In this latest instalment, a former investment banker tells how ‘accumulators’ favoured banks at the expense of Chinese clients.
Mushtaq Kapasi 26 May 2009
(Caijing.com.cn) Casino gamblers generally know they’re more likely to lose than win. If the odds of winning were even for an average gambler, after all, the world’s casinos would go out of business. Games are set up to give casinos a slight edge. Blackjack dealers, for instance, enjoy an advantage because they decide last whether to take another card.
Likewise, when it comes to betting on complex derivatives, the odds always favour banks. A difference between blackjack gamblers and derivative investors, unfortunately, is that the latter often don’t understand their handicaps. In my experience as a derivatives lawyer and banker, I’ve seen trades literally wipe out the profits of companies in China and elsewhere in Asia. In each case, the deal was designed in a way that gave the bank a much better chance than the client to win big.
Let me explain how this happened with a different analogy. If I want to buy a house, my bank might offer me a mortgage with a variable interest rate. If interest rates go up, I’ll have to pay more. But if interest rates go down, I would expect to pay less. I wouldn’t expect the bank to tear up my mortgage.
However, that’s exactly how many derivative deals in China were structured. A bank could walk away, but a buyer could not.
One notorious example of this phenomenon is the “accumulator” derivatives product. Tycoons and other private banking clients bet that a company’s share price will rise.
Wealthy investors agree to buy perhaps 1,000 shares every month at a fixed price. This fixed price in the accumulator is cheaper than the actual market price of the stock. In the bull market, accumulators were a great way for investors to build stock portfolios at a discount. They could hold stock or sell for a quick profit. Almost every investment bank sold these products to Chinese clients who bet on the Hong Kong Stock Exchange. By using accumulators, banks made sure they would not lose even if an investor won. They hedged their risks on the stock markets, and booked upfront profits from accumulators. Banks wanted to sell as many as possible.
But there was a catch. If a stock price rose too quickly, the accumulator would “knock out,” and terminate. Sure, it might pay a bonus when it knocked out. But even so, termination meant investors probably made less money than if they had simply owned stock. Buyers didn’t worry as long as the stock market kept rising, though, because they could simply buy a new accumulator as soon as another terminated.
We know how that story ended. When the Hong Kong stock market crashed last year, people with accumulators had to keep buying stock at prices that once seemed low but suddenly scraped the clouds. Also, in a bear market, they would be forced to buy twice as many stocks at an inflated price as they had been buying at a discount during the bull market. And sometimes, believe it or not, situations with accumulators could get even worse.
Let’s go back to the home mortgage example. You borrow money from a bank to buy an apartment, and the bank keeps collateral in the form of your home. If you fail to make your mortgage payments, the bank will take away your home. That’s unpleasant, but not unfair.
Collateral on derivatives is different. For individual investors and small companies, the collateral often isn’t a house or a factory; it’s cash. So if market conditions go against an investor, the bank can demand an immediate cash payment on the derivative. Not only that, but it can demand a huge amount -- equivalent to the value of all net future payments (predicted by the bank’s computer models). This cash amount can be 10 to 20 times more than what the client expected to pay in a single month under terms of the derivative package.
By using accumulators, banks could make investors pay up front for all theoretical losses on stocks they would have to buy through the life of the product. Buyers might get some of this money back if stocks recovered. But for many, only losses accumulated.
A lot of investors never understood the complicated contracts that obliged them to these repayments. That’s not surprising. Even though I’m a trained finance lawyer, it took me months to learn all the subtleties of these contracts.
How did banks get away with this unbeatable game? Because investors got a great, short-term deal during the bull market, when everyone was making money on accumulators and similar products. Almost anyone could walk into a local bank and get into the game. Now, with recent stock rallies, accumulators are back. I don’t know who’s buying them this time. What I do know is that there are much better ways to use derivatives to bet on short-term gains in stocks, without leaving oneself vulnerable to the next downturn.
Mushtaq Kapasi is president of Octagon Pacific, a structured finance consultancy.
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Confessions of Chinese Derivatives Deals, Part 3
In this latest instalment, a former investment banker tells how ‘accumulators’ favoured banks at the expense of Chinese clients.
Mushtaq Kapasi
26 May 2009
(Caijing.com.cn) Casino gamblers generally know they’re more likely to lose than win. If the odds of winning were even for an average gambler, after all, the world’s casinos would go out of business. Games are set up to give casinos a slight edge. Blackjack dealers, for instance, enjoy an advantage because they decide last whether to take another card.
Likewise, when it comes to betting on complex derivatives, the odds always favour banks. A difference between blackjack gamblers and derivative investors, unfortunately, is that the latter often don’t understand their handicaps. In my experience as a derivatives lawyer and banker, I’ve seen trades literally wipe out the profits of companies in China and elsewhere in Asia. In each case, the deal was designed in a way that gave the bank a much better chance than the client to win big.
Let me explain how this happened with a different analogy. If I want to buy a house, my bank might offer me a mortgage with a variable interest rate. If interest rates go up, I’ll have to pay more. But if interest rates go down, I would expect to pay less. I wouldn’t expect the bank to tear up my mortgage.
However, that’s exactly how many derivative deals in China were structured. A bank could walk away, but a buyer could not.
One notorious example of this phenomenon is the “accumulator” derivatives product. Tycoons and other private banking clients bet that a company’s share price will rise.
Wealthy investors agree to buy perhaps 1,000 shares every month at a fixed price. This fixed price in the accumulator is cheaper than the actual market price of the stock. In the bull market, accumulators were a great way for investors to build stock portfolios at a discount. They could hold stock or sell for a quick profit. Almost every investment bank sold these products to Chinese clients who bet on the Hong Kong Stock Exchange. By using accumulators, banks made sure they would not lose even if an investor won. They hedged their risks on the stock markets, and booked upfront profits from accumulators. Banks wanted to sell as many as possible.
But there was a catch. If a stock price rose too quickly, the accumulator would “knock out,” and terminate. Sure, it might pay a bonus when it knocked out. But even so, termination meant investors probably made less money than if they had simply owned stock. Buyers didn’t worry as long as the stock market kept rising, though, because they could simply buy a new accumulator as soon as another terminated.
We know how that story ended. When the Hong Kong stock market crashed last year, people with accumulators had to keep buying stock at prices that once seemed low but suddenly scraped the clouds. Also, in a bear market, they would be forced to buy twice as many stocks at an inflated price as they had been buying at a discount during the bull market. And sometimes, believe it or not, situations with accumulators could get even worse.
Let’s go back to the home mortgage example. You borrow money from a bank to buy an apartment, and the bank keeps collateral in the form of your home. If you fail to make your mortgage payments, the bank will take away your home. That’s unpleasant, but not unfair.
Collateral on derivatives is different. For individual investors and small companies, the collateral often isn’t a house or a factory; it’s cash. So if market conditions go against an investor, the bank can demand an immediate cash payment on the derivative. Not only that, but it can demand a huge amount -- equivalent to the value of all net future payments (predicted by the bank’s computer models). This cash amount can be 10 to 20 times more than what the client expected to pay in a single month under terms of the derivative package.
By using accumulators, banks could make investors pay up front for all theoretical losses on stocks they would have to buy through the life of the product. Buyers might get some of this money back if stocks recovered. But for many, only losses accumulated.
A lot of investors never understood the complicated contracts that obliged them to these repayments. That’s not surprising. Even though I’m a trained finance lawyer, it took me months to learn all the subtleties of these contracts.
How did banks get away with this unbeatable game? Because investors got a great, short-term deal during the bull market, when everyone was making money on accumulators and similar products. Almost anyone could walk into a local bank and get into the game. Now, with recent stock rallies, accumulators are back. I don’t know who’s buying them this time. What I do know is that there are much better ways to use derivatives to bet on short-term gains in stocks, without leaving oneself vulnerable to the next downturn.
Mushtaq Kapasi is president of Octagon Pacific, a structured finance consultancy.
KODA - Knock Out Discount Accumulator
北京富婆郝婷存款星展银行8千万，短短几个月后变为倒欠银行9千万
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