From Bad Debts to Healthy Securities? The Theory and Financial Techniques of the Brady Plan

By Dr. Walter T. Molano, Director of Economic and Financial Research, SBC Warburg

Introduction

Crisis and Response

Securitization of Debt

Introduction

The 1982 moratorium on debt service by the Mexican government sent powerful shock waves through the global financial system. Most financial institutions immediately shut-off credit to developing countries. Isolated from the international capital markets and lacking the level of domestic savings needed to service external obligations, most developing countries began to experience severe debt servicing problems. The result was the beginning of a decade-long crisis where many financial institutions were brought to the brink of failure and economic development in most emerging countries stagnated. Although the financial community and the debtor countries wished to arrive at a speedy resolution to the crisis, there were several obstacles. One of the most important problems was the inflexibility of the debt structure.

Loans to developing countries represented some of the most innovative features of the modern financial system. For example, most of the loans were issued by syndicated groups of private sector banks; thus, allowing the dissemination of risk. Yet, at the same time these loans failed to accommodate some of the more important realities of the modern financial system. Principally, the loans were very rigid, thus hampering the transfer or selling of portfolios. Hence, commercial banks were faced with few options when the risk situation in the debtor countries or the risk profile of the banks changed. Unable to get the loans of their books, the banks watched the credit profile of the debtor countries deteriorate. This situation was exacerbated by the large penalties and arrears that, in some cases, more than doubled the outstanding debt. Since the loan structure provided no room for maneuvering, banks could either allow the countries to default or demand full restitution. Of course, they demanded the latter. What was needed, however, was a little financial flexibility to allow a return of liquidity. A solution finally appeared in 1989, in the form of the Brady Plan.

The Brady Plan brought the 1980s debt crisis to an end by securitizing the existing debt and allowing market mechanisms to allocate the risk. Indeed, by liberalizing the very rigid lending model of the 1970s, the Brady Plan allowed a greater range of flexibility to debtors and creditors. This not only allowed the dissemination of risk across a heterogeneous pool of agents, but it also allowed economic agents to price the debt securities according to market, economic, and political conditions, without overburdening any particular organization. The use of market mechanisms also provided investors with rewards in return for the assumption of risk.

Furthermore, the securitization of debt provided a catalyst to promote further investment in the region. The recent Mexican devaluation has demonstrated that this type of market approach has imbued the emerging markets with a new resilience to face and absorb external shocks while minimizing the economic damage. When compared to the number of years it took after the 1982 debt crisis to restore capital inflows into Mexico, the mere five months that it took for positive inflows following the 1994 devaluation was very short. One important explanation for the relative rapid recovery was the ability to use market mechanisms to asses risk and reward that was obtained from the securitization of foreign debt through the Brady Plan.

Crisis and Response

What was initially labeled as a short-term liquidity crisis exploded into a decade long crisis of global proportions. Rising interest rates and depressed commodity prices exacerbated the crisis. At first, commercial banks attempted to resolve the problem by themselves, but it soon became clear that they lacked the necessary resources and will to arrive at a coordinated solution. By the mid-1980s, many multilateral and government agencies were forced to intervene. The banks and multilateral lending agencies demanded that the debtor countries stabilize their economies through sharp cuts in government spending and fiscal austerity. Unfortunately the measures were largely ineffective in generating repayment since they only pushed the economies deeper into recession.

In 1985, Secretary of the Treasury James Baker, announced a coordinated plan that would provide $29 billion in new loans in return for significant structural reforms. The plan, which later became known as the Baker Plan, shifted the emphasis from price stabilization to economic growth through structural reforms. Of the $29 billion promised by Secretary Baker, $20 billion would be involuntary lending by the banks and $9 billion would be in official credit. Banks would provide new credits, in the form of New Money loans, in exchange for economic reforms. The New Money approach provided countries with funds at relatively low rates (13/16s above LIBOR). The problem was that the time horizon was very short (1-2 years) and countries never seemed to have enough time to get their economies back on track. Thus, debtor countries found themselves at the re-negotiation table every few years. What was needed was a more permanent solution to the problem through significant debt reduction (Islam, 1989 and Clark, 1993).

In addition to the time horizon problem, there was also a growing realization that institutional constraints faced by many creditor banks were hampering a uniform solution to the crisis. Indeed, accounting rules differed significantly across countries. Some countries allowed banks to carry debt instruments at historical values while other countries’ accounting rules forced banks to mark them to market prices (Cohen, 1986). Hence, banks carrying loans at historical prices had an added incentive to demand full restitution of loans in order to avoid the sharp realization of loan losses. While banks already writing loans down to market prices could sustain a large write off that often was less than the market price. For example, by the late 1980s Argentine debt was being traded at 12 cents on the dollar, hence a 35% write-off would actually translate into a gain for a bank marking an Argentine loan to market. Thus, it was becoming impossible to arrive a coordinated solution. It some became evident that what was needed was a menu of selections to offer banks with a wide range of options.

Finally in 1989, a new coordinated restructuring plan was announced by Secretary of the Treasury Nicholas Brady. The so called Brady Plan, again offered official credit in return for the implementation of IMF-sanctioned structural reforms. Debtor countries were required to make fundamental changes which would foster investment, internal savings, and promote capital repatriation. The official credit of the Brady Plan, however, would be used to help reduce debt levels through Paris Club restructuring and the issuance of a new class of securities, thus enhancing the creditworthiness of the debtor countries. In other words, the Brady Plan required countries to establish an IMF-sanctioned stabilization plan and negotiate its Paris Club debt prior to renegotiating its commercial bank debt. Furthermore, the plan required banks and debtor countries to resolve or negotiate interest arrears situations.

The Brady Plan recognized that the problems of developing country debt was one of creditworthiness and liquidity. Therefore, one of the fundamental tenets of the new plan was the provision of guarantees for new securities that would be exchanged for the existing commercial bank loans (Unal, Demirguc-Kunt, and Leung, 1989). In the process much of the credit risk was transferred from the commercial banks to the multilateral lending agencies. In contrast to the Baker Plan, the Brady Plan focused more on obtaining debt reductions than providing new credits. Furthermore, debt reductions mechanisms very flexible and were negotiated on a case by case basis. They also were allowed to take the form of buybacks, swaps for new instruments, and debt-equity swaps. The World Bank and IMF agreed to set aside 25% of their funds ($30 billion) for debt restructuring programs. Last of all, the creditor countries agreed to make changes to their domestic laws in order to facilitate the reduction of debt levels.

Securitization of Debt

While Brady bonds come in many types and options, there are several consistent characteristics. The similarity stems from the fact that creditor banks were provided with a menu of three options for the restructuring of commercial debt. The first set of options allowed banks to exchange loans for a series of new sovereign bonds. Banks could either exchange original face value of the loans for new 30-year par bonds that paid fixed, however below market, interest rates. Otherwise, the banks could exchange the discounted amount of the loans, usually a 35% discount, for new 30-year bonds that paid a floating interest rate of LIBOR plus 13/16s. Hence, a new class of securities called Brady bonds were created. Banks declining either option had a third choice. This was the provision of new loans over a four year period to cover 25% of old loans and restructuring payments.

Bank or creditor preferences were not only contingent on institutional constraints, such as whether they would be penalized for accepting a sharp discount of the face value of the loan, but also on what the outlook was for future interest rates. For example, institutions expecting a decline in interest rates would tend towards the fixed rate option because the value of their bonds would increase as global interest rates declined and prices of fixed rate securities increased. Those institutions expecting an increase in global interest rates, however, would prefer to lock into floating rate instruments in order to obtain rate protection. Of course, the third option was basically for those institutions refusing to restructure their debt. Nonetheless, they had to lend new money in order to prevent free-riding from those institutions offering restructuring options. Interestingly, the latter option was the one selected with economic agents that had the most positive outlook on the country. For example, the Venezuelan Brady deal was completed at a time when the future looked bright. Most investors chose the new money option whereby a dollar in old bonds was tendered for a dollar in Debt Conversion Bonds (DCBs). Additionally, the investors provided new capital that were countered by a New Money Bond. The same occurred during the Brazilian Brady deal. Investors with a pessimistic view of the countries, however, tended to select Par bonds.

As Brady deals became more attractive, however, the bargaining power of the countries vis-à-vis creditors shifted. Initially, countries were forced to raise all of the collateral, past-due-interest (PDI), and rolling interest guarantees (RIGs) prior to the completion of the deal. Mexico, for example, was forced to pay all collateral and PDI prior to competing the agreement. The reduction on discount bonds was 35% and the government had to provide 3 guarantees. Venezuela had the same conditions except the guarantees were reduced to 2.3. Argentina was the third major Brady deal. The creditors eased the terms further by allowing the PDI to be securitized into Floating Rate Bonds (FRBs) and the guarantees were reduced to 2. The government also strong armed the banks into accepting a mix of discount and par bonds that was more favorable to the country. By the time Brazil implemented its Brady plan, the country was in the driver seat vis-à-vis the creditors. The country was allowed to phase in the RIGs, the PDI was securitized, and the government dictated the mix of discount and par bonds. The next three Brady deals eased the terms even further. Poland, Ecuador, and Peru were allowed 45% reductions in principal on its discount bonds, versus the normal 35% haircut, and all guarantees were waived. Peru even received a reduction in the PDI.

It was clear that each successive Brady deal increased the demand for the new instruments. Brady bonds became very attractive to investors for four major reasons, First of all, they represented collateralized U.S. dollars denominated instruments that offered both fixed and floating interest rates. Second, Brady bonds provided very attractive yields at a very opportune moment--especially since Bradies were introduced during a phase of credit expansion when the U.S. Federal Reserve was easing interest rates. Many investors hungry for higher yields immediately grabbed onto Brady bonds. Third, Brady bonds also featured major institutional improvements over sovereign loans that facilitate trading and ownership. Brady trades were cleared through the Euroclear system, a bond clearing system designed for Eurobonds, and transactions could be completed in 7 days. This was a vast improvement over the clearing procedures for bank loans. Loan trading agreements needed special assignment documents and notices had to be sent to the appropriate agents.

During the late 1980s, at the height of loan trading, closings were completed on a 21-day cycle. But sometimes it took up to several months to complete a transaction due to complications with the calculation of due interest amounts, past due interest, penalties, and arrears. Last of all, par and discount bonds offer an additional collateral amount to pay interest for a specific number of months (usually 12 to 18 months) in the event of missed payments. This collateral became known as a rolling interest guarantees (RIGs) and varied according to each Brady deal. The collateral could be in the form of AA- or better rated securities, and they are usually deposited at the Federal Reserve Bank of new York. For example, Mexico had three rolling interest guarantees, while Argentina had two. Each time that an interest payment is made and the collateral is not utilized then the RIG is rolled to secure the next unsecured semi-annual interest payment.

Given the standardized approach to debt restructuring, Brady style restructuring became appealing to debtor countries. As of August 1995, thirteen countries had availed themselves to this opportunity and issued Brady Bonds with a cumulative face value of $154 billion.

Although all of the major developing regions (Africa, Asia, Latin American, and Eastern Europe) implemented Brady debt restructuring programs, Latin America stands out as the region that used it the most. Indeed, in 1992 Latin America accounted for over 90% of all Brady instruments. Although its market share declined to 82% in 1994, it was still by far the most important region in the Brady market. One obvious reason for the prominence of the region in the Brady bond market was its large stock of commercial bank debt. However another more important reason lies with the fact that the region consists of middle income countries that offer the promise of high economic growth. One of the major impediments to growth and development, however, was a lack of international credit and the large debt overhang.

In addition to the rush to perform Brady type of restructuring, the demand by investors for Brady debt instruments also exploded. The securitization of developing country’s debt was warmly welcomed by the financial community. Indeed, many financial institutions were able to make handsome rewards from trading-related activities. Volatility in the secondary markets has been an important source of profits for many investors and financial agencies. The strong increase in trading volume and turn-over confirms this point. Commercial banks also saw the Brady deals as a much needed opportunity to divest problematic emerging market debt. The Economist reported that, by the end of 1990, the 9 largest U.S. banks had halved their exposure to emerging markets.

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