Octave Notes

Full story published in the South China Morning Post

The fourth part of a series on financial products and practices takes a look at Octave Notes

Octave Notes, the worthless structured investment product du jour, are making the news lately. The issuers and marketers of the notes are no doubt feeling the pressure as the prospect of another round of mini-bonds style protests brews. We’ve all read that unfortunate investors have lost their money on these things and that they were a bit riskier than everyone might have realized, but what exactly is an Octave Note.

You may have read that these things are impossibly complex and in some ways that’s true. To describe each Octave Note specifically I would need the entire newspaper, and that would be disappointing to everyone who wants to read the news or check their horoscopes. But the basic structure that governs this and a lot of other similar products I can describe pretty simply.

This product falls into the broad category of “credit-linked-notes”. Credit linked notes are, or at least were, a very popular derivative dreamt up by the same people who bought you the accumulator, the asset linked deposit and the mortgage backed security. By this I mean, very clever and very wealthy bankers who probably no longer have jobs.

A credit-linked note (CLN) in the present context is basically a credit default swap packaged into something that looks a bit like a bond. This is how it works: an institution, called the Issuer, creates the CLN with a load of paper and agreements and special-purpose companies in tax-efficient jurisdictions. The Issuer then offers investors a solid interest rate, say 3 per cent a year for five years. Investors buy the CLN from the Issuer and look forward to sitting back and collecting interest.

The institution then does two things. First it puts all of the money from investors in a safe place, usually by purchasing a bond or some other security from a highly rated entity, like a government. This will yield a small interest and, assuming nothing goes wrong in five years, will be available to repay the investors' principal.

Then the important bit. The Issuer will sell a credit default swap, or CDS, on a riskier credit. The credit default swap will pay a premium to the Issuer that, together with the interest received on the highly rated security, is then available to the Issuer to pay interest to the investors.

The CDS is the real crux of the CLN. The way the CDS works is this: if the Issuer sells a CDS to Alanson Bank for HK$100 worth of, say, Citigroup debt, the Issuer is basically selling Alanson Bank an insurance over that debt. If Citigroup defaults on this debt, the Issuer will have to pay Alanson Bank HK$100. In return for writing this insurance, Alanson Bank will pay the Issuer a CDS premium, like an insurance premium.

When the CLN is created, the Issuer sells a CDS for the full amount that investors have put in, thus placing the entire principal at risk.

Suppose I create a CLN that promises 3 per cent annual interest. I ask a few local banks to market it for me and I manage to raise HK$2 billion. I then buy HK$2 billion worth of US government bonds that pay 0.5 per cent interest per annum. That does not get me to 3 per cent, so I will sell a CDS to Alanson Bank for HK$2 billion worth of Citigroup debt.

In this case, Citigroup is called the "reference credit". The CDS premium that I get on the HK$2 billion of Citigroup debt is 4 per cent. I now have 4.5 per cent interest per year available to distribute to my investors, although because I will pay commissions to myself and my distributors, I will still be paying investors only the 3 per cent I promised.

If all goes well, at the end of the CLN term, usually five years, I will return the HK$2 billion to my happy investors. However, if something goes wrong with the Reference Credit, there is a slightly different outcome.

If Citigroup defaults on its debt, Alanson Bank is effectively entitled to claim on the CDS and require me to pay it the entire HK$2 billion I sold the CDS for. I have HK$2 billion in the form of US government bonds, and so all I have to do is sell those and give Alanson Bank the proceeds. That leaves nothing for the investors.

Under the rules of the CDS, once I have paid Alanson Bank the HK$2 billion, it will give me the Citigroup debt, and that might be worth something. So the CLNs will not be worth zero, but probably not much more.

So through the Issuer, investors are really selling a CDS and earning higher interest than they would by simply buying a highly rated bond.

There can be various layers of additional complexity. Quite commonly, there is more than one reference credit, or when the reference credit starts to look shaky (called a "credit event"), the Issuer can simply sell the CDS to a third party and wind up the note, at a loss to the investors.

A characteristic of these things is that the only entity taking any risk is the investor who buys the CLN. This is not unusual for retail finance products, but in our CLN example, the Issuer could be a subsidiary of Alanson Bank. Instead of buying a US government bond, it could buy an Alanson Bank bond, and the CDS it sells could, and probably would, be for debt that Alanson Bank itself holds. All in all, a good deal for Alanson Bank.

Now I imagine that if an investment adviser suggested a product to me that has half-decent interest, where my principal is invested in a high-credit-quality security, and with a link to a reference credit that sounds reasonable, I would probably be interested. But if it was described as me pooling my money together with a bunch of other investors and selling a credit default swap, I think I would be a bit more cautious.

In the case of the Octave Notes, we are well past that. In certain series, a credit event has taken place in respect of the reference entity, the high-credit-quality asset has been sold, and investors are left with whatever the CDS or the insured debt is worth, generally not much.

There is a point I want to make about these kinds of investment. The documents prepared by the Issuer are generally indecipherable unless you are a finance professional. Even then you would not be able to tell if the return on the CLN matches the underlying risk without access to real-time data on the CDS market.

The only way I can imagine average investors will be able to understand the risk of a credit-linked note is if their investment adviser can explain it. It was some time ago when these things were explained to their unfortunate purchasers and we will never know what went on. But I would hazard a guess that not many investors came out congratulating themselves on having bought exposure to the now infamous CDS market.

ALAN ALANSON