HKG FEARS FINANCIAL CENTER AMBITIONS AT RISK FROM

C O N F I D E N T I A L SECTION 01 OF 03 HONG KONG 002027

SIPDIS

STATE FOR EAP/CM AND EEB/OMA; TREASURY FOR MCCORMICK,
DOHNER, AND WINSHIP

E.O. 12958: DECL: 11/03/2033
TAGS: ECON EFIN PREL HK
SUBJECT: HKG FEARS FINANCIAL CENTER AMBITIONS AT RISK FROM
MINIBONDS

REF: A. HONG KONG 1925

B. HONG KONG 1801

C. HONG KONG 1790

D. HONG KONG 1762

E. HONG KONG 1757

F. HONG KONG 1719

Classified By: Consul General Joseph Donovan, Reason 1.4 b/d


1. (C) Summary: The Hong Kong Legislative Council (Legco)
is expected to decide November 12 whether to launch an
investigation of bank misconduct in the sale of Lehman
Bros.-issued minibonds. Local press has been filled for
weeks with tragic stories of elderly investors who lost their
life-savings after buying what they thought were safe assets.
While regulators investigate allegations of misconduct,
political parties have been quick to burnish their populist
credentials, helping victims obtain media coverage and
standing close by their side. The Hong Kong government
believes its ambitions to become a global financial center
are jeopardized by the possibility that Legco will use its
Basic Law-defined "powers and privileges" to subpoena bank
executives and confidential bank records. The government is
pressuring banks involved in the marketing of these products
to buy them back at some percentage of their face value now
and agree to return any additional value to investors when
the underlying collateral is sold. End Summary.


2. (C) Comment: The Hong Kong government's buyback proposal,
that banks that marketed Lehman Bros. derivatives buy them
back from investors at a relatively high percentage of their
face value, suggests an administration vulnerable to populist
appeals and calls into question the depth of the Tsang
government's commitment to Hong Kong's free-market economic
framework. There is no upside for the banks, other than the
appealing prospect of avoiding an embarrassing political show
trial in the Legco. Senior government officials agree that
regulators are doing a credible job of processing complaints
and recognize that their proposal flies in the face of
orthodox Hong Kong economic policy, but counter that no one
around the world is clinging to economic orthodoxy in the
current financial environment. The obvious difference is
that the Hong Kong government's buyback proposal isn't
designed to address a systemic crisis, but a political one.
Public attention is focused on bank improprieties, a
politically more acceptable target, rather than on regulatory
failings. The government believes its buyback plan will
boost its popularity and prevent the Legco from savaging the
banks. Officials here appear oblivious to the negative
impact of populist arm-twisting tactics on Hong Kong's
financial center ambitions. End Summary.

=================
The Minibond Saga
=================


3. (U) Over 43,000 Hong Kong retail investors purchased
complex investment products issued by Lehman Bros. and sold
through branches of local banks in Hong Kong, Macau and other
economies in the region. Over 33,000 Hong Kong investors
purchased US$1.6 billion worth of "minibonds" -- in fact not
really bonds at all, but rather complex synthetic
collateralized debt obligations (CDOs) linked to a portfolio
of unspecified international credits. (Even sophisticated
investors are unclear what the true nature of the underlying
collateral really is.) The minibond prospectus clearly
warned of the risky nature of the product, but its complexity
calls into question whether regulators should have allowed
these products to be sold to retail investors at all, said
one former corporate financier. When Lehman Bros. went bust,
these products failed to pay out scheduled dividends, leaving
investors without their expected income stream and no clear
understanding or access to the underlying assets of the
instruments. While the underlying assets do have some value,
the fall in equity prices and the illiquid nature of some of
these assets make them difficult to value and even harder to
sell.


4. (SBU) Hong Kong investors, encouraged by political
parties eager to burnish their populist images, have taken to
the streets and the media to demand that banks return their
money. Oer 14,000 investors have filed complaints with the

HONG KONG 00002027 002 OF 003


Hong Kong Monetary Authority (HKMA),accusing the distributor
banks of &mis-selling8 and failing to warn investors of the
risks of these complex investments. The HKMA has re-assigned
100 people, about one-third of its banking supervision staff,
and has hired contractors to investigate the validity of
these complaints, but will not report their findings to the
Financial Secretary until the end of the year. Misconduct is
typically punished by substantial fines. HKMA's Executive
Director for banking supervision said the government is
seriously considering banning the sale of these types of
complex products, but the move is opposed by banks, who see
these products as revenue spinners. The Hong Kong Consumer
Council (HKCC) has also jumped into the fray, announcing on
October 30 that it has identified 50 complainants it may
support in joint legal proceedings against the banks, if
mediation efforts fail. Staff at the HKCC told econoffs they
had identified the most egregious and media sympathetic cases
available.

============================================= =====
Populist HKG Pressures Banks to Buy Back Minibonds
============================================= =====


5. (C) Undersecretary for Financial Services and the
Treasury Julia Leung contacted the Consulate October 29 to
discuss the Hong Kong government's controversial response to
protesters eager to reclaim money lost after investing in
Lehman Bros.-issued financial products. The Hong Kong
government has publicly and privately pressured local banks
to settle with minibond purchasers and has strongly pressed
the banks to support a government proposed buyback scheme
that would see distributor banks repurchase minibonds at some
percentage of their face value. Leung explained that the
government is trying to find a market solution that can
pre-empt further political problems. She noted that the
minibonds' underlying collateral still has some value,
although she declined to repeat her earlier public estimate
that 80 percent of the instruments will retain 60-70 percent
of their value. She noted that many of these underlying
assets had been rated AAA and retain much of their original
value.

============================================= ===
HSBC an Obstacle to Returning Money to Investors
============================================= ===


6. (C) Leung accused HSBC, the trustee for the underlying
assets, of setting up roadblocks to the government's efforts
to return funds to investors. The government has approached
HSBC about the possibility of designating the Lehman Bros.
bankruptcy as a "credit event." Doing so would force HSBC to
unwind the US$1.6 billion fund and return money to investors,
but would be difficult in the current financial climate and
would almost certainly result in low returns. Many of the
products are worth only a fraction of their purchase price,
others are reportedly untradeable at this time.


7. (C) HSBC has declined to unwind the fund unless 20 percent
of all minibond-holders vote to sell the collateral. (NOTE:
With prices at current lows, investors have little incentive
to press HSBC to sell now, particularly when their efforts to
pressure the government to win back a larger percentage of
their investment seem to be paying off. END NOTE) Leung
said HSBC is not obligated to unwind the fund until all 32
minibond series have defaulted on interest payments, the last
of which falls due in March 2009. It will then take 3-6
months to unwind the fund and return money to investors.

=================
HKG to the Rescue
=================


8. (C) To avoid making investors wait for their money, the
government proposed the buyback scheme, said Leung. After
considerable public and private arm-twisting by the
government, the Hong Kong Association of Banks (HKAB) agreed
to appoint auditor Ernst & Young to develop a formula to
value the underlying assets in preparation for a buyback.
The HKAB and the government agreed on the proposed formula on
November 4, but the details have not yet been reported.
Leung expected that the banks would offer investors a
"haircut", say 40 cents on the dollar, even if the assessed

HONG KONG 00002027 003 OF 003


value is higher. If the assets appreciate beyond the buyback
price, banks will be required to make up the difference to
investors. If they depreciate, the banks will bear the loss.



9. (C) The government is trying its best to resolve the
problem, said Leung. Many unsophisticated investors put
their life-savings into these complex products without
realizing the risk, she said. It is only right that the
banks selling these complex products share the risk with the
people. When asked whether the buyback program was
compatible with Hong Kong's reputation as a liberal,
free-market economy, Leung noted that many free-market
economies are now taking measures that in years past would
have been unthinkable.

============================================= ==========
Legco "Power and Privilege" Threatens Finance Ambitions
============================================= ==========


10. (C) The buyback scheme will benefit investors by giving
them quicker access to their cash, but is also urgently
needed to forestall plans by the Legislative Council (Legco)
to exercise its "Powers and Privileges" under the Basic Law
to subpoena bank executives and confidential bank records,
said Leung. To date, these powers have only been used to
subpoena government officials and documents, but apparantly
nothing in the law limits use against the private sector.
Legco's power to compel witnesses to testify and subpoena
confidential banking records for discussion in open session
would severely damage Hong Kong's reputation as a financial
center, she feared. On November 12, Legco will vote on
whether to establish a Select Committee to investigate
allegations of banks mis-selling financial products. With
significant public interest in the issue, this could become a
media circus, warned Leung. If the Legco can subpoena
confidential bank records and subject bank executives to
grilling in front of the media, financial service companies
will be reluctant to set up shop in Hong Kong, she claimed.


11. (C) Hong Kong Solicitor General Ian Wingfield confirmed
to us that the Legco has the power to subpoena both public
and private sector officials and documents. A Legco select
committee could exercise this power, but it must be
explicitly granted by the Legco President. Testimony in
Legco is immunized, but could be publicly broadcast.
Business proprietary information could be exempted from Legco
subpoena, but there are precedents for sharing that type of
information. Wingfield noted that Legco often threatens to
convene a select committee to encourage cooperation, but in
practice such committees are rarely convened.
DONOVAN