Minibond explained

The following is the summary of Minibond saga:

This structured product [Credit-linked Note with CDS]is a typical output of financial engineering. There are four parties involved: the investors (Minibond holders), the special purpose vehicle (Minibond), the Counterparty LBSF (LB special financing) and the Trustee (HSBC Institutional Trust Services (Singapore) Ltd). The working mechanism is described below.

i) LBSF has a pool of corporate bonds from a number of reference entities. These corporate bonds are of good investment grade by the rating agencies. To guard against the credit default risk, LBSF sought to transfer the risk to a 3rd party [in this case, Minibond was set up]by purchasing insurance from Minibond under a Credit Default Swap [CDS]Scheme in which, LBSF will pay regular premium [Credit spread] of say 1% of the total value of the bond pool to Minibond and the 1% premium is payable to the minibond holders for assuming the credit default risk of the reference entities.

ii) Minibond [the issuer] uses the CDO ( In case of Minibond Series 1, the underlying security is Series 2008-15 US$40,600,000 Synthetic Portfolio Notes due 2011 issued by Beryl Finance Limited SIN Code: XS0382664547. The security may be different for other Minibond series) as the collateral for the CDS agreement. This CDS is called funded CDS to mitigate CounterParty risk [i.e.in case of Minibond's (Counterparty, with respect to LBSF)inability to honour the CDS obligations]. The Minibond is linked to the credit rating of the reference entities.

iii) In case when a credit event happens, LBSF will seek physical/cash settlement from Minibond under the CDS agreement. Minibond will have to deliver physical CDO or dispose of the CDO to pay cash to LBSF as the case maybe under the CDS agreement. In exchange, the bond pool will be delivered to Minibond and disposed of. The recovered amount,if any,will be distributed among Minibond holders.

iv) Since Minibond is a SPV, it will need to raise fund from investors by selling notes with say 5% coupon payment. Minibond then uses the fund to purchase "low risk CDO" to provide regular cashflow [coupon] same as the coupon rate and maturity of the notes. In order to attract higher rating, the CDO is backed by Lehman Brothers Holdings Inc. as the swap guarantor. The CDO is rated investment grade by rating agencies.

v) The CDO also pays coupon to Minibond which has an interest rate / currency SWAP with LBSF to ensure coupon payments to investors are regular and fixed.

vi) If the Counterparty [LBSF] is in default, the trustee will dispose of the CDO and pay the investors. The amount will be marked to market However, in the credit crunch situation like today, the value is likely to be zero.

In effect, the Minibond has transferred the credit default risk of the reference entities to the Minibond holders. As Minibond holders have fully paid the investment, LBSF has no counteraprty risk [Minibond]. In addition, the Minibond holders have also assumed the risk of CDO being devalued or worthless under the current situation.

The following is the announcement in Businesss Times on 18 Nov 08 by HSBC International Trust Services pertaining to Minibond Series 1: