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A FRAMEWORK FOR RESTRUCTURING DEBT IN DEVELOPING
COUNTRIES THROUGH THE CREATION OF SPECIAL
SOVEREIGN BORROWING ENTITIES1
Roger W. Clark2
Austin Peay State UniversitySchool of Business
Clarksville, TN 37044, USAPhone: 931-221-7574Fax: 931-221-7355
Email: [email protected]
And
George C. Philippatos
University of Tennessee432 Stokely Management CenterKnoxville, TN 37996-0540, USA
Phone: 865-690-9684Email: [email protected]
And
David J. MooreCollege of Business Administration
California State University, Sacramento
Tokoe Hall 21176000 J Street
Sacramento, CA 95819-6088Email:[email protected]
First draft January, 2003Revised May, 2006Revised March, 2007Revised November 2010Current Draft April 2013
1 Earlier abbreviated versions of this research were presented at the fifth Encuentro de FinanzasInternacional USACH, Via del Mar, Chile, January 2003, The Durham University Finance Conference,June 27, 2006, Durham, UK and at several universities. The authors wish to thank participants at theseconferences for their suggestions. Needless to say, the authors take full responsibility for any errors stillremaining in this paper.2 Corresponding AuthorJuly 2-3, 2013Cambridge, UK 1
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A FRAMEWORK FOR RESTRUCTURING DEBT IN DEVELOPING
COUNTRIES THROUGH THE CREATION OF SPECIAL
SOVEREIGN BORROWING ENTITIES
By Roger W. Clark, Austin Peay State University, P.O. Box 4415, Clarksville, TN 37044, USA; andGeorge C. Philippatos, University of Tennessee 432 Stokely Management Center Knoxville, TN 37996-0540, USA; and David J. Moore, California State University, Sacramento, CA. 95819-6088, USA
ABSTRACT
The recent Global Financial Crisis (2007- present) has renewed the interest of theInternational Financial Institutions (IFIs) in finding new methods of accommodating thecontinuing needs of developing countries for outside capital.
This paper proposes the creation of a special sovereign borrowing entity (SSBE)under the auspices of the International Monetary Fund (IMF) and other InternationalFinancial Institutions (IFIs) that would guarantee bond issuances by developing nations,package them in relatively small denominations of $50,000 - $500,000 US, and auctionthem to the public. Should a nation fail to pay its debts the SSBE may raise fundsthrough a punitive tariff on all exports from the developing country, administered by allnations that are members of the IMF.
An extensive illustration that contains computations and a Monte Carlo simulationis also provided to enhance the analytical material in this paper regarding the feasibilityand viability of the proposed Special Sovereign Borrowing Entity (SSBE)
Key Words: special sovereign borrowing entity, sovereign debt, bankruptcy, default,debt restructuring, Monte Carlo simulation, IMF, IBRD
JEL Code: F18, F34
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1. INTRODUCTION
The financial arrangements of the current system of sovereign debt issuance are
similar to financing in the nineteenth century. Loans are made on general credit; the
creditors do not have full access to the debtors books, and in many cases they do not
have real control over how the money is spent or how it is to be repaid. The remedy for
default is the sovereign equivalent of debtors prison; that is, the drying up of trade
credits and restrictions on trade with the debtor country. To the chagrin of the global
financial system, these sanctions have not aided the debtor nations in paying off their
debts. Starting around 2004, Great Britain agreed to pay off 10% of the debt of
developing countries1, but this does not reach the underlying problem of their growing
needs for outside capital.
The present paper proposes the creation of a special sovereign borrowing entity
(SSBE) under the auspices of the International Monetary Fund (IMF) and other
International Financial Institutions (IFIs), that would guarantee bond issuances by
developing nations, package them in relatively small denominations of $50,000 -
$500,000 US, and auction them to the public. Should a nation fail to pay its debt the
SSBE may raise funds through a punitive tariff on all exports from the developing debtor
country, administered by all nations that are members of the IMF.
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2. NATIONAL DEBT VS CORPORATE DEBT
Bulow, et. al. (2002) have likened debt of developing countries to corporate junk
bonds, the main differences being collateral and control. Corporate bonds generally have
the assets of the firm for backing. Further, should a corporation have poor governance,
the trustee in bankruptcy has the option to replace completely the management team.
Neither of these two options is operationally feasible with national debt. The markets
also rate the debt of developing countries at junk-bond levels, viewing them as more than
likely to default, generally a 50% writedown is anticipated over the next decade. (Bulow,
et. al. (2002))
A further problem exists in the size of the total national debt and its uses. While it
has been observed that in general the total national debt of a developing country amounts
to only three to six months of its GDP, this is deceiving (Bulow, et. al., 1997). Sachs
(2002) has developed this concept further with his so-called poverty trap. He notes the
large number of small developing countries (SDCs) that have been in a continual state of
financial crisis for many years and that the only ones that have been cured of high debt
were the countries with larger gross domestic incomes (GDIs) initially. From this he
infers that, in contrast to the neo-Classical view, savings and capital accumulation rates
are non linear. Low income countries will be spending more on basic survival rather than
the building of capital. As a consequence, these small countries will almost never be able
to lift themselves out of poverty. Also the problem with lending from multinational
agencies such as the IMF and the World Bank is that they have been prone to use
arbitrary formulas for lending (and lending only enough to avert disaster, rather than
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solve the basic problem). Sachs proposes that debt renegotiations take into consideration
the fact that maximization of debt repayments is only one of a series of objectives. Other
objectives are: (a) giving the insolvent country a fresh start, (b) preserving its public
functions, and (c) achieving its development objectives. This calls for the creditor
countries and International Financial Institutions (IFIs) making independent plans and
estimates for the debtor countries development, and for pulling them out of the poverty
trap.
All of the above literature, however, begs the question of why a nation would
bother paying its debts. The age of gunboat diplomacy, where a powerful nations fleet
could sail into the harbor of a defaulting debtor nation and seize its assets, is past. Also,
most developing nations do not have assets of high value outside of their borders subject
to seizure. Still, nations that renounce their debt entirely are few or almost non-existent.
Nations in financial trouble usually undergo financial reorganization under the auspices
of the IMF and renegotiation of debt under the Paris and London Clubs. Again, why
would they go to this trouble if they can simply renounce their debt?
Eaton and Gersovitz (1981) have advanced the Reputational Capital model. In
their framework the potential loss of future borrowing power is greater than the amount
of debt renounced. However, this has been questioned by Bulow and Rogoff, (1989) who
argue that loss of reputational capital alone cannot account for the full value of the debt
renounced. Rogoff and Zettelmeyer (2002) have noted that the literature of the 80s does
not give easy solutions. It would appear the true economic loss is both loss of
reputational capital and the possibility that individual lawsuits against a nation would
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trigger cross-default clauses in all contracts of the country. This would entail a rush to
the courthouse by all creditors and imperil ongoing IMF loans.
Another cost of default would be the drying up of trade credits for both imports
and exports (Cohen, 1991, Kaltesky, 1985, Rogoff, 1999). This could effectively cut off
the debtors trade with the outside world and bankrupt merchants in the debtor country
that depended on this trade. Also, Rose (2002) has noted that a countrys problems with
portfolio creditors may have an adverse impact on foreign trade. In his paper Rose notes
that a typical debtor countrys outside trade shrank on average 8% a year and the effects
lasted for fifteen years after renegotiation of debt under the Paris club [Rose (2002) p.
19]. One question that was not explored was whether this was a punishment by the
creditor countries for defaulting or a natural consequence of poor economic conditions in
the debtor countries examined.
In a paper released later the same year Rose (2002) finds a high correlation
between the amount of loans a creditor country makes to a debtor country and amount of
trade with the debtor country. This seems to add weight to the hypothesis that trade can
be used as a lever to obtain favorable terms by the creditor. Should this be the case, it
would appear the market for government bonds of developing countries is limited to the
trading partners of the debtor country. Potential creditors (e.g. for example portfolio
investors) in other countries may not have the power to enforce payment under present
arrangements.
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3. RENEGOTIATING NATIONAL DEBT
When a nation finds itself unable to make timely payments on its debt it must first
go to the IMF to obtain temporary financial relief and submit to a program approved by
the IMF for resolving the underlying problem. Once the country has agreed to the IMF
program it petitions the Paris Club to renegotiate its sovereign debt. The Paris Club is
an (ad hoc) informal organization of nations that work to reschedule loan repayments on
terms the debtor nation can afford to pay. It can lengthen the terms and/or change the
interest rates, depending on the needs of the nation. This club has no formal enforcement
powers and works by consensus. The process usually takes six to eight months.
Afterwards, the debtor nation goes to the London club to work out its private loans. In
general, the London Club reschedules loans using the same terms as the Paris Club. This
arrangement has generated some criticism. Typically, the criticism is that the IMF has a
one size fits all policy that does not take into full consideration the specific problems in
each country (Stiglitz, 2002). Also, the mere existence of supra national organizations
may create a moral hazard problem.2 Additionally, the fact that the Paris Club operates
by consensus without enforcement authority may create a free rider problem3 (supra).
Finally, the entire process of negotiation engenders serious problems with informational
asymmetries and adverse selection.4
The presence of such informational asymmetries may affect asset values through
a nexus of economic distortions that manifest themselves as agency costs, signaling
costs, moral hazard costs, free rider costs, and adverse selection costs, among
others. In general the presence and costs of informational asymmetries are higher in the
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mixed market economies of the developing (debtor) nations than they are in the market
economies of the G8 (creditor) countries. Much of the problem can be traced to lax
accounting standards, poor record keeping and internal auditors controlled by those being
audited.5 (Johnson, 1992).
Should a country actually have a healthy, corruption free system it will find its
official statistics not much different from a corrupt country that also misrepresents its
own statistics. Here we have a problem with informational asymmetry and adverse
selection. It is to the creditors interest to have as much information as possible
concerning a nations ability to repay its debts. However, as Stiglitz (1975, 2002) has
suggested, it is not in the creditors interest to have this information made public
knowledge, so that he/she can take advantage of this informational asymmetry to demand
higher interest rates. All of this, of course, leads to the problem of adverse selection.
Creditors, without the benefit of credible public regulatory agencies that promote and
enforce full disclosure, will be forced to rely on private, often unreliable, channels of
information. This will force interest rates up to offset perceived debtor risk. Debtor
nations will, in turn, only borrow if they have high positive NPV projects or when they
have no intention of repaying the full amount of the debt. As a consequence of this, debt
from developing countries has consistently stayed at junk bond levels (see Bulow, 2002).
Informational asymmetry also arises in the prospect of a nation having its debt
repurchased by the larger industrial countries. The problem here is that the entire
premise of this debt repurchase rests on the value of the debt remaining at the market
before the repurchase is announced. When it is discovered the debt will be repurchased
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by the larger industrial nations, the debt value will rise to approximate the value of the
larger countries bonds. (Bulow and Rogoff, 1990 )
One possible solution to this problem of informational asymmetry may be in the
syndicated loan market. Sufi (2005) finds informational asymmetry is greatest with
companies new to the loan market. Here due diligence and monitoring are most needed.
Lead bankers that arrange the loans usually overcome this fear of informational
asymmetry by taking a large position in the loan amount. The reputation of the lead
lenders may mitigate, but not reduce significantly, the effects of informational
asymmetry.
Additional support along the efforts to mitigate informational asymmetry through
the syndicated loan market is offered by Dailami, et. al.. Using data from J P Morgan
Emerging Market Bond Index Plus (EMBI+) spreads, they studied the secondary
markets of Brady Bonds and Eurodollar issues for all major sovereign borrowers (17
countries), by separating the public data into crisis and non-crisis periods for
countries that are close to the borderline of solvency and those that are not. The
authors concluded as follows, there is evidence that investors are much more able to
discriminate among borrowers, and less likely to infer that problems in one country signal
problems in others (p.27). They further offer clinical evidence of the Argentinean
debt default in 2002 the largest known default in recent history which did not cause
much disruption in world capital markets, nor did its neighboring countries suffer major
increases in their spreads6.
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3.1 Moral hazard
In general, the concept of moral hazard stems from the behavioral perceptions that
insurance against some unforeseen event may actually encourage it to occur. As applied
to multinational finance, the IMF has arranged standby funding packages for several
emerging-market countries in financial crisis. To wit, some parties have expressed
concern that this could have long-term adverse effects on the world economy. For
creditors it encourages lending to poor countries without factoring fully the importance of
financial risk. Thus, some debtor countries may obtain financing without undertaking
needed economic reforms.
Another case of moral hazard exists when we witness the private creditors egging
the IFIs on to bail out the bankrupt debtor countries, although we know that it would
be better, from an efficiency standpoint, if they could precommit not to bail out the
countries in distress. Bulow (2004), further states the IFIs are probably making
loans that earn zero economic profits. Therefore the IFIs facilitate excessive lending.
(ibid, p.6) Indeed, in many cases, the IFIs make loans that are below the break even
point. Therefore the cost to the IFIs must be greater than or equal to the
inefficiencies created.7
The overall question is whether we have empirical evidence of the presence and
the extent of moral hazard in sovereign debt financing. Kamin (2002) has studied moral
hazard using the spreads before the 1995 Mexican bailout as a benchmark. This was the
first major bailout of a large country in financial trouble and, he reasons, before this,
countries would have no reasonable expectations of a major bailout in the event of a
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financial crisis. He finds no statistically significant increase in the spreads before and
after the Mexican bailout except in the period of 1996 through mid 1998, which he
attributes to financial market exuberance. Thus, Kamin (2002) concludes that there is
little evidence for moral hazard.
DellAriccia, Schnabel, and Zettelmeyer (2002) discovered possible evidence for
moral hazard in the aftermath of the Russian lending crisis of 1998. Here the authors
regressed the spreads of sovereign bonds against country fundamentals both before and
after the Russian crisis. The results were that these spreads increased significantly after
the crisis when it was perceived that country bailouts were not going to be as common as
in the past. Further, these spreads were largest in emerging market countries8. They
point out, however, that this evidence for moral hazard rests on the premise that country
bailouts do not significantly reduce true economic risk. Should this premise be rejected
the increase in spreads reflects the increased risk in a world without these safeguards.
Rogoff (2002) notes in an article commenting on moral hazard and the IMF that to date,
the IMF loans have, in general, been paid in full. Further, he notes that, even if there
were a default, the countries involved are so small that the loan would amount to a
miniscule portion of the global GDP. Rogoff further likens the IMF loans to the
performance of the Federal Reserve System in the 1930s. This system performed well
until the 1980s before there was any appreciable loss from moral hazard in the form of
the Savings and Loan (S&L) crises. This should be balanced against the roughly fifty
years of relative stability in the U.S. banking system.
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3.2 The free rider problem
Sachs (1986) outlined the free rider problem of renegotiating debt in the current
environment. When a country defaults on debt involving several creditors it is to a
creditors advantage to hold out in any renegotiations, rather than join in with the rest of
the creditors. In this way the creditor may sue to enforce their legal rights and obtain a
better settlement than other creditors. This can cause a destructive race to force a debtor
to pay through the courts. Balanced against this is the problem of jurisdiction. The fact
is, that these lawsuits are brought in a country other than the debtor country. Unless the
debt is secured by collateral located in another country the debtor nation can simply
refuse to pay.
3.3 Off balance sheet financing and SSBEs for
sovereign borrowing.
With the Enron and World Com scandals the Special Purpose Entity (SPE) has
acquired a rather questionable reputation. Much of this is undeserved. The SPE was
originally conceived as a method of allowing private firms to avoid capitalization of
certain types of leases under Financial Accounting Standard (FAS) 13. Under the
original SPE rules, outside investors would contribute at least 3% (now 10%) of a
companys capital while the originator company could guarantee as much as 90% of the
SPEs debt. In many cases this allowed the SPE to obtain lower financing rates than the
originator companys normal borrowing rate. Additionally, the SPE had the cosmetic
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effect of keeping the liabilities associated with the project off the originator companys
books9.
The SPE is still used broadly in private industry and in some cases in
governmental entities. In the United States the Federal National Mortgage Association
(Fannie Mae) and the Governmental National Mortgage Association (Ginnie Mae),
among others, function as SPEs. In addition Japan has formed offshore SPEs to handle
non-performing loans and enhance the income statements and balance sheets of their
commercial banks.
The international financial institutions (IFIs) such as the World Bank or the IMF
also function as a form of SPE for the United Nations and the world community. They
generally couch their aid to developing countries in the form of loans or loan guarantees.
This allows the developed countries to utilize leverage in aiding less developed countries.
As an example, the World Bank is capitalized at $189.5 billion while only $11.5 billion
has been paid in by the subscribing countries (Bulow, et.al. 2002)10.
3.4 Comparative Statics of Known U.S. Government
SPEs and Proposed Special Sovereign Borrowing
Entity (SSBE)
By far the best known United States Governmental SPEs are Ginnie Mae
(GNMA), Freddie Mac (FRE), Fannie Mae (FNMA) and Sallie Mae (SLM). All four are
institutions founded by the U.S. Government11. Their responsibility is to provide
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liquidity for the housing and student loan markets where they rate, grade, securitize, and
frequently auction underlying claims (mortgages and/or loans).
The main focus of Ginnie Mae is to ensure liquidity for U.S. Government insured
mortgages, including those insured by the Federal Housing Administration (FHA), the
Veterans Administration (VA), and the Rural Housing Administration (RHA). The
majority of mortgages securitized as Ginnie Mae (MBSs) are those guaranteed by the
FHA. FHA mortgagees are typically first time home buyers and low income borrowers.
Sallie Mae, on the other hand, guarantees the timely payment of interest and principal for
college education (student) loans, while Fannie Mae resembles a hybrid of Sallie Mae
and Ginnie Mae. , below, summarizes the attributes of the proposed sovereign borrowing
entity (SSBE) and Sallie Mae, which appears to be the closest equivalent among the U.S.
Government SPEs.
Tables 2 presents some descriptive statistics from another well-known government SPE,
Freddie Mac (FRE) for the 15 year period 1990-2004. From the statistics it transpires
that mortgage purchases during this period increased by a multiple of 11.25 times, while
the issuance of mortgage backed securities (MBSs) increased by a factor of 9.8 times. As
can be seen from Charts 1 and 2 the delinquency rates of all loans, which include Freddie
Mac loans, is higher than the delinquency and foreclosure rates of conventional loans.
This is expected as the buyers under Freddie Mac are usually first time buyers making
comparatively low down payments.
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The default rates of Sallie Mae student loans are not published in detail, but Sallie
Mae has estimated that Consistent with historical experience, the assumed average
lifetime default rates are 15 percent for borrowers attending four-year schools, 30 percent
for borrowers attending two-year schools, and 10 percent for borrowers attending
graduate or professional schools12.
4. A MODEL FOR SOVEREIGN COUNTRY BORROWING
UNDER AN SSBE
Let us assume there is one country, , that wishes to borrow money. It may
choose to borrow directly from a creditor country, , or borrow through the SSBE.
Should borrow through and finance it with the issuance of sovereign bonds, it will
face the penalty of trade restrictions in the event of default. Rose (2002) and Rose and
Spiegel (2002) have demonstrated that these restrictions can be and apparently are used
in such circumstances. They do not seem particularly effective as the punishment hurts
the creditor in trade as well as the debtor, without actually remedying the default.
Apparently the market does not think highly of this as a remedy; hence the trading of
these obligations at junk bond levels.
Should the country choose to go through the SSBE, it will receive a loan amount
of L from the SSBE. We begin with a two-period model in which L will be received in
period one and repaid in period two at D where D = (1+r)L; and r is the debtor
countrys cost of capital. Loan proceeds will be used to enhance trade with other
countries, thus fostering diversification of trading partners and giving the debtor country
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revenues in the second period of T; where, T is the total amount of exports from the
debtor country. It is further assumed the prices of the exports are inelastic. The utility
function in country will satisfy the following condition:
E1(U) = U(C1) + E(U(C2)) (1)
where U >0, U r, and r
represents the new discount rate of the country in default, adjusted for costs of
reputational capital and loss of foreign trade.
From equations (3) and (4) it is evident the utility maximizing choice of the
debtor country will be to pay its debts under all circumstances.
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5. AN ILLUSTRATION OF THE PROPOSED
SPECIAL SOVEREIGN BORROWING ENTITY
VIABILITY AND FEASIBILITY
The Special Sovereign Borrowing Entity (SSBE) is expected to operate in a
higher default rate environment than U.S. government-sponsored SPEs (US-SPEs). In
such an environment interest will be collected from a smaller percentage of loans.
However, the combination of higher interest rates (to compensate for higher risk) and the
presence of credit enhancements13may partly offset the effects of increased defaults.
At this stage we identify several preliminary conjectures regarding the proposed
special sovereign borrowing entity (SSBE) viability and feasibility:
Profitability sensitivity conjecture. The profit margin of firms that securitize
loans is insensitive or positively related to the default rate of underlying loans.
Effective spread conjecture. The effective spread14 of a loan securitization SSBE
is not adversely affected by increased default rates.
Feasibility conjecture. The cash reserve requirements of the proposed SSBE are
sufficiently small to be accommodated by available IMF/World Bank funds.
To test these conjectures we analyze data obtained from COMPUSTAT, Reuters
Corporate Spreads for Industrials and annual reports of Fannie Mae, Freddie Mac and
Sallie Mae, for various sub-periods between 1968 and 2004 (whenever they are
available). Using these databases, we compute the profit margin of these US sponsored
SPEs over time and estimate the effect of risky debt on such margins. We then employ
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these computations to draw inferences about the proposed Special Sovereign Borrowing
Entity (SBE). From here we estimate the relationship between default rate and spread
and incorporate the results into a Monte Carlo simulation of SBE operations to arrive at
the effective spreadmeasure.
5.1 Profitability sensitivity
5.1.1 Model
It is important to illustrate the connection between profit margin and default rate,
given the likelihood of higher default rates by poorer LDCs. In addition, delinquencies
have the potential to impact earnings adversely through increased servicing costs,
collection costs, and account charge-offs. Therefore, delinquency rates capture much of
the cost of carrying risky debt as do default rates. Hence, given the availability of a
sufficient number of observations, we should be able to infer the impact of default rates
on profit margins using delinquency rate data. This was shown in Table 2, which
presents the U.S. delinquency and foreclosure rates (as a percentage of outstanding loans)
for all loans and for conventional loans during the period 1990 2004. However, the
number of observations available is not large enough to yield statistically significant
results.
Nevertheless, since the primary purpose of this exercise is to provide a practical
illustration, we shall proceed with the empirics and rely on quarterly delinquency data
from the three U.S. sponsored SPEs (FNM, FRE and SLM). To test the profitability
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sensitivity conjecture, we apply the asset pricing model in Equation 5 to profit margins
and include delinquency rate DELRATE as follows:
PMt
0
1PMM,t
2DELRATEt
ut (5)
where profit margin PM is defined as net income divided by sales. If the coefficient
2 is positive and statistically or economically insignificant, we will have
demonstrated lack of profitability sensitivity to delinquency rates.
5.1.2 Model inputs
In order to run the regression specified in equation (5), three data items are needed: i) the
profit margin over time for each US sponsored SPE; ii0 the market profit margin over
time, and ii) delinquency rates over time. US sponsored SPE profit margin data are
extracted from COMPUSTAT for FNM, FRE, and SLM for the periods 1968 2002,
1986 2004 and 1981 2004, respectively. The market profit margin is computed on a
year by year basis as the equal-weighted profit margin for all companies with nonzero
sales (to avoid division by zero). Default rate data are extracted from the U.S.
delinquency and foreclosure rate for all loans during the period 1990-2004 data
previously shown in Table 2. Although default rate is not explicitly published, we
consider the foreclosure rate as synonymous with default rate.
5.1.3 Results
Regression (5) is run for each of the three US sponsored SPEs and results are reported in
Table 3below with standard errors in parentheses.
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5.2 Effective Spread
5.2.1 Model
A percentage ( CER ) of the SSBE loan portfolio will likely have credit
enhancements while the remainder (1 CER ) will not be credit-enhanced. The typical
spread of 200 basis points associated with less developed country debt is assigned to the
spread of the credit-enhanced portfolio SCE . By construction of credit-enhancements,
all interest will be collected from the credit-enhanced (CE) portfolio irrespective of the
default rate experienced. However, the amount of interest collected from the non-credit-
enhanced (NCE) portfolio will depend on the associated spread SNCE and default rate of
NCE loans DEFRATENCE . Therefore, the effective spread ES is as expressed in
Equation (6) below:
ES CER SCE R
AAA 1 CER 1 DEFRATENCE SNCE RAAA RAAA (6)
where RAAA represents the rate of a AAA rated corporate bond. A Monte Carlo
simulation of (6) is run and the value of ES is compared to the average spread associated
with US-SPEs.
5.2.2 Model inputs
This section describes the data used and construction of requisite inputs to the Monte
Carlo simulation of equation (6).
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a) Spread-default rate relationship for CE portfolio
We estimate the relationship between the default rate and spread based on credit
ratings by utilizing data from: (1) Reuters Corporate Spreads for Industrials (June, 2004);
and (2) Moodys Investor Service Global Credit Research (February, 2002). From these
data we estimate the relationship between default rate and spread. The data reveals that
the spread between a bonds rate and the 10 year U.S. Treasury security Spread
increases as the bond rating decreases.15
b) Credit-enhancement ratio
In computing the credit-enhanced percentage of the total mortgage portfolio, Freddie Mac
excludes non-Freddie Mac agency16 and non-agency17 mortgage related securities.
However, delinquency rates are subdivided for credit-enhanced and non credit enhanced
portions of total mortgage portfolio. The general aim of this model is to connect the
spread between loans to sovereign countries and bond coupon payments in the context of
higher default rates and mortgage guarantees. Therefore, the exclusion of agencies and
non-agencies is acceptable given the equivalent guaranteeingfunction embodied in
credit enhancements.
Based on Freddie Mac Data. a random variable for CER was generated that has a
triangular18 distribution with lower limit, modal value, and upper limit equal to the
minimum, mean, and maximum values ofCER , respectively.
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c) Spread-default rate relationship for the NCE portfolio
Freddie Mac reports delinquencyrate data for its credit enhanced and non credit
enhanced portfolios while our Monte Carlo model (6) requires the overall defaultrate.
The relationship between delinquency rates of CE loans and NCE loans can be estimated
using Freddie Mac delinquency data. From this relationship we infer the NCE/CE default
relationship and thus mitigate the shortcomings of default rate data unavailability. A
random variable for the NCE default rate is formed based on the CE default rate and the
NCE/CE relationship.
Finally, now that we have a value for the NCE portfolio default rate, we compute the
associated spread by utilizing the spread/default relationship obtained earlier.
5.2.3 Simulation Results
Referring to Table 2, the average default rate (foreclosures started) for all mortgages
in the U.S. is 0.34% over the period 1990 to 2004. Using the previously determined
default rate relationship, this translates into a spread of approximately 80 basis points. In
the neighborhood of this spread, the three US-SPEs have persisted (i.e., have remained
viable). Error: Reference source not found reflects the effective spread of the SSBE
given for various values for the credit-enhanced loan spread. As you can see, the
effective spread at the proposed 200 basis point value of SCE is well above the 80 basis
point US-SPE spread. In other words, the proposed SSBE is able to realize a higher
effective spread than that of US sponsored SPEs. What this means is the higher costs of
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default (including lost interest payments) are more than offset by the additional revenue
generated from having a larger spread.
5.3 Feasibility Conjecture
To investigate the feasibility of creating the proposed SSBE, we consider i) the cash to
loan ratio of US sponsored SPEs (USCTLR) and ii) the anticipated amount of SSBE
loans. On average, the loan balance for US sponsored SPEs is approximately 80% of
total assets. Therefore USCTLR can be calculated as:
USCTLR cash
0.80* totalassets (11)
Using this calculation the average cash-to-loan ratios for FNM, FRE, and SLM are 6.5%,
11.5%, and 16.0%, respectively. Should the anticipated amount of loans handled by the
proposed SSBE be designated as $ 50 billion, the initial amount of IMF/World Bank cash
needed to seed the SPE is $3.25 to $8 billion dollars.
5.4 Tentative Conclusions
Based on the analytics, empirics, and Monte Carlo simulations of Sections IV and V, we
can infer the following:
1. SSBEs, which securitize loans, can be profitable even in the presence of higher
default rates;
2. In addition, only a small amount ($3.25 to $8 billion dollars) of available IMF
funds is needed to fund the start up costs associated with the proposed Sovereign
Borrowing Entity (SSBE) for an anticipated amount of loans of $50 billion.
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3. Finally, in light of the above it is evident that the utility maximization choice will
motivate borrowing nations to pay rather than default of their SSBE sponsored
loans.
6. RECOMMENDATIONS
This paper proposes a new type of sovereign bond issuance where risk is largely
determined at the time of issuance and greater transparency is given to the purchasers.
The International Monetary Fund will create and fund a special sovereign borrowing
entity (SSBE) that will be modeled after the Federal National Mortgage Association
(Fannie Mae) in the United States. They would examine the debt capacity of countries
interested in offering bonds on the market using methodologies similar to that used by
Moodys or Standard and Poors or an investment bank deciding whether to underwrite a
private bond offering19. An acceptable price would be established commensurate with the
risks involved. The SSBE would then package the issuance in a manner similar to the
Fannie Mae bonds in the United States and sell them at auction on a regular basis. They
will guarantee the bonds at a specific interest rate. Should a nation fail to pay when due,
the agency will have power to levy a tax or tariff on the exports of the debtor country.
This will give the agency enforcement capabilities through its member nations. In
addition, the debtor nation will make its books available to the SSBE and funds will be
released only as the projects, such as roads or schools, are completed. This arrangement
should open the markets for developing country bonds to a worldwide group of investors.
Since there will be no one nation heavily invested in the debtor country (diversification
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effect), the temptation to restrict trade will be minimal. Instead, a tariff can be better
tailored to collect revenues with minimal effects on the debtor countrys external trade.
In perspective, our recommendations for an SSBE based sovereign debt structure
contain implicitly several advantages and financial safeguards, as follows:
1. The auctioning of the SSBE-claims on a regular basis will foster some
semblance of practical diversification, which will enable claim-holders to develop
risk-adjusted measures of return for these SSBE bonds.
2. The guarantee provisions of SSBE claims by the IMF will likely upgrade
these claims eventually to investment grade and improve their liquidity and
marketability. In the long-run, as the default probabilities of such bonds are
reduced (or, at least, bounded), some financial institutions may wish to employ
them as instruments of portfolio immunization along with other investment
quality claims.
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Tables and Charts
Table 1 Sallie Mae and proposed sovereign borrowing entity attributes
Similarities Between a U.S. Government SPE (SLM) and Proposed Sovereign Borrowing Entity(SBE)
SALLIE MAE (SLM) Proposed SOVEREIGN BORROWING ENTITY(SBE)
Rates, Grades, Securitizes and auctions off loans ofCollege Students
Rates, Grades, securitizes and auctions off the loansof Less Developed Countries (LDCs)
Funds are released as academic work progresses (ona semester basis)
Funds will be released as projects progress (on aquarterly basis)
Loan repayments are typically made. Studentborrowers will repay old loans by taking new loans(refinancing)
Loans typically will not be paid off, rather they willbe replaced with new loans. This will allow moreinterest to be earned (from refinancing).
Default is mitigated by a screening (monitoring)process and the refinancing of loans.
Default will be mitigated by a screening/monitoringprocess (rating, grading, and frequent auctioning)
and the refinancing of loans.
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Table 2 U.S. delinquency and foreclosure rates frame
Percent Of Outstanding Loans
All Loans Conv Loans
Delinquency RatesForeclosures
Started
Delinquency RatesForeclosures
Started60-90 Days > 90 Days 60-90 Days >90 Days
1990 0.82 0.78 0.29 0.51 0.44 0.26
1991 0.83 0.86 0.35 0.52 0.5 0.22
1992 0.7 0.8 0.34 0.44 0.47 0.26
1993 0.65 0.79 0.31 0.39 0.43 0.22
1994 0.69 0.76 0.33 3.43 0.43 0.22
1995 0.72 0.73 0.33 0.47 0.41 0.25
1996 0.73 0.63 0.33 0.44 0.32 0.24
1997 0.75 0.65 0.37 0.46 0.35 0.27
1998 0.73 0.64 0.37 0.44 0.32 0.27
1999 0.67 0.6 0.3 0.37 0.28 0.212000 0.79 0.66 0.31 0.44 0.28 0.23
2001 0.87 0.78 0.38 0.55 0.35 0.28
2002 0.79 0.82 0.37 0.5 0.42 0.27
2003 0.71 0.8 0.4 0.84 0.3 0.2
2004 0.66 0.73 0.4 0.35 0.29 0.2
*Percent of outstanding loans
Note: data are as of year-end except for 2004 (1st quarter)
Source: Mortgage Bankers Association
As quoted in Freddie Mac Factbook 2004
Table 3 - Regression results for quarterly data
Firm 0
1
2
N R2
adjR2
FNM 8.98 (12.35) -1.19 (1.15) 17.30 (22.50) 32 0.05 -0.01
FRE 98.83 (42.89) -13.01 (3.74) 183.26 (77.34) 17 0.60 0.54
SLM 0.49 (2.20) -2.63 (1.58) 2.84 (2.05) 17 0.17 0.05
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Chart 1 60-90 day U.S. delinquency rates Chart 2 - >90 day U.S. delinquency rates
U.S. Delinquency Rates 60-90 days
0
0.2
0.4
0.6
0.8
1
1990
1992
1994
1996
1998
2000
2002
2004
Percentoutstanding
loans
All Loans
Conv Loans
U.S. Delinquency Rates >90 days
0
0.2
0.4
0.6
0.8
1
1990
1992
1994
1996
1998
2000
2002
2004
Percentoutstanding
loans
All Loans
Conv Loans
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Stiglitz, Joseph E., 2002, Globalism's discontents: integration with the global economy
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ENDNOTES
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1UK Pledges Intl Debt Relief; Urges Other Lenders Do Same The Wall Street Journal. September 26, 2004 Found at
http://online.wsj.com/article/0,,BT_CO_20040926_001724,00.html. The U.K. pledge was augmented by more concrete
pledges made at the G8 Glenn Eagle summit, held in June, 2005, Scotland, U.K. See IMF Survey, Vol. 34, No. 13, July 18,
2005, p. 2003
2 In general, the concept of moral hazard stems from the idea that insurance against some unforeseen event may actually
encourage it to occur. As applied to multinational finance, the IMF has arranged standby funding packages for several
emerging-market countries in financial crisis. Several experts have expressed concern that this could have long-term
adverse effects on the world economy. For creditors it encourages lending to poor countries without factoring fully the
importance of financial risk. Thus, some debtor countries may obtain financing without undertaking needed economic
reforms.
Another case of moral hazard exists when we see the private creditors egging the IFIs on to bail out the bankrupt
debtor countries, although we know that it would be better, from an efficiency standpoint, if they could precommit
not to bail out the countries in distress. Bulow (2004), further states the IFIs are probably making loans that earn zero
economic profits. Therefore the IFIs facilitate excessive lending. (ibid, p.6)
3 Sachs (1986) has outlined the free rider problem of renegotiating debt in the current environment. When a country
defaults on debt involving several creditors it is to a creditors advantage to hold out in any renegotiations, rather than join
in with the rest of the creditors. In this way the creditor may sue to enforce their legal rights and obtain a better settlement
than other creditors, which can cause a destructive race to force a debtor to pay through the courts. Balanced against this is
the problem of jurisdiction. The fact is, that these lawsuits are brought in a country other than the debtor country. Unless
the debt is secured by collateral located in another country the debtor nation can simply refuse to pay.
4 Informational asymmetries arise when the assumption of perfect information of neoclassical economics theory is violated
by the presence of differential information among the market participants engaged in negotiations and/or transactions. The
presence of such informational asymmetries may affect asset values through a nexus of economic distortions that manifest
themselves as agency costs, signaling costs, moral hazard costs, free rider costs, and adverse selection costs,
among others. In general the presence and costs of informational asymmetries are higher in the mixed market economies of
the developing (debtor) nations than they are in the market economies of the G7 (creditor) countries. Much of the problem
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can be traced to lax accounting standards, poor record keeping and internal auditors controled by those audited. The
consequences of this agency-like phenomenon are compounded by the confounding of the roles of those being audited
(agents) and those performing audits (principals) (Johnson, 1992).
5 The consequences of this agency-like phenomenon are compounded by the confounding of the roles of those being
audited (agents) and those performing audits (principals). The reader is referred to the alleged involvement of Goldman
Sachs in restructuring the books of the Greek Government. This, in effect, handed Greece a $1 billion loan from the
eurozone in exchange for $300 million in fees for the restructuring efforts of the investment bankers (see Michael Lewis,
Boomerang, W.W. Norton company pages 12-21).
6 Dailami, et al, also cite a paper by Masson (2003) who found that co-movement of EM spreads was lower in crises
subsequent to the Asian crisis, indicating greater differentiation among countries. Ibid, p.27
7 The above arguments notwithstanding, Bulow, Rogoff and Bevilaqua (1992) inform us that Hardly any debt to the IMF
or the World Bank has ultimately defaulted. However, when there is a loan default to the IFIs, as Jeanne and Zettelmeyer
argue, the moral hazard is born by the domestic taxpayer in the debtor countries.
8 Since Russia has recently become a free-market republic these results should be viewed with healthy skepticism.
9 It should be noted here that since the early 1970s many science and technology based companies have employed SPEs to
finance their research and development activities. Known variably as SWORD or R&D limited partnerships (LPs) these
spun-off entities have become the financing vehicles of choice for chemical and pharmaceutical companies, where R&D
activities are characterized by high costs of financing, long horizons, great uncertainty and lengthy regulatory approval
processes. Such R&D SPEs involve an additional type of agency problem, i.e. between the investors of the SPEs and the
management of the parent company. Of course, the ultimate test for SWORDS and R&D LPs as financial innovations is
whether they enable parent companies to raise capital at a lower cost for a unique class of assets like R&D or to raise capital
that could not be gathered through other traditional financing modalities.
10This enables countries such as the United States to guarantee $30 billion in loans while showing on the books that the
World Bank membership has only cost them $2 billion throughout its history (Bulow, et.al (2002) p.236).
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11 While we realize that the problem associated with the sub-prime loan crisis have put these companies in the spotlight we
also believe that their long and successful record will ensure their future survival in some enhanced organizational forms.
12 CBO Papers, The Experience of the Stafford Loan Program and Options for Change, Congressional Budget Office, 1991
13 Credit-enhanced loans are loans for which the lender or a third party has retained primary default risk by pledging
collateral or agreeing to accept losses on loans that default (e.g., private mortgage insurance provider). In some cases, the
lender's or the third party's risk is limited to a specific level of losses at the time the credit enhancement becomes effective.
14 The net effect of higher default rates, higher interest rates, and credit enhancements
15 Many of the computational details are shown in an appendix, in order to keep the size of this paper within proper limits.
This detailed appendix is available from the authors upon request.
16 Securities issued or guaranteed by Fannie Mae or Ginnie Mae
17 Rely primarily on subordinated tranches to provide credit loss protection and therefore limit exposure counterparty risk
18 Triangular distributions are chosen over normal distributions to ensure positive percentages and over uniform
distributions to capture estimated central tendencies
19 These are flow-through securities.
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