A good RMBS result

The first securitisation of residential mortgages by a public Japanese agency is judged a success in Tokyo’s financial markets. But it was helped by a timely and fortuitous policy change on March 19 by the Bank of Japan (BoJ), which effectively meant a return to zero interest on the key overnight money market rate. When the deal for ¥50 billion ($403 million) of bonds, backed by Government Home Loan Corporation (GHLC) residential mortgages, closed on March 22, it was fully sold, according to Credit Suisse First Boston (CSFB), one of the joint lead underwriters.

Investors lined up for the GHLC residential mortgage deal

The deal was regarded as a critical test of both the investor appetite for residential mortgage-backed paper and the ability of Japanese state agencies (known as zaitokikansai) to obtain funding from the capital markets rather than through the government budget. As a result of a recent government policy change, some 20 state agencies will now have to fund themselves through the markets.
It is also hoped that a successful GHLC issue will give a big boost to the development of a mortgage-backed securities market, along the lines of the one created in the US around the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). The GHLC issue, which is expected to be the first of four ¥50 billion offerings this year, has closely followed the US model, according to Simon Maru, Tokyo head of debt capital markets at CSFB, which underwrote the transaction together with Goldman Sachs Securities and Sanwa Securities. There have been a handful of residential mortgage securitisations from private lenders since the market was introduced in 1999, but it has developed more slowly than the commercial mortgage-backed sector. Most important now, says Maru, is for the investment banks to create an active secondary market in residential mortgage-backed securities (RMBS).
The GHLC’s 35-year amortising bonds carry a 1.75% fixed coupon and were issued at par. Initial investor response had been muted. But the BoJ’s package of measures, which involve injecting increased liquidity into the Japanese economy (and a presumed consequent drop in interest rates to zero), brought a late surge in demand for the pioneering bond issue. Soon after the deal closed, the bonds were trading at 100.34% to 100.41%. Underwriters say the triple-A rated bonds were bought by major life insurance companies, city banks and regional and savings banks. “Because this was an important trial issue, we roadshowed from Hokkaido to Kyushu [the most southern and northern of Japan’s five main islands],” says Maru.
The deal was 9.3% over-collateralised on a pool of ¥55.126 billion in mortgages. To take into account prepayment risk on the underlying mortgages, the GHLC deal assumes a 3% prepayment rate and an average life of 12.6 years for the underlying pool of mortgages. But to build in some leeway, the corporation has a call option to retire its bonds after 30 years.
Of the 20 state agencies that must now fund in the markets, only GHLC and the Japan Finance Corporation for Municipal Enterprises (JFM) are able to use the securitisation route. JFM, which also has a loan portfolio, is thought to be planning a ¥100 billion loan-backed bond issue in October or November, underwritten by Mizuho Bank.

Unleashing Asia’s demons

Asia’s banks are only now slowly emerging from the economic crisis that ravaged the region between 1997–98. Many smaller institutions, still weighed down by crippling debt levels and high funding costs, are struggling to implement vast restructuring programmes. But the publication of the Committee’s latest consultative paper on capital adequacy could stretch many of Asia’s banks even further. While the new Accord pledges to create a level playing field across the world’s banking systems, some of Asia’s troubled institutions face tough times ahead, with soaring funding costs and heavy investments in risk management systems. Indeed, some bankers in the region even question its relevance to Asia’s banking systems.

One prominent Singapore-based banker, who requested anonymity, says he feels that the Accord may be too much of a leap for many of Asia’s banks. He says: “Not many Asian banks – I think one in Singapore, and maybe two or three in Hong Kong – are aggressively addressing capital adequacy, capital structure and balance sheets. Most of the banks, to put it very bluntly, are so far behind the curve, I’m not sure this Accord really means a lot.”

The Asian Crisis clearly demonstrated that the 1988 Accord was in dire need of a comprehensive overhaul. While the vast majority of the region’s financial institutions claimed to have implemented the proposals, in many cases they were paying mere lip service to the recommended 8% capital adequacy ratio. In reality, a large number of banks were crippled by ballooning non-performing loans (NPLs) and had dwindling capital reserves to deal with the problem, transforming what could have been at best a currency misalignment to an out-and-out economic crisis.

The result, a new consultative proposal on the Basel Accord, was presented on January 16. It attempts to address some of the shortcomings of the original agreement. The primary objective, says William McDonough, president of the Federal Bank of New York and chairman of the Basel Committee, is to make the new Accord more “risk-sensitive” and to strengthen banking systems hardest hit by the crisis by revamping the methodology for calculating capital levels.

Consequently, the new proposal ditches the one-size-fits-all approach and adopts a methodology for gauging capital adequacy ratios based on credit risk, while also incorporating charges for operational risk. Also included are proposals for a stringent supervisory review process and recommendations for increased levels of market discipline. The new document extends many of the characteristics of the first consultative paper published in June 1999, but leaves a consultation period of only four-and-a-half months, with a planned implementation in January 2004.

Central to the new framework is the idea that sophisticated international banks meeting stringent regulatory standards can internally assess the risk levels of their portfolios, effectively allowing the larger banks to calculate their own capital charges. The Committee estimates that high investment grade banks using this model, called the Internal Ratings-Based (IRB) approach, could reduce risk capital levels by around 2–3%, effectively acting as an incentive for investment in risk 
management systems.

This IRB approach is divided into two components. The first is a foundation approach, which allows banks to estimate the probability of default for each borrower, with other risk factors supplied by the regulator. The second, the advanced approach, enables banks meeting tough regulatory criteria to utilise their credit risk models to calculate additional risk factors.

Investors’ Brazilian love affair?

The energy industry is at the forefront of Brazil’s privatisation programme. The monopoly status enjoyed by state oil and gas company Petrobras and its electricity counterpart Eletrobras has now been removed, and these markets are opening to competition.

This, added to the new currency stability after devaluation of the Brazilian real in January 1999, has attracted much-needed foreign investment (see box, page 21). But risks inherent to nascent energy markets and emerging countries threaten to keep investors at bay.

Certainly Vittorio Perona, director of utilities, Latin America, at Rio-based investment bank Dresdner Kleinwort Wasserstein, feels the climate is right for investment in Brazilian energy. “A lot of people see Brazil as a very promising market,” he says. “Despite the devaluation of the real, inflation has not shot up and the investment climate in Brazil is looking as good as it has been for 15 years.”


Currency risk

But Brazil’s attempts to lure investors have been hindered by the currency risks faced by entrants to the energy markets. Amerada Hess, the New York-based independent energy company, is just one example of a firm that nearly reconsidered participating in the country’s energy market after discovering the tight controls due to be enforced by the government.

Under its original rules, the government would not allow foreign companies to hold non-real denominated accounts, thereby forcing the companies to convert money every time they wanted to trade internationally. After negotiations with the government, a compromise was reached.

Tim Kieft, Amerada Hess’ director for Brazil, explains: “We now have a halfway-house solution where we are allowed nominated dollar accounts for certain activities and our currency risk is reduced, but it is still there.”

Another major currency stumbling block in the Brazilian natural gas market comes at the Bolivian border, where gas is bought from Bolivia in US dollars by companies dealing in Brazilian reais. But Dresdner Kleinwort Wassterstein’s Perona says this currency clash might soon be resolved. “The government is meeting with the industry and regulators to address the currency mismatch. There are many proposals and one or two ideas are looking pretty promising,” he adds.

As well as currency risk, companies also have to contend with each of the local taxes imposed by the country’s 26 states. This tax can be traded off against business units in other states, but there is industry pressure on the government to act to reduce this added cost. Amerada Hess’ Kieft says: “Everyone is waiting to see if the government can revamp the tax structure to bring in a federal value-added tax, in place of the current individual state taxes, which we would definitely see as a benefit.”

Brazil’s attempts to lure investors have been hindered by the currency risks faced by entrants to the energy markets

What troubles many is the fact that there is little opportunity to hedge the currency risk and so other solutions have to be found. Some US firms have built secretive “black box” solutions that protect them to an extent, but others have adopted a more fundamental approach. 

Bruce Williamson, president and chief executive officer of Houston-based Duke Energy International, tries to stem risk at the source. “We are looking very carefully at structuring our portfolios to mitigate all the expected risk,” he says.

But Williamson recognises that the biggest risk of all in Latin America is not to invest in Brazil at all. “The size and overall fundamentals of Brazil’s economy made it a place we knew we should be looking at,” he says.

Duke Energy International, an arm of Duke Energy, has interests in Australia, Asia and Europe, and in other Latin American countries as well as Brazil. The company has a 95% stake in Paranapanema, a 2,300 megawatt (MW) hydropower plant in São Paulo state in Brazil, where it also has a 520 MW gas-fired thermal plant. Duke is also planning two peaking gas plants in conjunction with Petrobras, one either side of the Bolivia-Brazil border.

Power shortage

What has drawn many energy companies to Brazil is the forecast power shortage the country is facing as its economy grows. A long-running lack of investment in generation and an increase in demand has led to a large predicted shortfall in electricity supply. 

The Brazilian government estimates that the current power generation capacity of nearly 70,000 MW will not be able to prevent an undersupply of around 15% for 2001. The prediction is that 4,330 MW of new generating capacity is required every year for the next 10 years if supply is to keep up with expected demand.

Thankfully for Brazil, ambitious building and buying schemes are commonplace there. As well as Duke, other Houston-based energy companies are jumping on the generation bandwagon. 

El Paso Corp has bought the 158 MW Rio Negro plant and is building a 409 MW facility in western Brazil. These plants contribute to El Paso’s status as the largest independent power producer in the country. 

To the north-east, in January 2000, Alliant Energy took stakes in four privatised utilities at a cost of $347 million. Jim Hoffman, president of Madison, Wisconsin-based Alliant Energy Resources at the time of the acquisitions, predicted a return of at least 15% on the investment. Since those acquisitions, Alliant has continued to buy assets, thereby strengthening its position and servicing at total of 1.6 million customers. 
John Peterson, president of Alliant Energy International, says: “We are successfully executing our strategy to take advantage of the business opportunities that exist there. Energy consumption there is growing faster than electricity use in US homes and business.” 

Other major US and European energy companies have been quick to seize upon the opportunities afforded by Brazilian privatisation. Established companies such as the US’s Enron Corp and AES have invested significant amounts in South America, particularly in Brazil. And these firms have been rubbing shoulders with European companies including Belgium’s Tractebel, Spain’s Endesa, Electricidade de Portugal (EdP), and Paris-based monopoly Electricité de France (EdF).

The next generation

The Brazilian government is keen to reduce the country’s reliance on hydropower – currently more than 90% of Brazil’s generation capacity is hydroelectric. 

Key to this hydro capacity is the mighty Itaipu facility on the Paraná river at the Paraguay-Brazil border to the south-west. It is the world’s largest hydroelectric generator, producing 12,600 MW. The plant feeds the south of Brazil, where electricity-hungry cities such as Rio de Janeiro and São Paulo are growing. 

But this region still needs a great deal more electricity from somewhere. And while there is significant hydro potential far to the north, the cost of transmission makes it impossible for electricity to reach the southern regions.

Consequently, the government is looking to natural gas. It aims to raise the consumption of natural gas to 10% by 2010 from 3% in 1998, primarily for electricity generation. In 1999, the Ministry of Energy and Mines introduced the Emergency Thermoelectric Programme, an initiative aimed at creating new gas-fired power plants, totalling 1,500 MW of capacity, by the end of 2003. Analysts expect the total investment required for this undertaking will be in the region of $6.6 billion. 

Duke’s Williamson feels the building programme in Brazil is facilitated by lessons learned from other markets. “Facilities can be built in Brazil far more quickly than in other places, such as California, as there are clear incentives [offered by the government for such investment].” But he is wary of the same mistakes made in California being made in Brazil: “It is important that Brazil doesn’t start capping prices and scaring investors away,” he adds.

Nonetheless, one head of corporate finance at a major European utility investing in Brazil, is certainly excited about the increasing number of opportunities in the natural gas sector. “Brazil has much larger gas reserves than was initially thought,” he says. “Our plan is to be a major player in gas and power, as the two are going to be so closely linked in Brazil.” 

He is also upbeat about the competition coming in from experienced European and US players. “Companies like [Spain’s] Iberdrola and EdF are establishing a real presence in Brazil, particularly in electricity, and other companies like TotalFina Elf are going about it by buying generation assets in Argentina,” he says.

A surfeit of oil

The oil industry is another business Brazil’s President Cardoso was keen to open to competition and investment. Hence, in 1997, the National Petroleum Agency (ANP) was set up to oversee its running. 

Brazil’s oil reserves are estimated to be the largest in Latin America after Venezuela, and total more than 7 billion barrels (bbl). Over the past two years, Brazil has been successful in attracting foreign companies to its richest oil and gas fields in the Santos and Campos basins, off the south-east coast. Auctions for exploration and production blocks in these areas were conducted in June 1999 and 2000, with another due to take place this summer. 

Petrobras owns a large proportion of these blocks and has the advantage of having been in the region longer than others. The company’s expertise is envied in the region as it sets records for depths of exploration and drilling.

Brazil still needs more electricity. And while there is hydro potential in the north, transmission costs make it impossible for electricity to reach the southern regions

Amerada Hess is a major investor in the oil and gas exploration area, operating four blocks. Amerada’s Kieft says things are looking promising for his firm after vital early negotiations.  “One initial problem was that Brazil used to be very protectionist and there were barriers in place that made it difficult for international companies to import required equipment without paying tax on it. Usually companies pay tax on revenue, not on the investment,” he says. After negotiations through a lobby group, during which it was made clear to the government that such taxes would scare investors away, Brazil allowed tax-free imports of equipment. Kieft considers this an important victory on the path to investing in Brazil.  Moreover, Kieft is very interested in the nascent exploration business, despite no real ground being made. “It’s early days,” he says. “Nobody has really found anything yet. Announcements have been made by a few companies, but nobody has made a major gas discovery so far. But I am confident that we will soon be able to deliver gas soon at a price that can compete with the gas imported from Bolivia.” Until gas is successfully drawn from Brazil’s offshore resources, the vast Bolivia-Brazil pipeline is the source of most of the country’s gas. The pipeline stretches from Bolivia, west of Brazil, to São Paulo and Rio de Janeiro, in the south-east. There is also another a large pipeline that comes in from Argentina. All this means Brazil is Latin America’s largest importer of energy.

What about the environment?

Brazil’s Amazon rainforest accounts for nearly a third of the world’s remaining tropical forest. In terms of energy expansion plans, this puts the country in a precarious position, which environmental groups are keen to monitor.  While these vast forests act as efficient carbon sinks – absorbing large amounts of carbon dioxide and converting it into oxygen – Brazil is the largest emitter of carbon dioxide in Latin America. According to the Washington, DC-based Energy Information Administration, Brazil pumped 84.5 million tonnes of carbon into the atmosphere in 1998, some 1.4% of the world’s output. Environmentalists find this figure horribly high.  But Brazil strongly argued at the 1997 United Nations-sponsored Kyoto Summit on Climate Change that it, like other developing nations such as China and India, should be exempt from cutting emissions, as the need for power generation is still growing.  Thus, even after the Kyoto agreement, emissions are still rising. However, it is hoped that the cuts made by developed countries will offset the emissions of developing nations. Another major environmental risk stems from the actual construction of energy facilities such as generation assets and pipelines. The huge Bolivia-Brazil pipeline runs for more than 2,500 kilometres in Brazil, has the capacity to carry 30 million cubic metres daily and has an off-shoot pipe to Enron’s gas-fired plant at Cuiabá in western Brazil.  One of the investors in the project, US government investment agency, the Overseas Private Investment Corporation, described the pipeline as a “world-class project”. But Atossa Soltani of environmental pressure group Amazon Watch has called it “a world-class disaster”. The pressure group claims Enron has not kept its promises to preserve parts of the Chiquitano forest, through which the pipe runs. Enron has refuted these claims, restating its commitment to the area.  Companies in Brazil clearly must be very careful when considering plans to build facilities in such environmentally protected areas, a fact which has the potential to scupper many development plans.  Tim Kieft at the New York-based independent energy company Amerada Hess says: “The Ministry of the Environment has very clear and publicised objectives and rules. However, the ANP [National Petroleum Agency] has eased the situation by making a commitment to get more staff at the Environment Agency to support the growing industry.

President Cardoso and Brazil’s changing fortunes

Brazil is on the road to recovery. Such is the widely held belief of the international community following the emerging markets slump seen in 1998.  Investor confidence in the emerging markets has been low since many south-east Asian markets crashed, but economies are gradually recovering. Crucial to the upturn in Brazil’s fortunes has been President Fernando Henrique Cardoso, a man with a firm belief in free markets and privatisation.  An increased sense of political stability has also helped Latin America gain a new attractiveness to investors, with relations between South American countries improving over recent years.  Political analysts have partly attributed this increased steadiness to Cardoso’s re-election in 1998 imparting a certain degree of consistency to the largest country in South America. This second term was only made possible by Cardoso’s 1997 changing of the constitution, a move undertaken to ensure his market reforms are completed. It has not been easy for Brazil, which saw its currency, the real, devalued in January 1999. One real is currently worth $0.53. The real, previously pegged to the US dollar, has achieved the independent stability required to make Brazil a more attractive opportunity for national and international investors alike.

Why the World Bank loves hedge funds

The World Bank may be losing the treasurer and chief investment officer who revolutionised its asset management, but it is now an established alternative investor. Risk budgeting is the key tool. By Matthew Crabbe At Carlyle, Beschloss will head a new asset management group. It will come as no surprise to those who have been following the World Bank’s investment strategy closely over recent years that among the launches she is planning at Carlyle are a hedge fund of funds and a private equity fund of funds. Since she joined the World Bank from JP Morgan, where she worked in corporate finance, Beschloss has been an innovative and daring manager of its fixed-income portfolios. In late 1997, her treasury team made $22 million speculating that the Bank of England would raise UK interest rates. It has been bets like that, along with capital markets deals such as the launch of the World Bank’s first electronically distributed bond issue back in 2000, that have captured headlines. More recently, Beschloss has been working on plans to create an electronic swaps trading platform, soliciting support for the idea of an alternative to the bank-run SwapsWire consortium among other major end-users of the swaps market including, market sources say, Fannie Mae and GE Capital. But perhaps the most important contribution she has made to the World Bank has been the transformation of its investment risk management group, notably the creation of a risk budgeting model for its pension fund investments – a process that has gone hand-in-hand with an ambitious strategy of investment in hedge funds with a business line of credit like this and it's ok. Now, while other investors have been talking about risk budgeting – a framework for measuring the risk in new investments and its impact on the risk and return profile of the portfolio as a whole – the World Bank is one of a handful of institutions that can actually use risk budgeting as part of the asset allocation process. The World Bank pension fund’s policy allocation is 30% to US equities, 30% to non-US equities, 20% to global fixed-income and 20% to alternative investments. Those alternative investments include private equity, real estate and hedge funds. The World Bank pension fund actually made its first hedge fund investment back in 1983. But when Beschloss joined from JP Morgan, where she had worked on both the asset management and derivatives businesses, she set about creating a treasury team and a risk management framework that would allow her to crank up an absolute return strategy. The classic long-short hedge fund was top of the list of new investments. At the time the World Bank was beginning to build its risk budgeting model, the buzz-words in asset management were “portable alpha” – the idea that investors could chase juicy returns if they released cash from passive investments and reinvested it in high-risk, high-return strategies, such as futures overlays. It was a popular idea, largely because of the growing weight of evidence that index-tracking pension fund managers were consistently under-performing their benchmarks. But while the idea was much talked about, it was rarely put into practice. The World Bank pension fund, like most pension funds, simply prefers direct investments with fund managers expert in alternative strategy, such as shorting stocks, or who are active traders of a relatively small number of stocks, and are not best judged against standard benchmarks. It also, says Beschloss, likes the idea of highly incentivised fund managers. Hedge fund managers – who typically keep 20% or more of the returns they generate for their investors – fit that bill perfectly. Over the past two years, the World Bank has dramatically increased the proportion of its pension fund assets invested in hedge funds, from 1% to 6%. That represents well over $600 million managed by 29 different hedge fund managers. The results have been good: overall hedge funds have generated an internal rate of return of 12% since February last year. The core hedge fund portfolio, which is similar to a diversified fund of funds, generated a 16% return. The fund has now decided that, over the next two years, the proportion of its investments in hedge funds should increase to as much as 10%, partly because it currently sees less opportunity in the real estate and private equity markets. “That [level of hedge fund investment] is the optimum in this kind of market,” says Beschloss. “A lot of talented money managers with good risk discipline have moved into the hedge fund arena. They have the tools to short the market.” But the World Bank still needs to know what marginal impact a new fund manager is going to have. Risk budgeting means it can measure how the total risk in the portfolio is broken down into the 1,000, 10,000 or 1 million basis trades being made by the fund managers.