Derivatives and Regulatory Failure – Precipice Bonds

Financial engineer Gordon Kerr presents the prequel to his article How to destroy the British Banking System – Regulatory Arbitrage via “Pig on Pork” Derivatives.

The 1997 Labour victory promised major changes to regulation and supervision of banks and the financial services industry. Shortly after Labour came to power I was working as a structuring engineer on the derivatives/securitisation desk at a big brand UK bank; I was aware of a few of the tricks of the trade, and I looked forward to rules being published that would no doubt tighten things up.

It soon became clear that the scope of the Financial Services Authority’s supervisory remit would grow. Regulators were gaining airtime and political clout, particularly in the aftermath of the 1998 collapse of Long Term Capital Management, a large US hedge fund set up by famous traders and derivatives specialists.

By early 1999 I began to realise that the actual regulatory function of the Financial Services Authority (FSA) was indeed changing; it was weakening markedly.

Relationships between bank staff and regulators were becoming friendlier, more personal. Actual supervision appeared to be widening but was in fact becoming less substantial. Greater weight appeared to be being placed on the bank’s “internal” regulatory function and I suspect that the FSA officers looked up to many of my internal colleagues. Why? Because I sensed the officers were just a little out of their depth. They needed help from the team of bank staff tasked with presenting our new structures to the regulators for approval.

Our internal teams that dealt with the regulators began to grow in confidence.

One day in the summer of 1999 my equity derivative colleagues returned from a conference call with the FSA to the trading room punching the air in triumph. They were roaring with laughter at the absurd questions they had been asked about their latest invention – precipice bonds – which were being submitted for approval at the most relaxed and least protected level of supervision.

The emergence of precipice bonds represents a classic question for regulators: in a free market economy how far should regulators go to ensure that investors understand both their risks and their returns?

What is a precipice bond? It is a savings product with a potential sting in the tail. A typical structure would be a 5 year retail investment offering an above market return – say 9% per annum when average savings rates were 6%. The catch would be an event or combination of events, such as the average of the UK, French and German stock market indices falling by [25%] during the life of the investment. If this happened, the investors would lose substantial value.

Crucially, the public did not understand the value of the options that they were selling in return for the premium they received of 3% per annum. The reason that these precipice bonds emerged was that there was an arbitrage available to the derivative structuring teams; banks like mine could buy these options from the public by embedding them in an instrument billed as a savings product, strip the option from the investment as the funds flowed in, then sell the options back to the market at a profit. The reasons the structures were called “precipice bonds” is simple. The option sold would protect the bank against fairly catastrophic drops in the indices that were the subject of the options. Therefore, if in the example cited the indices actually fell past the trigger point, the investor returns would fall off a cliff, hence the term ‘precipice’.

These instruments were purely option based products that had a tangential relationship only to the stock market, no impact whatsoever on the actual stock market (other than to drain money that might have gone into shares away), and yet the FSA swiftly approved them for pension pots (ie the highest level of approval we had sought with the minimum health warnings).

We all knew that the FSA mistakenly believed that they were some kind of investment in shares. No junior graduate trainee on our desk would have fallen into the trap that so easily snared the FSA. If we had set the outcome event as the probability of Manchester United finishing more than 5 places below Arsenal in football’s Premier League, the impact on the stock market would have been no different and the structuring technology pretty much identical.

I thought hard about saying something to senior management but did nothing.

Why did I do nothing? The answer is that I had blown the whistle before, more than once. It was never a pleasant experience. This character flaw had led to one or two job changes by the time I was old enough to understand the operation of the markets and had acquired basic structuring skills. The first time was when I worked for a major US investment bank in London. In April 1988 I alerted senior New York based management to concerns that my immediate colleagues on the perpetual floating-rate note eurobond desk were falsely reporting inflated values of bonds we could not sell in order to massage up the bonus pot. The traders appeared unconcerned that one side effect of their understandable desire to be paid well would be to cause the bank to produce false accounts. I was flown over to New York to run through this. I was thanked, action was to be taken and I was told to stay and press on with my role. However I became concerned when I learned that only juniors were to be fired and the most senior culprit appeared to me to have got away with it.

I took another job since I was not convinced that the senior chap (still in my reporting line) would forgive me for rocking his boat. I had a big mortgage. My only pleasant memory from that particular experience was a brief chat with Whitney Houston on the Concorde trip to New York.

Seven years later I was working for a Japanese firm in London. In January of 1995 I was asked to lead a large and profitable project. The pot of gold here was very easy to see. The idea was to buy large volumes of life policies from terminally ill (less that 2 years life remaining) AIDS and cancer patients in Florida hospitals and hospices.

The opportunity hinged on exploiting the least well off patients, those who lacked medical insurance and whose families could not afford their medical bills. We would pay the premia on the policies for the rest of each patient’s life. In return the patient would assign his policy to us unaware that given his short life expectancy we were only paying about half the value of the death benefits we would receive. Since there was no market that the individuals could then access they had no way of understanding how far away from a fair price they would be selling.

I did not feel particularly comfortable about taking so much value from the widows and orphans of our customers, particularly since in most cases they were losing the family breadwinner. I made waves internally about this in the bank, the project was terminated and I was fired for “not fitting in” and “playing too much squash” a few days later.

By the summer of 1999 and the launch of the ill-fated precipice bonds I had managed to persuade Patricia Morris to marry me. I became stepfather to her two daughters, I had a big mortgage, increasing responsibilities and I was pushing 40. What was the point of kicking up a fuss? The entire bank management chain were salivating at the prospect of the profits, the FSA had approved the structure. I though about leaking it anonymously to the press but feared that they would not understand the maths behind the derivative option-pricing model. Would the press care anyway? Not much of a story and of course there was always the chance that investors might not lose their money even though they were gambling with the dice heavily loaded against them.

Instead, I turned my nose to the grindstone and decided to look for inoffensive ways of making money out of the regulatory anomalies that were bound to jump out of the flurry of rules that our then new super regulator was dreaming up.

After a few days thought we found what we were looking for. A classic arbitrage, “low hanging fruit” waiting to be plucked from the boughs of trees nurtured on the healthy compost of the FSA’s rapidly changing rulebook. A simple circular structure was quickly conceived that exploited the new and easy capital environment that applied to any risk that was characterised as derivative exposure. We had a few billion in loans that were guaranteed by large US insurance companies, at that time of undoubted strength. By inserting a passive bank between us, as a further guarantor, and the US insurer we could achieve the same result as if our Bank had issued fresh capital and thus enable senior management to leverage the bank significantly higher.

All we had to do was find a passive, risk averse, fairly weak European bank and pay them an accommodation fee to sit in the middle of this structure which we called “pig on pork”. The assets were already insured by the US entity. Now the assets would be guaranteed again, by a new fangled instrument – a “credit derivative”. The additional premium to each party was tiny. Since the US entity was regarded as stronger than the European Bank this extra protection was not regarded as adding significant benefit. The leverage benefit to the bank was enormous. The capital requirement of 8% became 0.5% overnight, the equivalent balance sheet benefit of a significant capital raising exercise, and all because the FSA failed to understand that credit derivatives were essentially loans, and the two regimes should have been no different. They still don’t appear to have caught on, and this type of rule arbitrage remains.

Further reading

• How to destroy the British Banking System – Regulatory Arbitrage via “Pig on Pork” Derivatives
• How to avoid future encounters with financial meltdown