By Vernon Hamilton Budinger
“When will Brazilian investors embrace structured finance?” The question came from a prospective international client last week. Investors have a right to be concerned; 2012 was not a year that the Brazilian asset-backed securities (ABS) market will remember fondly. Defaults have risen to record highs in many credit sectors, especially consumer loans. In addition, Brazil’s central bank (Banco Central do Brasil - BCB) has had to rescue 7 banks since 2010. At least 5 of those banks failed because of fraud or other misdeeds involving ABS or collateralized securities: Banco Panamericano, Banco Morada, Banco Cruzerio do Sul (BCSul), and now Banco BVA(BVA).
At least 4 of the banks issued Fundos de Investimento in Direitos Creditórios (FIDCs) – the structure favored the most by Brazil’s ABS market or Cédulas de Crédito Bancário (CCBs) that utilized commingled accounts. We wrote about the practice of commingling accounts and suggested alternative structures in an article in the May 2012 edition of Alternative Latin Investor. We revisit this feature again and examine the Comissão de Valores Mobiliários (CVM , Brazil’s SEC) upcoming regulations to prohibit commingled accounts. The bottom line is that structuring firms and investors who do not adhere to best practices must accept part of the responsibility for the problems in ABS market in Brazil.
Investor Credibility in Brazil’s ABS Market Falls
The fall in investor credibility in Brazil’s ABS markets has been surprising. It has only been a little over 2 years since BCSul was once considered such a strong credit that it issued debt in US dollars. In June it became the largest Latin American corporate bond default in 10 years according to a Bloomberg story posted by Boris Korby on September 14, 2012. While investors in BCSul’s FIDCs are likely to get their money back, the last few months have been a wild ride for them. Investors in Banco BVA FIDCs may not be so lucky. On October 19th the BCB took over Banco BVA and problems with payments to the FIDCs began surfacing immediately.
We measure the damage to investor psyche by looking at issuance. FIDC issuance has declined precipitously since 2010, and 2012 marked the lowest issuance since 2004. The press has attributed much of the decline to confusion among Brazilian ABS issuers regarding CVM Instruction 489. Last year was the first full year that the instruction was put in effect.
The possible lack of demand from investors due to an increase of investor risk aversion has received little mention in the press. However, our discussions with Brazilian investors have been dominated by fears of about investing in FIDCs and we feel that this aversion could also be a factor in driving spreads wider and reducing issuance.
Who to Blame?
The CVM and the BCB have struggled to control the damage from a series of middle-market bank failures, all of which have involved some sort of structured finance product. The press has focused blame on the unscrupulous mid-tier bank operators, the CVM, the BCB, and issues with regulation and supervision.
However, other players in the financial markets contributed to the embarrassing developments for structured finance in Brazil. There has been a trend in Brazil to use accounting practices that runs contrary to every concept of good practice for ABS management. One of the most abused practices is commingling of cash from the FIDC with that of the bank or issuer.
Many FIDCs are structured so that FIDCs' cash payments are channeled through the issuer first. The issuer is then responsible for sorting out what cash goes to the FIDC. The argument in favor of this arrangement is that the issuer usually has a short time-frame to remit the money to the FIDC, generally 24 to 48 hours.
Over the past 4 or 5 years large issuers, credit agencies, auditors and the law firms associated with FIDCs and structured finance have convinced (pummeled into accepting) most investors that separate bank accounts for FIDCs are not necessary. The claim is that a 48hour window is too small to commit fraud and that such illegal activity would be easily identified. These ill-advised commingling practices were implemented by the issuers and condoned by the law firms, accounting firms, and the rating agencies before being approved by the CVM.
The Solution – Just Do Not Commingle
In the May 2012 issue of Alternative Latin Investor, Jason Smith and I wrote a previously mentioned article criticizing this practice and suggesting alternatives. We focused on the case of Banco Morada, who is at the center of an ongoing fraud investigation regarding issuance of Cedulas de Crédito Bancário (CCBs – Bank Notes) by shell companies associated with Banco Morada. The central problem was that prepayments where misdirected and not applied to maturing the loans in the CCBs. The Banco Morada failure resulted in losses of millions of Brazilian reals for some of Brazil’s biggest pension funds and one Swiss bank. This is our commentary.
The entity acting as agent, in this case Morada, is the same one that is receiving cash flows and payment information. Therefore this agent is the sole gatekeeper for information and funds for the investor, or the principal. It comes as no surprise that Morada was tempted by the large moral hazard to exploit the principal, the one party in the transaction who has equity or “skin in the game.” Morada consequently perpetuated the shell game to mask shoddy underwriting and credit controls. Since Morada was never putting capital at risk, why not?
Best practices would dictate that the “servicer,” or collector and workout agent for payments from borrowers should be a legally separate (or at least ring-fenced) entity that can provide full disclosure to the investors whom are the principals in this transaction. Since the very nature of government-sponsored consignados makes having a separate servicer difficult to implement (remember that these banks have special agreements with government institutions that allow them to collect on payrolls before the borrower has access to the funds) a sensible solution would be to ring-fence a separate box or create a strict firewall within the bank that receives the payments from borrowers.
With that small change, Figure 2 illustrates how borrower funds and payment information could flow directly to the investors and help keep the underwriter honest by having a “check” upon their flow of capital and information. Of course, they could still create value by selling these loans into the structure at more than their cost to originate, but their long-term incentive shifts away from payment fraudulence and towards underwriting loans.
The past year has shown us that even 24 hours is plenty of time for misdeeds. Banco BVA and its FIDCs are the latest examples. According the article by Uqbar, “BVA FIDCs: Credit or Operational Risk” that was posted on its portal TLON on December 5th, the BCB intervened on October 19th, 2012 and took over Banco BVA. The bank operated 5 FDICs: Multisetorial Open Victory (Victory), FDIC Multisetorial BVA Master (Master), FDIC Multisetorial BVA Master II (Master II), the FDIC Multisetorial BVA Master III (Master III) and FIDC Multisetorial Italy (Italy).
Uqbar reported that Austin Ratings downgraded the cotas of 3 of the FIDCs on October 11th and placed the funds on negative credit watch. Master II and III had their cotas downgraded by 5 levels, from brAA(sf) to brBBB(sf). The Brazilian credit agency cited the high level of late payments in the portfolios as the prime reason for taking such drastic action.
Uqbar then reports that S&P put the funds on negative credit watch a few hours after the intervention because of operational problems in the FIDCs that could increase with the BCB’s seizure of BVA. Unlike the Austin report, the S&P report noted that there was a decrease in the payments collected, but did not attribute the reduction to the late payments in the credit portfolio. In addition, S&P noted that the magnitude of the problem and the nearly simultaneous timing of the late payments suggested the existence of operation problems associated the collection agent (surprise, BVA was the collection agent).
The story continues when the cota holders of FIDC Italia petitioned BRL Trust DTVM, administrator of the FIDC, to clarify the efforts being adopted by BVA to collect the late payments (Note: According to CVM Instruction 356, the custodian should be in charge of collections in a FIDC). Uqbar pieces together the parts of the puzzle to conclude that BVA was misdirecting payments from loans in the FIDC to cover its cash flow needs in other parts of the bank.
Uqbar reports that this Banco BVA’s commingling arrangement is well known in the Brazilian market. In Banco BVA’s case, it was justified by a stipulation that the bank had to transfer the funds within 24 hours.
Banco BVA and Banco Morado were not the only banks to abuse commingling privileges. BC Sul also joined the party according to Moody’s. The rating agency reports that BC Sul “stopped transferring cash flows belonging to one of its securitizations (FIDC BC Sul Verax II) to the FIDC’s custodian following the bank’s liquidation” on page 8 in their report “Latin America Securitization: Outlook 2013.”
CVM to the Rescue - New Regulations to Prohibit Commingling
But fear not, after 5 failures in less than 2 years, the CVM plans to issue a new set of “normas” or regulations to eliminate the practice of commingling of FIDC funds. They will require FIDCs to set up separate bank accounts for receiving payments. Moody’s reports that the “sellers will no longer be able to commingle cash belonging to the securitization with their own accounts.”
The rules were available for comment from May 2012 to September 2012 and should be issued early in 2013. Once again, we heard the same contorted views from the banks and associated legal and accounting experts as to why the CVM should not pass these regulations. Most of the rating agencies seem to have learned the lesson and are now quietly supporting the new standards.
The moral of the story is that the CVM and the regulators cannot catch every problem. The new CVM regulations should help restore confidence in the market. However, investors could help police the market by avoiding structures that do not adhere to best practices. This means not investing in deals that deviate from best practices even though prestigious law firms or accountants have put their stamp of approval on features. Investors should only invest structures that utilize pure true sale and where the sponsors of the structure participate in a form that motives a proper principal-agent relationship. Various market-sponsored entities, such as the Associação das Entidades dos Mercados Financeiros e de Capitais (ANBIMA), could issue a code of conduct that sets standards for the market based on best practices.
LatAm Structured Finance is an investment advisor specializing in Latin American asset-backed securities. We use our proprietary technology and experience to identify unique investment opportunities and to protect our clients from risks embedded in complex structures. Vernon Budinger is an investment professional and a CFA with more than 28 years of experience. Prior to forming LatAm Structured Finance, Vernon worked at Western Asset Management and spent the last 3 years working for Western in Brazil where he evaluated Brazilian structured finance.
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