When someone reputable offers you an investment, don’t just invest based on reputation.
You have to have the competency, to evaluate the risks, the probability of risk event happening and the impact.
Last week, I wrote about the sudden news of Swiber Holdings winding down. One of the consequence of this event is that the bond holders may face an impairment of their capital.
In layman terms, it means they will suffer a capital loss that would be very very difficult to make back.
Imagine that your Private Banker introducing you to purchase a 4 year corporate bond with a yield of 7.1% in 2013
Then because its a bond, and upon the recommendation of your private banker to do bond leveraging you decide to purchase the bond with 50% leverage at less than 1.5% interest. Your leveraged yield becomes 12.70%.
In a low yield environment for the well heeled, this looks great.
While the above is hypothetical, I would think that there are some checks in the banking organization that prevents a heavy leverage, or any leverage on unrated bonds.
It turns out that this is not the case.
Some folks really got hurt here.
A self-employed man Mr Jin, invested $500,000 in 2 Swiber Bonds, which was issued by DBS.
Take a look at how he attempted to rationalize things:
“I was simply following the advice of my relationship manager, who never told me much about the company. I just thought, a bank in Singapore, with this much regulation, would not recommend risky investments”
“I’m a new immigrant and could barely understand English. I just signed whatever papers the relationship manager gave me.”
He is not the only one who faced impairment of capital.
A 34 year young lady Laura also have a problem now. What made her a unique case study is that she is also a banker:
“My banker said DBS could lend me money to invest, so I’m 50 per cent leveraged on Swiber bonds. Now they’ve defaulted, I’m asked to pay the bank $250,000 by next Tuesday to cover the margin.”
What can we learn from this?
Halo Effect clouds our judgement
The first thing is how reputation is a qualitative indicator of risk, and a rather unreliable one. In this case, the customers of DBS, trusted that a Singapore Bank would not sell them shitty things.
Turns out that there is no evidence of adequate risk control here.
Even the explanation is very dodgy:
The Swiber Holdings bonds sold by DBS Bank to clients were rolled out to voracious demand, at a time when the company and oil prices were going strong. So DBS should not be singled out for scrutiny over bondholders’ exposure to Swiber’s demise, a bank spokesman noted.
“DBS does lend against all eligible and acceptable market securities, and investment leverage is offered to wealth customers based on prudent underwriting standards. This includes imposing criteria on the credit quality and duration of fixed income securities as well as requiring the underlying investments of each customer to be diversified.”
Investors with some competency would know that most of these businesses are order book based, and cash flows are not always the most stable. So it is puzzling when DBS say they shouldn’t be singled out.
If this is prudent underwriting, then we should be very scared about their exposure to oil and gas, marine customer risk. The about turn a day later, suggest that they do not want this to be blown up into a full scale loss of confidence. Swiber looks like the tip of the iceberg.
If you are an individual investor, you are likely to face this cognitive flaw that just because it is a reputable bank like DBS, whatever that they sold won’t make you lose money, are safe, that it is in your best interest.
This example shows that this is clearly not the case.
To make matters worse, once the problem happens, they immediately pull off all your buffer, and margin call you.
Risk Management is Often Ignored
Especially in the face of greed.
In a low yield environment, our mind is often lulled to think that the worse case scenario, or low probability events, that cause us to lose a substantial, if not all our capital, will not happen to us.
To be fair, not enough information is revealed.
While the sum of money looks big, to the two investors, it might be just a small part of their net worth.
They do not have a Wealth Machine
You would think investing in bonds is prudent investing, but there are certain level of competency required if you invest in bonds.
Certainly assessing the quality of bonds and whether the reward is good enough for the risks that comes with the bonds is a vital competency.
Mr Jin obviously are not well equipped here. The same could be said for Laura, whom I was thinking should be better equipped considering she is a banker.
When you invest without adequate competency, systems and processes to make it a sustained success, you are just buying financial instruments.
You do not have a wealth machine. You failed to built around a financial instrument what is necessary to make bond investing viable to be a sustained success.
Particularly 2 competencies was found lacking, with 1 on equities that may be related:
- Some bonds are highly risky as it is and volatile enough. If you leverage it further, it just going to greatly impact the magnitude of price draw down should the worse case scenario happened
- Lower grade or unrated bonds are not the same as rated bonds, in that the probability of default can be much higher
- While having cash buffer in the event of margin call is a risk management tactic, private banks do have the propensity to remove certain stocks from the list of stocks that you can margin. In this case, you would have to sell and payback or top up almost all your debt
There is always a mismatch in judging how much knowledge is enough to having sustainable success in investing in a certain way. Most of us would think we are ready, when we are actually far from it, or inadequate.
The failure to be cautious in investing in bonds linked to the oil and gas industry clearly shows that.
I was really stunned by the response of DBS to this episode where they basically say I am not in the wrong because everyone is doing it. Honestly, I wasn’t that afraid of the big oil and gas exposure before but how this event unfold somehow gives me the feeling of a lack of risk control.
Most importantly, the person that cares the most about your wealth is yourself. If you cannot surround with people that you trust AND have good competency in this area, then make sure you build up that competency!
Just because you invest in stocks and bonds, doesn’t mean you have a Wealth Machine. If you are not sure what I meant, when I talk about Wealth Machines, read this article here.
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