what they did not see within the highly structured investment was a bundle of derivatives with the potential to turn into a ticking time bomb.

There are multiple series of Octave Notes. In most cases, that bomb has already gone off, or is about to. Three series of the notes have already collapsed. Ten of the remaining 15 have lost 90 per cent or more of their value.

Bank of China (Hong Kong) was the biggest seller of Octave Notes, according to the Allied Victims of Lehman Products campaign group. A bank spokeswoman would not comment on this data. She said the bank complied with the law when selling Octave products and prospectuses contained clear risk disclosures.

But Mr Wang and others claim they never realised how Octave Notes worked. Two senior structured- finance lawyers said people without a background in finance could probably not read the prospectuses.

When they bought Octave Notes, investors really took out high-stakes wagers with Morgan Stanley on the future financial performance of a range of companies, some of which were to become very troubled. The notes contained two very conceptually advanced mechanisms known as credit default swaps and synthetic collateralised debt obligations.

Octave Notes' advertising brochures stated very clearly that they were not principal-protected and that they were "linked to the credits" of companies including Lehman Brothers. Campaigners question whether investors understood what this meant.

Last Sunday, just under 100 Octave investors attended a campaign meeting organised by the Democratic Party in Hong Kong.

"At the meeting, all those present said they had never heard anything from bank staff about credit derivatives or CDOs," said Democratic Party chairman Albert Ho Chun-yan.

"When people were asked to show hands if they had not heard about CDOs, the show of hands was unanimous."

Each Octave Note is structured slightly differently. But series 10, which the Wangs bought and has since been liquidated, is typical in its complexity.

When customers bought Octave 10, their money flowed into a shelf company called Victoria Peak, which Morgan Stanley headquartered in the Cayman Islands tax haven. As soon as Victoria Peak obtained retail investors' funds, it essentially placed a few bets, all perfectly legally and well documented in product prospectuses, of course. These gambles employed credit default swaps.

In Note 10, one of Victoria Peak's swaps wagered that a group of companies, including the now-bankrupt Lehman Brothers, would not default on loan payments. Under the terms of that bet, if any one of these supposedly safe companies defaulted, Victoria Peak would lose all its money. So when Lehman Brothers went bankrupt, investor money was gone.

Just like gambling in Macau, Octave 10's investors were betting against the house. Victoria Peak did the credit derivative swap with an entity named Morgan Stanley Capital Services, owned by the investment bank. So when Lehman Brothers collapsed, Morgan Stanley collected retail investors' cash. Note 10, as well as Notes 11 and 12, which were also credit-linked to Lehman Brothers, went into liquidation in this way.

She spent US$60,000 buying Octave Notes series 17 from Citic Ka Wah Bank. Note 17 was not credit-linked to Lehman Brothers. But it is currently priced at a valuation of only 4 cents on the dollar. Ms Chan's would realise just US$2,400 if she sold now.

She also lost US$35,000 on Lehman Brothers minibonds and a further HK$500,000 on equity-linked notes issued by Lehman Brothers.

Ms Chan says she is too busy to analyse investments, and claims she always relied on the staff at Citic Ka Wah, with whom she has banked for a decade. Ms Chan claims the bank's staff sold her the investment in a five-minute phone call. She was under the impression it was "like a time deposit".

Most of the Octave Notes are structured similarly to Note 17, so this product is worth a deeper look. It took Your Money three days of poring over hundreds of pages of documents and questioning bankers and lawyers to find out where May Chan's and other investors' money had gone.

When retail investors paid US$28 million into Octave Note 17, the cash also went to Victoria Peak, the zombie company set up by Morgan Stanley in the Cayman Islands. Victoria Peak has only US$250 of its own money, however, so Octave 17 investors hunting for their cash will not find it here. After Victoria Peak collected the money, it went gambling again (all perfectly legally and detailed in the prospectus). It placed a high-stakes bet on the future financial performance of 100 global companies, which retail investors are perilously close to losing.

The bet basically said this:

If all companies in the group of 100 remain healthy, Morgan Stanley will pay Victoria Peak, and therefore Octave 17's investors, a certain amount of income per year. But if a certain number of companies in the reference pool miss loan payments - probably eight to 10 - Victoria Peak must give everything it owns to Morgan Stanley Capital Services.

So far six of the companies in the betting pool have missed loan payments, including Icelandic bank Landsbanki and US mortgage guarantors Fannie Mae and Freddie Mac. According to structured-finance experts, as soon between four and seven more names default, retail investors lose their cash.

The bank's structured-finance whizz kids built a "synthetic CDO" for Victoria Peak's wager. Synthetic CDOs exist only conceptually. They do not own anything. Instead, they are like a term sheet from the Jockey Club, detailing the agreement gamblers have made.

The way the CDO was structured means retail investors cannot be sure how many defaults need to happen in the pool of 100 firms before Note 17 is wound up.

The synthetic CDO in Note 17 is a pretend pot of money. Retail investors lose their cash as soon as this pretend money runs out.

The CDO started life with US$1billion of fake money. It has US$328 million of fake money left. Each company in the structure is "worth" a pretend US$100 million. So four more defaults could wipe the CDO out completely.

But companies' bonds often have some value after they miss loan payments. The value of pretend money in the CDO would reflect this. There may be enough money for another seven or eight further defaults before the betting vehicle expires.

If the CDO expires, Morgan Stanley cashes in. But this probably will not enrich the bank. According to informed sources, Morgan Stanley Capital Services (MSCS) has made hundreds of further bets on Octave 17 with other banks. It will have to pay all these counterparties something if Octave 17 fails. So as soon as MSCS gets the money retail investors put into Victoria Peak, it all may fly off somewhere into the complex, interconnected web of derivatives agreements between financial institutions.

If this all sounds mind-bogglingly complex, that could be the main point. Hong Kong's financial regulators, banks who sold Octave Notes and Morgan Stanley, their architect, must ask themselves if such products can ever be suitable for financially unsophisticated retail investors.

A Morgan Stanley spokesman said the investment bank was working with Octave Notes distributors to help them keep customers fully informed. It has also set up a website containing relevant issue documentation and a section on frequently asked questions.

A spokeswoman for the Bank of China (Hong Kong), which apart from Citic Ka Wah was the only distributor to answer questions, said: "The bank, as one of the distributors of the Octave Series, complies strictly with the relevant laws and regulatory requirements and internal rules and guidelines."

Regulators and lawmakers will have to decide whether this is enough.

Investors who feel bamboozled by Octave Notes want only compensation. Who they will pursue remains to be seen.

Quoted: 2009-6-7(Sun) South China Morning Post P.16