Trading in Sovereign Promises
By: Dr. Sam Vaknin
Also published by United Press International (UPI)
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Martin Schubert and his New-York (now Miami) based investment boutique, European Inter-American Finance, in joint venture with Merrill Lynch and Aetna, pioneered the private trading of sovereign obligations of emerging market economies, including those in default. In conjunction with private merchant banks, such as Singer Friedlander in the United Kingdom, he conjured up liquidity where there was none and captured the imagination of businesses on both sides of the Atlantic.
Today, his vision is vindicated by the proliferation of ventures similar to his and by the institutionalization of the emerging economies sovereign debt market. Even obligations of countries such as Serbia and Iraq are traded, though sporadically. Recently, according to Dow Jones, Iraqi debt doubled itself and is now changing hands at about 15 to 20 cents to the dollar.
The demand is so overwhelming that Geneva-based brokerage firm Trigone Capital Finance created a special fund to provide interested investors with exposure to Iraqi paper. Nor is the enthusiasm confined to this former member of the axis of evil. Yugoslav debt is firm at 50 cents, despite recent political upheavals, including the assassination of the reformist and pro-Western prime minister.
Emerging market sovereign debts are irresistible. Some of them now yield 1000 basis points above comparable US Treasuries. The mean spread, according to JP Morgan's Emerging Markets Bond Index Plus is c. 600 points. Corporate securities are even further in the stratosphere.
But with frenzied buying all around, returns have been declining precipitously in the last few weeks. Investors in emerging market bonds saw average profits of 10 percent this year - masking a surge of 30 percent in Brazilian and Ecuadorian paper, for instance. JP Morgan Chase's EMBI Global index is up 19 percent since September 2002.
Nor is this a new trend. The EMBI Global Index has witnessed in each of the last four years an average gain of 14 percent. According to Bloomberg, the assets of emerging market debt funds surged by one tenth since the beginning of the year, or $948 million - compared to $648 received during throughout last year.
The party is on. Emerging market debt is either traded on various exchanges or brokered privately to wealthy or institutional clientele. The obligations fall into categories too numerous to mention: insured and uninsured credits, defaulted or performing, corporate against municipal or sovereign and so on.
A dominant class of obligations is called "Brady bonds" after the former U.S. Treasury Secretary Nicholas Brady. These securities are the outcomes of the rescheduling pf commercial bank loans (sometimes defaulted) to developing nations. The principal of the rescheduled debt - guaranteed by U.S. zero coupon Treasuries deposited by the original issuer in the Federal Reserve or some other credible institution - remains to be fully paid. The interest accrued on the principal until the moment of rescheduling is reduced and the term of payment is prolonged.
Brady countries include Venezuela, Brazil, Argentina, Ecuador and Mexico, to name just a few. The bonds have been trading since 1989. Only one Brady bond has ever defaulted (Ecuador). No interest payment was ever missed or skipped.
As Nazibrola Lordkipanidze and Glenn C. W. Ames observe in their paper, "Hedging Emerging Market Debt", the terms of individual Brady packages vary. Individual countries have issued as few as one, and as many as eight different bonds, each of which can vary with respect to maturity, fixed or floating coupons, amortization schedules, and the degree to which principal and interest payments are collateralized.
The market is besieged by - mostly offshore - mutual funds managed by the likes of Pacific Investment Management Company (PIMCO), AllianceBernstein, Scudder Investments, MFS Investment Management and Mainstay Investment Management.
Emerging market debt attracted entrepreneurial fund managers who set up nimble and agile shop. Ashmore Investment Management was divested to its current owners by Australia & New Zealand Banking Group. Despite the obvious shortcomings of its size - limited access to information and research - it runs a successful Russian fund, among others.
When the United Kingdom based firms, Garban Securities and Intercapital Securities, merged late in 1999, they transferred their illiquid emerging market securities businesses into a common vehicle, Exotix. The new outfit's team was poached from the trading side of emerging markets divisions of various investment banks. Exotix brokers the purchase and sale of fixed income products from risky countries.
Maxcor Financial, a broker-dealer subsidiary of Maxcor Financial Group, is an inter-dealer broker of various securities products, including emerging market debt. It also conducts institutional sales and trading operations in high yield and distressed debt. AIG Trading, of the AIG group, maintains a full-fledged emerging markets team. It boasts of "senior level contacts within many central banks, allowing us to provide rare insight".
Other outfits stay out of the limelight and offer discrete services, custom-tailored to the needs of particular clients. The Weston Group, in operation since 1988, is active in the Mexican market. It does underwriting, private placements and structured finance.
Companies such as Omni Whittington have specialized in "debt recovery" - the placement and conversion of defaulted bank and trade debt from political risk countries. They buy bad debt through a dedicated investment fund, collect on non-performing credits (on a "no cure, no pay" basis) and manage portfolios of loans gone sour, including the negotiation of their rescheduling.
Vulture funds are financial firms that purchase sovereign debt at a considerable disaggio and then demand full payment from the issuing country. A single transaction with a solitary series of heavily discounted promissory notes can wipe out the entire benefit afforded by much-touted international debt relief schemes and obstruct debt rescheduling efforts.
One sure sign of this niche's growing importance is the proliferation of conferences, consultancies, seminars, trade publications and books. Banks and law and accounting firms have set up dedicated departments to tackle the juridical and commercial intricacies of defaulted debt, both corporate and sovereign. International law is adapting itself through a growing body of legislation and precedents. Moody's Investors Service, Standard & Poor's and Fitch regularly rate emerging market issues.
RBC Investment Services (Asia), a business unit of the Royal Bank Financial Group, a Canadian investment bank, advises its clients in their investments in Bradys. Union des Banques Arabes et Francaises, 44 percent owned by Credit Lyonnais and the rest by Arab banks, including the Iraqi Rafidain, is an aggressive buyer of Iraqi and other Middle Eastern debt.
But the market is still immature and inefficient. In an address to the Sovereign Debt Restructuring Mechanism Conference earlier this year, Kenneth Rogoff, Research Director of the International Monetary Fund surveyed the scorched landscape:
"Private debt flows to emerging markets (produce) wild booms, spectacular crashes, over indebtedness, excessive reliance on short-term and foreign-currency denominated debt, and protracted stagnation following a debt crisis. Emerging economies' governments ... sometimes borrow more than is good for their citizens (and are) ... sometimes willing to take on excessive risk to save on interest costs. On the investor side, there is often a reluctance to hold instruments that would provide for more flexibility and risk sharing, such as GDP-indexed bonds, domestic equity, and local currency debt—in part, because of poor policy credibility and weak domestic institutions. The result is an excessive reliance on 'dangerous' forms of debt, such as foreign-currency denominated debt and short-term debt, which aggravate the pain of crises when they occur."
Weak property rights, uncertain debt recovery mechanisms, political risks, excessive borrowing, collective action problems among creditors and moral hazard are often associated with credit-insatiable emerging economies, failed states, erstwhile empires, developing countries and polities in transition.
Signs of trouble abound from Turkey to Bolivia and from Paraguay to Africa. Nigerian President Olusegun Obasanjo said last July that paying civil servants was more important than avoiding default on the country's $30 billion debt. Its Supreme Court ruled in April 2002 that it is unconstitutional to pay down the external debt before all other government expenses. Nor would that be the first time Nigeria reneges. The Paris Club of creditor countries has been rescheduling its debts repeatedly.
This is not to mention Argentina. Its corporate sector missed $4.6 billion in payments in the last six months alone and the country defaulted on a whopping $95 billion in obligations. The conduct of debtors, transparency and accountability are not improving either. Russia all but withheld information regarding a French lawsuit in a plan to swap $3.1 billion in new Eurobonds for about $6 billion of defaulted Soviet-era debt.
The status of creditors is under further strains by the repeated floating of schemes to put in place some kind of sovereign bankruptcy mechanism. The Bush administration proposed to modify all sovereign debt contracts pertaining to all forms of debt to allow for majority decision making, the pro-rata sharing of disproportionate payments received by one creditor among all others and structured, compulsory discussions led by creditor committees.
The IMF's First Deputy Managing Director, Anne Krueger, countered, in November 2001, with the idea to allow countries to go bankrupt within a Sovereign Debt Restructuring Mechanism (SDRM). Legal action by creditors will be "stayed" while the country gets its financial affairs in order and obtains supplemental funding. Such an approach makes eminent sense.
In opening remarks to the Council of the Americas in November 2001, Martin Schubert offered these observations:
"Talk of adopting bankruptcy procedure protection for governments ... similar to that employed by private companies, could be the match that lights the fire, due to the conflicts such a standstill would create. Moreover, what government debtor would be willing or able to assign assets to a trustee or assignee in bankruptcy, for the benefit of creditors?"
But investors never learn. In a world devoid of attractive investment options, they keep ploughing their money into the high-yield scenes of financial crimes committed against them. This self-defeating tendency is reinforced by the general stampede from equities to bonds and by the slow-motion implosion of the US dollar, partly as a result. Until the next major default, that is.
The Bankrupt Sovereign
The Demonetization of the East
O'Neill's Free Dinner - America's Current Account Deficit
The Delicate Art of Balancing the Budget
Economic Management in a State of War
Governments and Growth
Iraq's Reconstruction - Payback Time
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