Loan Mystery Confronts Derivatives Buyers

In the wake of financial trouble at Banco Espirito Santo, some investors are realizing they don't know how much risk they took on.

Some investors are waking up from a stimulus-induced malaise and realizing they don’t exactly know what risk they’ve assumed.

There’s a prime example in buyers of credit-linked notes created by Banco Espirito Santo SA last year.

Investors who bought the securities agreed to protect against losses on a 2 billion euro (US$2.68 billion) pool of commercial loans made by the Portuguese bank, according to marketing documents reviewed by Bloomberg News. That was under the assumption that they stood to get annual returns in excess of 10 percent.

Now that Banco Espirito Santo’s finances are unraveling, investors in the Lusitano Synthetic II Ltd. deal are understandably getting nervous about the specific loans they’re guaranteeing. They asked for details last month, which the issuer is declining to give them, according to a July 23 notice on the Cayman Islands Stock Exchange.

The Lisbon-based lender’s sudden fall is a rude awakening for bondholders who’ve generally been rewarded for delving into the riskiest, most-illiquid securities for the past five years. The easy-money policies of central banks across the globe have propped up debt prices, suppressing borrowing costs so much that investors have piled on more and more risk to meet their return targets.

A Banco Espirito Santo official responded to emailed requests for comment by saying the bank may have a statement later.


Offloading Risk

Credit-linked notes work like traditional bonds with interest payments, except the principal gets wiped out when losses on the underlying debt accumulate enough. Such deals, which use credit-default swaps, have been used as way for banks to raise cash while offloading some of the risk tied to the loans they’ve made.

In Banco Espirito Santo’s case, investors who bought the 184 million euros of synthetic securities agreed to absorb losses on thousands of loans, according to the marketing documents. The notes were sold with expected returns of more than 10 percent, according to a person familiar with the matter who asked not to be named because the talks were private.

It’s not surprising the bondholders are now getting jittery. Banco Espirito Santo’s finances have quickly come undone. The lender said May 20 there was a “serious financial situation” at the bank’s holding company.

The lender was compelled to raise capital after uncovering potential losses on loans to other companies tied to the Espirito Santo group. The Bank of Portugal said Aug. 3 it will take control of the bank, leaving junior bondholders with losses.

Holders of the credit-linked notes requested information on July 4 about whether their investments were tied to loans extended to Grupo Espirito Santo or any of its affiliates, according to the notice published on the Cayman Islands Stock Exchange.

They were told that the deal was designed to include a “blind pool” of obligations, and that the bank “is not obliged to disclose, and has not disclosed, the identities of the reference entities relating to the reference obligations,” the notice said.

It can’t be good to hear you don’t have a right to know what you’re invested in at a time when it suddenly matters.

The longer low yields continue, the more investors will delve into risk they may not fully understand in search of extra returns. Brace for more unpleasant revelations when central banks pull the plug on their stimulus.

About the Author

Lisa Abramowicz

Lisa Abramowicz

Lisa Abramowicz is a Bloomberg Gadfly columnist covering the debt markets.

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