The following post is by a hedge fund manager friend of DB who shall remain nameless. He runs the emerging markets desk at his firm.

Brazil has been one of the most confidence-inspiring credit stories in Emerging Markets. At the end of September, Moody’s awarded the country an investment grade rating. But while most of the market showers praise on the tightest-of-the-Latin-majors credit spreads, the 6 Bs of ratings, and dollar-crushing currency, a certain class of creditors is shouting about an imminent default. Their shouts are going largely unheeded, and they are learning a hard lesson about sovereign lending to Emerging Markets. In EM, there is no solidarity among creditors.

The controversy relates to a class of debts called precatorios. These are instruments representing judicial claims against government entities - the federal government, states, and municipalities. While this might sound like a small and obscure corner of government finance, litigating against the government has become something of a Brazilian national pastime. Hopeful plaintiffs don’t lack for grounds of complaint. The inflation stabilization plans of the 1980s imposed very complicated monetary correction formulae on all manner of wages, pensions, and prices, sparking disputes that continue to this day. Price controls on ethanol, also from that happy decade, have likewise spawned generation-spanning suits. At the same time, Brazilian jurisprudence has an incredibly expansive notion of direitos adquiridos - “acquired rights” - that cannot be messed with. Think of it as the insanely broad conception of fault that you find in American malpractice law, applied to the field of takings. Any meaningful reform creates losers; in Brazil they are only losers (from a new law or policy) as long as it takes to sue the government, at which point they become winners (of a lawsuit). In fact, government legal losses have consistently enough generated large liabilities for the government that most analysts’ fiscal projections still include a line for “skeletons” - the term of art for old claims that get adjudicated against the government.

In the 1990s, the claims piled up so high and fast that many government entities ended up with a major backlog of unpaid claims, which spawned even more court battles. The government decided to grasp the nettle and regularize the situation. In 2000, it created a new regime for precatorios. Precatorios would be transformed into a debt-like instrument, amortizing in equal installments over 10 years and paying interest linked to an inflation index. The precatorios were to be paid strictly in chronological order - that this needed to be spelled out is a bit of a strange concept given that an amortization schedule was established, but the Brazilians, having an admirable degree of self-knowledge, anticipated that even under the new regime payments might fall behind schedule. The point was that the government couldn’t pay some favored holders ahead of others. To the extent a holders faced delays in payment, he could move to “arrest” assets of the debtor government.

The federal government has for years now been up to date in its payments on precatorios. State and municipal governments have proved somewhat less punctual. Their days of fiscal murder are still ongoing, and so new skeletons pile up. All told, Brazil has accumulated more than R$100 billion in debt under precatorios. Just as no pile of carrion will sit for long without attracting vultures, the huge supply of precatorios - fixed-income-like claims against sovereigns in a jurisdiction with tightening credit spreads - didn’t take long to garner the attention of securitizers. Deutsche Bank, for example, issued two FIDCs (these are Brazilian mutual funds) with a mandate to buy Federal precatorios. With Eurobond spreads having plunged to meager levels, by 2006 and 2007 offshore banks and hedge funds saw buying precatorios as a way to squeeze a few hundred basis points more out of taking Brazil risk,. Sure, they’re less liquid than bonds and, yes, they aren’t exactly bonds legally speaking, but they’re Brazilian debt, right? And Brazil’s the country of the future, on a steady march toward fiscal sustainability, investor-friendly norms, and good governance… right??

At the same time, many state and municipal governments found precatorio payments taking up an uncomfortably large chunk of available fiscal resources. Moreover, Brazil’s much-praised Fiscal Responsibility Law imposes a fiscal straight-jacket on these governments: they can’t borrow in the market to meet the precatorio payments. Violation of the FRL can lead to criminal liability for governors and mayors. Stuck between the hammer and the anvil, they needed an extraordinary solution. Their alighted on the idea of a constitutional amendment to override the rights of precatorio-holders.

The so-called PEC 12 would radically revise the precatorio regime, and would apply not just to future precatorios but to precatorios already issued. PEC 12 first off makes sure no government, regardless of how large a balance of precatorio debt it racks up, will face meaningful fiscal pressure as a result. Governments would be able to impose a limit (it ranges from 0.6% of revenues to 2.5% of revenues, depending on a variety of factors) on annual payments on precatorios. Running the maximum payments against revenue projections and precatorio balances, one finds that under PEC 12 it would take some states nearly a century to pay off their entire balances! Meanwhile, PEC 12 increases the cost to creditors of waiting: the amendment would change the interest rate on precatorios from inflation + 6% to poupanca rate (the rate on state savings accounts), historically a much lower rate.

While the above changes benefit debtors at the expense of all creditors, PEC 12’s other components seem designed specifically to spite financial investors in precatorios and precatorio securitizations. First, the issuing entity of a precatorio will be able to set-off precatorio payments against any tax debts of the original awardee, not merely at the time of award, but on any subsequent payment date, regardless of whether the original awardee still owns the precatorio and regardless of whether the tax debt predates or postdates the issuance of the precatorio. Given that precatorios might now stay outstanding for twenty years, how secure would you feel owning a precatorio originally awarded to some random ethanol producer, knowing that your precatorio payments could be intercepted if that random ethanol producer ever gets into a tax dispute with the government? Second, PEC 12 changes the order of payment of precatorios. Recall that before, strict chronological order prevailed. Instead, 50% of the available resources for precatorio payment would be dedicated to buying back precatorios via auction. Holders would bid according to how large a haircut they would accept. The remaining 50% would go to pay precatorios in reverse order of size. That is: smallest first. Financial investors have generally bought only the largest precatorios due to the high fixed per-transaction due-diligence costs. You might have bought a precatorio issued in 2006, originating from a lawsuit from the 1980s, but if police officer Joao Souza convinces a judge that his pension payments were off by R50 per month for the last year, he’s going to get paid first.

While the amendment was introduced in 2006, lobbying by the most heavily indebted states and municipalities (led by the state of Sao Paulo, which owes R$20 billion) only managed to get the legislative process in gear last year. The amendment passed the Senate earlier this year. This week, the lower house commission on constitutional issues voted in favor, which sends PEC 12 to the House floor, where it needs 2/3rd majority to pass and become effective. Until very recently, foreign holders of precatorios seemed pretty relaxed about PEC 12, believing it would sink in the mire of Brazilian legislative apathy. And indeed, simple failure to get a quorum - i.e. to persuade those diligent Brazilian representative and Senators to get their asses back to Brasilia on time - has doomed many a worthy law. But now that PEC 12 is a mere single step away from becoming law, foreign investors are starting to react.

They join a constituency that has waged a lonely battle against PEC 12, the Brazilian bar association (OAB). While it would be nice to believe that an abstract dedicated to the rule of law compels the OAB to take on the deadbeat politicians, OAB’s pugnacity probably has more to do with the fact that lawyers in suits against the government typically get paid on contingency. That means they get paid in precatorios! Many of the precatorios peddled to investors came not from plaintiffs but their lawyers.

Unfortunately for OAB and the foreign investors, they’re finding that they don’t have effective tools to derail PEC 12. OAB has argued that PEC 12 would represent a default on the part of Brazil. It’s pretty fair argument: the precatorios had a certain interest rate and amortization schedule, and those have been unilaterally changed to creditors’ detriment. The flaw isn’t so much in the argument, but in its consequences, or lack thereof. None of the ratings agencies, except local agency Austin Ratings, has shown any concern that this “default” on precatorios might require a re-evaluation of Brazil’s investment-grade rating. The foreign banks involved in precatorios have even had difficulty getting the Emerging Markets Trading Association (EMTA) to take a position on PEC 12. The many EMTA-member banks that have lucrative government business in Brazil, but small or non-existent precatorio holdings, resisted association with any statement or action than might offend Brazil. The precatorio holders can make as persuasive an argument as you please about how PEC 12 demonstrates a profound disrespect for the rights of creditors, an attitude that should give pause to anyone considering buying debt of Brazil, but the fact is that bondholders only appear to care about Brazil’s attitude toward eurobonds.

It’s an issue you see with other cases of unusual credits: Russia FTO debt, Nicaraguan land bonds, Argentine local law paper, Dominican Republic prom notes. They may be morally or even legally pari passu to bonds; their shabby treatment may reflect some deep truth about the local credit culture; but if bondholders are getting paid, they aren’t going to go on a buyers’ strike or make a stink to protect the guys who bought a weird credit several hundred bps cheap to the bonds. When they came for the precatorios, I said nothing, because I was a Eurobond…. When considering the likelihood of differential or selective default, it doesn’t matter whether you believe your debt ranks the same as the benchmark debt. It only matters whether the holders of the benchmark debt think your debt ranks the same. From the look of it, Brazilian Eurobond holders don’t think so highly of precatorios.