Lehman's mini-bonds The good inside the bad

http://www.economist.com/node/18486397?story_id=18486397

A settlement in Hong Kong reveals substantial value inside dud securities

Mar 31st 2011 | Hong kong | from the print edition

WILL this be the end of months of protests outside the branches of Hong Kong’s big banks by holders of so-called Lehman mini-bonds? A settlement announced on March 28th provides most of the retail investors in these structured products with a 70-93% recovery rate on their initial investment; an additional payment pushes the recovery range up to 85-96.5%.

In truth the products were neither “mini” nor all that much to do with Lehman. In Hong Kong alone, thousands of residents held the securities. Lehman structured many of the instruments and provided a sophisticated guarantee through a swap, which is why they were dragged into the firm’s bankruptcy, but the underlying assets were mostly collateralised-debt obligations issued by others.

On the surface the settlement sounds pretty good. Back in 2009 Hong Kong’s regulators and 16 banks that marketed the products offered the bondholders 60% of their investment back, and the possibility of a higher repayment based on further recovery, in exchange for title to the bonds. Almost 30,000 customers, with a total of HK$5.5 billion in assets, agreed. That allowed the banks to go after the Lehman estate for access to the assets, which in turn led to this week’s settlement.
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The final payout is nowhere near as stingy as had once been feared. Locally the deal is seen as a consequence of shaming the financial institutions which sold the products into coughing up. When the “mini-bonds” stopped paying out, local regulators were deluged with complaints. Just how aggrieved investors had a right to feel is unclear: the products came with thick, and doubtless unread, prospectuses detailing the risks involved. But picket lines, clanging drums and acerbic signs focused the attention of bankers and regulators on the plight of people whose financial expertise amounted to spotting products with higher interest rates than low-yielding bank deposits.

As litigation surrounding the Lehman bankruptcy advanced, the odds against a good outcome for the little guy stacked up. A British court ruling in a related case implied the assets were the property of the bondholders; an American court ruled they were part of the Lehman estate. This kind of mess is for Goliaths, not Davids.

Yet investors may even now have cause for complaint. Just how much value was surrendered to extract the assets from the wreckage of Lehman is not clear, but the amounts are likely to have been large. The size of the payouts suggest that the assets underlying the securities are far from worthless, even if the tumultuous markets and Lehman’s bankruptcy obscured their value at the time. Working out what collateral lies behind the instruments is not easy but they include bonds issued by solid corporate names which did not default; upon maturity, the proceeds from some of these bonds were reinvested in Treasuries. If there was no default, investors might ask why they are not being fully reimbursed.

The mini-bond saga raises wider questions, too. For retail investors in particular, the risks of having securities held by people in one jurisdiction sold by companies operating in another jurisdiction that may have assets in yet another and come under multiple regulators look indefensibly complex to gauge. Yet these sort of structures continue to thrive even now.

The mini-bond recovery rates suggest, too, that other Lehman-linked securities which froze up in the panic of 2008 could yield big returns for investors that were brave enough to pick them up. The crisis was both the revelation of a broken financial system and a panic where prices evaporated because confusion reigned.