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Bank of America’s tail-risk warning may indeed be precisely the impetus needed for another Abu Dhabi (the emirate of last resort?) -financed bailout, though there is some question as to whether the technical defaults of two state-owned firms–Dubai World, an investment firm, and Nakheel, a real-estate subsidiary of Dubai World–necessarily imply the defacto default of the sovereign emirate as a whole in the first place. In fact, argues Gavan Nolan, a research analyst at Markit Group, a financial information services company:

“It should be made clear that the Dubai sovereign is not in any immediate danger of a default. The standstill, if it is mandatory, may constitute a technical default on Nakheel and Dubai World. However, the Dubai government did not make an explicit guarantee on the companies’ debt, and are under no legal obligation to honour the debt. This is clearly the position Dubai’s wealthy sister emirate Abu Dhabi favors. Its actions this week seem to indicate that, while it will support the sovereign, its backing is conditional. The funds are available – Abu Dhabi has immense oil resources and the world’s largest sovereign wealth fund. Indeed, Dubai has already been advanced funds by Abu Dhabi. But it was quite clear that Nakheel and the rest of Dubai World will not be allowed to benefit from the largesse.”

The exact point was trumpeted by Saud Masud, a Dubai-based real estate analyst, in a comment made to Bloomberg:

“Abu Dhabi and Dubai have decided to seek to bolster long-term confidence in the market by forcing weaker parts of government businesses to take responsibility for bad decisions and could involve defaults at some Dubai firms, Masud said.”

Less debatable, however, is the absurdity of the hitherto resulting regional contagion, which immediately drove up the cost of protecting emerging-market sovereign debt against default. Default swap contracts on Abu Dhabi rose 23 basis points to 183, Qatar climbed 17 to 131, Malaysia was up 11 at 104, Saudi Arabia climbed 18 to 108, while Bahrain rose 22.5 to 217. Having said that, one could buy the theory that the Dubai announcement is merely the requisite impetus whereby the ‘risk rally’–which having essentially been on since March seemed destined to eventually taper–unwinds. If the rally does unwind, moreover, frontier and emerging markets, which represent the tail end of the risk curve, would be the first to feel it. Templeton Asset Management Ltd.’s Mark Mobius, for example, said on Friday that Dubai’s attempt to reschedule debt could indeed cause a “correction” in emerging markets.

Yet even a market correction per se should not correlate with a higher sovereign default risk–this is where the current, broad brushstroke of contagion should be arbitraged. Abu Dhabi and Qatar, for instance, remain as resource and reserve rich as ever, objectively speaking. But fund managers clamoring to keep in tact whatever YTD returns they have may be hesitant to brashly step in front of the bus so quickly–suggesting the sudden and drastic point spike may even have some more legs to it. Nevertheless, ultimately, as Silk Invest’s Baldwin Berges reminded investors on Friday, “the major driving forces for the GCC region’s economy are still intact: high reserves, low taxes (competitive advantage) and geographic location. It’s all about perspective, investor sentiment and above all valuation. The medium term investor could be looking at a great opportunity here.” Nolan concurs:

“The sovereign CDS market sometimes has a habit of conflating geographical proximity with economic similarity (eastern Europe earlier this year springs to mind). Unlike Dubai, the countries mentioned above have significant natural resources and their public finances are in better shape. To an extent this has been reflected in CDS spreads for some time (see chart above). It seems that Dubai is something of a special case and its problems are not necessarily found elsewhere.”

The following appeared in the August edition of Business Diary Botswana. Right now I find myself fascinated by the role that securitization and a mature credit derivatives market will ultimately play in frontier economies; as J.P. Morgan once penned, “credit derivatives allow even the most illiquid credit exposures to be transferred to the most efficient holders of that risk.” Despite its perils (notably the lack of respect issuers had for the potential correlation on mortgage defaults), it is my belief that the underlying concept supporting derivatives is a sound one if handled correctly. As wealth continues to flow to developing markets in the coming decades, so too will the management of risk continue to mature.

Back in late March, not long after the S&P registered its ominous 666 low, an understandably seething writer in The New York Times charged that above all, the “key promise” of securitization–a process involving the pooling and repackaging of cash-flow producing assets into tranche-laden (arranged by risk rating), tradeable vehicles that was effectively born in the late 1970s at then Salomon Brothers in relation to mortgage-backed securities–“turned out to be a lie. Banks used securitization to increase their risk, not reduce it, and in the process they made the economy more, not less, vulnerable to financial disruption.” The column raised eyebrows, not only because of its vociferous and encompassing indictment, but because of the man behind it: Paul Krugman, winner of the 2008 Nobel Memorial Prize in Economics. Moreover, the charge ran counter-intuitive to previously uncontroversial financial theory; on its face, the concept of securitization should be a boon to issuers and investors alike. As J. David Cummins, Professor Emeritus of Insurance and Risk Management at Wharton wrote in 2004, “securitization provides a mechanism whereby contingent and predictable cash flow streams arising out of a transaction can be unbundled and traded as separate financial instruments that appeal to different classes of investors. In addition to facilitating risk management, securitization transactions also add to the liquidity of financial markets, replacing previously un-traded on-balance-sheet assets and liabilities with tradeable financial instruments.” In other words, improved market efficiency in the form of an increased rate of capital utilization (asset and liabilities moved off-balance sheet to a special purpose vehicle (SPV) are free of capital requirements and in turn reduce the expected costs of regulatory intervention arising from any deterioration in them), simultaneously lowers transaction costs and spreads risk as once static, embedded cash-flows mired on balance sheets become pliable. In the context of residential mortgages, this meant cheaper sources of funding for a wider pool of applicants. Credit card and corporate loans soon followed.

Yet along the way something went terribly wrong, and it’s this hiccup that so infuriates detractors of the practice like Krugman, who conclude that far from “bringing securitization back to life” through increased scrutiny and regulation, the Obama Administration shouldn’t even try. ‘What went wrong’ is that securitization was effectively hijacked, its role of transferring assets and ultimately shrinking a bank’s balance sheet pirated and replaced en masse by a new form of structured finance that involved a hitherto underutilized credit “derivative” called a credit-default swap (CDS), in which contract buyers are essentially insured by sellers of a given entity’s continued solvency. When J.P. Morgan began to slice, dice, arrange and then sell its burgeoning corporate exposure in order to reduce its corporate-based risk in light of the 1997 Asian crisis, it became the first bank to free up capital not by reducing its balance sheet by selling loans (which would damage client relationships), but rather by expanding it under the guise of having perfectly hedged against the risk of default. The most liquid portion of the market revolved around synthetic collateralized-debt obligations (CDO), in which investors insured against an entire group of loans in exchange for regular premium payments, and banks often kept the (allegedly) riskless, “supersenior” tranches on their own balance sheets with little or no capital in reserve. Over the course of a decade, such “loans” began to be manufactured across Wall Street (“originate and distribute”), and CDOs became increasingly supported by increasingly dodgy borrowers in a vicious cycle as banks succumbed to pressure (by directors, manages and shareholders alike) to continually accelerate returns. The rest is history. But lost in the clamor and media frenzy over the industry’s reckless abandon has been much in the way of level-headed, objective analysis. In particular, little has been concluded as to the broader economic impact of securitization. If you listen to the likes of Krugman (and in a “science” as convoluted and cryptic as economics, you’d almost be foolish not to), the jury is in, and securitization should be ‘out’. Yet as one commentator prudently surmised, “the problem with a lot of what looked like securitization over the past decade was that many banks thought that they’d sold off all their risk, when in fact they hadn’t.” Moreover, there is a growing amount of research that quantitatively supports the model–in its fundamental form at least. A study published in late June by NERA Economic Consulting, for example, assessed the long term impact of securitization, with a focus on the residential mortgage-backed securities market. The study found that: (i) securitization lowers the cost of consumer credit, reducing yield spreads across a range of products including mortgages, credit card receivables, and automobile loans; (ii) increases in secondary market purchases and securitization of mortgage loans have positive and significant impacts on the amount of mortgage credit available per capita, particularly among traditionally underserved populations; and (iii) conversely, declines in secondary market purchase and securitization activities negatively impact the amount of available mortgage credit. Moreover, the study reported, a reduction in securitization activity has a negative impact on all types of lending activity, including but not limited to residential mortgages; as such, it stated, bank lending activity is likely to be significantly and negatively impacted if securitization remains at its current, depressed level. The findings add further support to a seemingly pre-crisis consensus that the practice of trading cash flow streams allows parties to manage and diversify risk, arbitrage, and otherwise invest in previously unattainable classes of risk–all of which in turn enhances market efficiency.

Such rationale cannot be stressed enough if securitization is to continue its spread into developing economies and increasingly illiquid markets. As for African markets, the practice is still in its infancy. “Securitization is a bit more sophisticated than the reality in Africa,” said one asset manager. “The Commercial Paper (a money market instrument) market is where most of this activity is centered.” According to South African investment banker Stephanus de Swardt, aside from both the proper regulatory environment (which “allows for the special capital treatment of securitization bonds”), as well as the right legislative one (in order to “structure the transfer of assets”), securitization also depends on relatively developed capital markets that already feature both a government bond market and at least some form of corporate bond market, as well as “at least partially liberalized exchange controls” already in place. Some countries are naturally ahead of the curve. Botswana, for one, initiated the issuance of government debt in 2003 precisely with its market’s maturation in mind. Said the central bank at the time: “the [government] bond issue is a momentous event as the objective of the issue is not driven primarily by a need to raise revenue or funding but to develop the domestic capital market. The bonds are expected to help Botswana establish a relatively risk free yield curve that will serve as a benchmark for other private sector and parastatal bonds.”

In further happenings, last fall the Botswana Stock Exchange (BSE) hosted a conference on how to change illiquid assets into instruments that can be issued and traded in order to provide corporations a “new and potentially cheap form of funding.” Said a research note, “for banks and finance companies that have successful loan programs but are faced with capital constraint, securitization is a means of removing assets from the balance sheet and freeing up capital to support further lending.” Furthermore, new products may ultimately emerge in such markets even as more traditional ones begin to take root. For instance, as per capita income grows in developing countries, it can be expected than products such as life insurance and annuities will become more in demand. As Cummins pointed out in his 2004 treatise on the subject, the securitization of life insurance and annuity cash flows and risks “can increase the efficiency of insurance markets by utilizing capital more effectively, thus reducing the cost of capital and hence the cost of insurance, for any given level of risk-bearing capacity and insolvency risk. Securitization can accomplish this goal by spreading risk more broadly through the economy rather than by warehousing risk in insurance and reinsurance companies, which have lower capacity and diversification potential than the capital market as a whole.” Finally, securitization may even play a vital role in reducing poverty and improving lives in the SADC region. In a 2008 paper, World Bank Senior Economist Dilip Ratha and fellow economists Sanket Mohapatra and Sonia Plaza estimated that Sub-Saharan Africa could raise up to $30bn a year and further access international capital markets by “exploring previously overlooked sources of financing such as remittances and diaspora bonds, and strengthening public-private partnerships.” Said Ratha: “Preliminary estimates suggest that Sub-Saharan African countries can potentially raise $1 to $3 billion by reducing the cost of international migrant remittances, $5 to $10 billion by issuing diaspora bonds, and $17 billion by securitizing future remittances and other future receivables,” such as remittances, tourism receipts, and export receivables. In this latter form,future foreign-currency receivables are pledged as collateral to a SPV which issues debt to an offshore collection account that the borrowing country can then access. These securities have a higher investment grade rating than “the generally unfavorable sovereign credit ratings” given to Sub-Saharan countries, the Bank reports, which effectively opens them up to new, larger classes of investors.

According to the Financial Times, pressure is intensifying on Argentina to settle with holders of defaulted debt, who are now owed $29bn including interest.  In 2001 the country defaulted on $95bn worth of debt.  Ever since, the country has been effectively barred from capital markets, despite a 2005 debt swap accepted by the majority of bondholders, since those holding out would be able to seize any funds raised.  A plan to settle with the hold-outs fell through last September after the Lehman collapse, and consequently Argentina’s continuing financial isolation is making it hard for it to meet its debt obligations.  Some economists fear it could be heading for a new default next year.

 

That said, some kind of settlement could be drawing near.  Five-year credit-default swaps based on Argentina’s bonds have taken a beating of late, and have soared nearly 10 percentage points in the past month, the worst performer among credit-default swaps tied to government debt.  Traders eyeing a convergence could be rewarded.

JGW

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