Don't Drink The Water

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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.
Emerging Markets and derivatives are like alcohol and barbiturates: each on its own has attractions but create a recipe for choking on one's own vomit when combined. And despite all warnings, rock stars (or in the case of finance "rock stars"), real and aspiring, continue to do just that. The latest set of investors to get the Jimi Hendrix experience: writers of CDS on the Kazakh financial institution BTA Bank. The bank, by some measures Kazakhstan's largest, declared its intent to restructure its debt back in late April, after the authorities alleged its loan book to be riddled with undisclosed related-party deals and its controlling shareholder, Mr. Mukhtar Ablyazov, fled the country. On a loan book of KZT 2.4 trillion, it has now provisioned nearly KZT 1.5 trillion, the sort of write-down that makes Merrill Lynch look like a bunch of pikers. Sadly for creditors, it didn't occur to Mr. Ablyazov to try to pitch the bank to Ken Lewis.
The chicanery at BTA Bank itself is another story, though. ISDA's Determinations Committee declared a credit event on April 29th. The baleful interaction of EM and derivatives relates to the CDS credit event auction. BTA Bank had issued a fairly full curve of eurobonds, most of which traded in the wake of the default in the mid-20s. The spirit of creativity was strong with the Kazakhs, though, and the bank was understood to have done a fair number of private deals. Less well-understood was the magnitude of off-balance sheet borrowing. A few "shell" borrowers - reputedly related to BTAS's controlling shareholder -- had taken out loans from western banks, which in turn got guarantees on these loans from BTA. The "shell" borrowers in turn onlent to Ablyazov-related entities (as Borat would say, "Naughty, naughty!"). Credit Suisse was the most active lender; at the time of making the loans - which yielded a premium to other BTAS obligations - it had gone and hedged itself by buying CDS from the market.


The diffuse suspicion came into crisp focus when ISDA published the list of BTAS's deliverable obligations. Alongside fifteen Eurobonds and a few bilateral loans, there appeared the following:
-- Guarantee from JSC Bank Turanalem in favour of Credit Suisse, London Branch as facility agent dated 23 November 2005 and as amended and restated on 30 November 2005 and 23 March 2006, relating to the US$50,000,000 Facility Agreement between Ergen Trading, Ltd as borrower, Credit Suisse International as original lender and Credit Suisse, London Branch as agent and arranged dated 29 November 2005 and amended and restated on 20 March 2006
-- Guarantee from JSC Bank Turanalem in favour of Credit Suisse, London Branch as facility agent dated 15 December 2005 and as amended and restated on 23 March 2006, relating to the US$50,000,000 Facility Agreement between Mintex Trading, Ltd as borrower, Credit Suisse International as original lender and Credit Suisse, London Branch as agent and arranger dated 14 December 2005 and amended and restated on 4 March 2006
-- Guarantee from JSC Bank Turanalem in favour of Credit Suisse, London Branch as facility agent dated 15 February 2006 and as amended and restated on 14 March 2006, relating to the US$50,000,000 Facility Agreement between Berment Ventures, Ltd as borrower, Credit Suisse International as original lender and Credit Suisse, London Branch as agent and arranger dated 15 February 2006 and as amended and restated on 14 March 2006
-- Guarantee from JSC Bank Turanalem in favour of Credit Suisse, London Branch as facility agent dated 9 October 2006, relating to the US$75,000,000 Facility Agreement between Group of Companies "Titan" Limited Company as borrower, Credit Suisse International as original lender and Credit Suisse, London Branch as agent and arranger dated 6 October 2006
-- Guarantee from JSC Bank Turanalem in favour of Credit Suisse, London Branch as facility agent dated 4 August 2006, relating to the US$50,000,000 Facility Agreement between United Clearing and Processing Company Limited as borrower, Credit Suisse International as original lender and Credit Suisse, London Branch as agent and arranger dated 2 August 2006
Though the information provided was exiguous - note that the list provided no information on the borrowers of record besides their names (frankly comical - Mintex Trading? Group of Companies "Titan" - did they ask for advice in sketchy SPV-naming from Andy Fastow or the Parmalat guys?), nor even the interest rates or maturity dates of the underlying loans - what was provided was enough to provoke concerns. Given the accusations about related-party lending to Ablyazov, how would Kazakh authorities treat these guarantees? The Kazakh government, through its holding company Samruk-Kazyna, had taken control of the bank and would propose a restructuring. Recovery value for each instrument would depend largely on what the Kazakh government proposed, not on a clear-cut developed-markets bankruptcy process. So the Kazakh government's attitude toward a particular obligation or class of obligations could turn out to make a huge difference in ultimate recovery.
Given the questions about these guarantees, how did they end up on the deliverable obligations list? Clearly, Credit Suisse proposed them (as it was their right to do) to the Determinations Committee. The DC engaged Allen & Overy to perform legal review of proposed deliverable obligations. But A&O's review consisted - again, in line with ISDA's rules for credit derivatives -- of a narrow checking of the proposed obligations' characteristics against the deliverable obligation characteristics of the standards CDS contract: is the obligation senior, for example? Is it under foreign law? Is it in one of the specified currencies? These guarantees met all those rather simple formal criteria. Any market participant could appeal the DC result, but on his own dime. And it didn't appear that the challenge would lead to a review of something as uncertain and legally nebulous as whether the obligation would be somehow treated a suspect by Kazakh authorities. Here's an example of the pernicious interaction of developed-markets-oriented derivatives rules with emerging markets realities. For a developed-market corporate, that an obligation is by US or UK-law lights a valid, senior claim in a specified currency is enough to know that it will end up treated like other valid, senior claims. When it comes to an emerging market borrower, however, that might represent just the beginning of the story.
Initially, though, concerns about the guarantees stayed rather muted. Up until just before the auction date, several dealers remained willing to bilaterally cash-settle outstanding CDS at a mere two or three point spread to liquid bond prices. But as the auction date approached, market participants' worries about the guarantees sharpened. On a call the new management of the bank held for creditors, one hedge fund manager asked a question about whether the bank considered any contingent obligations incurred by the old management illegitimate. The bank's representatives refused to answer. Since CS held CDS against the guarantees, it seemed likely that practically the full amount would get physically delivered. That meant that if a protection writer opted for physical delivery, he would face a meaningful probability of getting delivered these guarantees. On the morning of the auction, The FT's Mergermarket published a short note about questions surrounding the guarantees.
Still, in the first round of the credit event auction, dealers made inside markets that suggested a recovery around 22 cents, not that far below where bonds were indicated. That confidence evaporated, though, when the initial round showed a whopping $809 million of net demand to sell paper in the final round of the auction. Writers of protection had considered the guarantee issue and individually decided they'd rather not deal with it - opting instead for cash settlement at the auction determined price. Alas, with so many opting for cash settlement, there was a huge overhang of paper, and few bidders. To make matters worse, those bidders had to bid for guarantees they knew very little about. The underlying loans had confidentiality clauses. Getting a look at the underlying docs meant signing a confidentiality agreement. That could imply coming into possession of material non-public information, which in turn would make it impossible to bid in the auction! Joseph Heller, call your office! Bids, then, were scarce and totally overwhelmed by selling interest. The auction cleared at 10.25.

For those who bid in the auction, here's where the spirit of Monty Hall spiced up their day. Creditex (the manager of the auction) paired up each dealer with other(s), and deliverable obligations were exchanged (and passed on by the dealers to their respective bidding clients). Some writers wound up with bonds - worth around 25. Others found behind curtain #2 a goat named Mintex (or Ergen, or "Titan), which ended the day bid at 13. Of course, that's still better than the 10.25 recovery for accounts that chose cash settlement. Ironically, based on the way the pairing works, bidders through Credit Suisse (or CS itself if it chose to bid for itself) had the best chance of getting mostly "good" deliverables.
Now, the cheapest-to-deliver option has always been a feature of CDS. And since the recent institution of auctions, the market has seen several instances of auction-clearing levels coming in meaningfully below where liquid bonds are trading right in advance of the auction (Lehman being an example). But 10.25 clearing price for a credit with bonds trading in the mid-20s is something else entirely (for comparison: Alliance Bank, another defaulting Kazakh bank saw its auction clear within a point of the inside market midpoint and in line with bids for its bonds; it had no unusual deliverable obligations). It's precisely EM's relative lawlessness than makes its difficult to adapt derivatives to them. There's always some crazy eventuality that an emerging market can generate that defies the most thoughtfully drafted contract. As for the guarantees, the lucky new owners must wait to find out whether they'll be considered true creditors. BTA Bank says it will announce its restructuring proposal later this summer.

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