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ISDA PRESS REPORT - DECEMBER 19, 2001
CREDIT DERIVATIVES * Bank of England warns on trading practices - IFR LATIN AMERICA * Vulture firms begin to set their sights on troubled Argentina - Financial Times * Telefonica bids to shield at-risk Brazil interests - Financial Times REGULATORY * Armey Would Split Derivatives Issue From Stalled Bankruptcy Reform Bill - BNA Bank of England warns on trading practices IFR - December 15, 2001 The Bank of England (BoE) last week sounded warnings about the increasing use of credit derivatives to transfer credit risk and counterparty risk management practices. Its half-yearly financial stability review examined the transfer of credit risk between the banking and insurance sectors. It noted that markets for risk transfer are, in principle, beneficial because they allow greater dispersion of risk. However, the BoE said that it is important for regulators to track whether or not concentrations of risk might decline in some places only to re-emerge in others. In particular it cited unfunded risk transfer as being difficult to monitor. "If flows of risk are not accompanied by flows of funds (insurance or derivatives), they become harder to track in aggregate," the report said. The review discussed possible areas where seemingly transferred credit risk by banks could revert to the sector. It said that some techniques used in deals such as synthetic securitisations can leave banks with residual risks, whether contractual or implicit. "The credit default swap market has not really been tested under a severe downside scenario and if the worst happens and the whole house falls down people may well find that none of their risk has actually been transferred," said one analyst who was sympathetic to the BoE's line. Credit derivatives dealers are more sanguine, however. "Often you have no option but to use credit derivatives to back up transactions. They can be used to get round regulatory and sourcing difficulties and some times they are just quicker and cheaper than the alternatives," said one dealer. The BoE also said that even in the instances where banks have genuinely transferred credit risk, there is a question as to whether the appetite of the risk takers will be sustained. "General insurers, reinsurers and life insurers might reduce their asset allocation to credit risk if losses were to increase materially during the current economic slowdown," said the report. The banks active in the credit derivatives market are confident that their risk transfer techniques work, but admit that losses for insurance company sellers of protection could threaten the continuing growth of the market. The BoE also questioned the extent to which the banking system can change from being the 'originator and holder' to 'originator and distributor' of credit risk, saying that this may be limited by the close link between credit and provision of liquidity. "Credit risk is being transferred from banks to insurance companies. But if credit losses crystallise in stressed market conditions, insurance companies may need to have recourse to the banking system in order to meet their obligations under credit risk transfer instruments," the report said. Elsewhere in its review, the BoE examined counterparty risk management and found that disclosure practice is still not sufficient to facilitate effective management. It said that banks have growing exposure to non-bank participants in over-the-counter derivatives and other capital markets, such as insurance companies, energy companies and large multinationals. The recommendations of the official and private sector reports on counterparty risk management following the LTCM crisis were addressed particularly to banks' hedge fund exposure. However, the Enron case shows that many apply more widely, particularly the need for counterparties to make adequate financial disclosure. Vulture firms begin to set their sights on troubled Argentina Financial Times - December 19, 2001 Edward Bozaan says he made money in Russia and Thailand soon after they devalued their currencies in the late 1990s. Now, the New York-based fund manager is considering buying assets in Argentina, Bloomberg reports. "I buy into extraordinarily depressed markets, and Argentina is definitely on my screen right now," says the 44-year old president of Waterford Partners, a fund management company whose promotional material contains pictures of tanks and explosions. "Its markets are really scraping bottom." As the country nears default on most of its Dollars 132bn debt and struggles to avert devaluation, Mr Bozaan says he and others who specialise in investing in countries in crisis are assessing whether prices have reached bottom after the Merval stock index fell to 10-year lows and bonds plummeted. Mr Bozaan's fund grew 114 per cent in 1999, helped by his purchase of Russian companies such as Vimpelcom Communications after the country defaulted on Dollars 40bn of debt and devalued the rouble. In the first nine months of this year the fund lost 17.9 per cent, compared with 26.6 per cent drop in the MSCI Emerging Market Index. Domingo Cavallo, Argentine economy minister, blamed foreign funds such as Mr Bozaan's for the country's troubles, saying they drove down stock and bond values and pushed up interest rates. That forced the government last week to limit deposit withdrawals to prevent a collapse of the banking system, Mr Cavallo said. "They are the same (funds) that got rich in Russia in 1998 and who attacked Ecuador and hurt the Ecuadorean people," Mr Cavallo said in a speech. "The same funds have been focused on Argentina in 2001." While many describe companies such as Waterford as vulture funds, Mr Bozaan says he is not responsible for driving down Argentine markets. "Some see my business as morbid, but it wasn't me who brought down the prices," says Mr Bozaan. "I see value in markets after they've been battered." In fact, any fund that buys Argentine securities would help the economy, says Charles Cassel, who helps manage Dollars 450m in emerging market assets at Standard Asset Management. "Vulture funds are a beneficiary to the economy in that they provide an inflow of capital at a time when it desperately needs it," he says. Mr Bozaan uses studies of past financial crises elsewhere as a guide to when prices may recover. "I strongly believe Argentina will become one of the best- performing markets in the world some day and that's when we'll make our money," says Mr Bozaan, who typically acquires shares that have dropped 60 per cent to 70 per cent in a market where the benchmark index has lost 50 per cent. By Mr Bozaan's rule, he should already be investing in Argentina. Since January 1, the Merval has dropped by half and leading stocks such as Grupo Financiera Galicia, a bank holding company, have fallen more than two thirds. The benchmark floating rate bond due in 2005 gained a second day to yield about 60 per cent. The Merval, now trading at levels last seen in March 1991, rose 1.5 per cent. "There are many corporate stocks and bonds that would be extremely interesting once uncertainty over the government's restructuring and future is cleared up," says Richard Segal, director of research at Exotix, ICAP's London-based debt brokerage. Mr Bozaan says he has not yet invested because he believes the government may devalue the peso, which was fixed at par with the US dollar in 1991 and is a key reason, economists say, why Argentine industry is unable to compete with cheaper imports. "There's definitely more downside to come," says Mr Bozaan. "I want to see some resolution in what the government will do. If Argentina devalues after I've bought, the fund could lose a lot of money." Mr Bozaan says his interest in Argentina has grown as the country suffers an increase in public protests against rising unemployment and cuts in government spending on salaries, pensions and health. "I bought after China's Tianenmen Square massacre, Peru's Shining Path crisis and Thailand's riots," he says. "Argentina's not quite on that scale, but its situation isn't good." Among shares Mr Bozaan may buy are Grupo Financiera Galicia, Telecom Argentina Stet-France Telecom and Perez Companc, an oil company. Group Galicia trades at about 2.8 times past earnings compared with Banco Bradesco, a Brazilian bank that trades at 8.1 times earnings, and Citigroup of the US, which trades at 17 times. Telecom Argentina trades at 14 times earnings against 27 times for Brasil Telecom. Perez Companc trades at 7.2 times earnings compared with BP's 13 per cent. Mr Segal recommends buying bank and utility bonds. "Grupo Galicia and Banco Rio look like good buys; so do some of the telecom and electricity companies," he says. Telefonica bids to shield at-risk Brazil interests Financial Times - December 19, 2001 By Leslie Crawford and Krishna Guha Telefonica of Spain, the largest foreign investor in Latin America, has used derivatives to hedge against a possible devaluation in Argentina and any risk of that country's financial crisis spilling over into neighbouring Brazil. Cesar Alierta, Telefonica chairman, told the Financial Times: "The crisis in Argentina is not a Latin American crisis. We are confident that Brazil has decoupled from Argentina's problems." Telefonica has more than Euros 35bn (Dollars 31.6bn) invested in Latin America. The region provides 41 per cent of its revenues, which totalled Euros 23bn in the first nine months of the year, and almost 45 per cent of the company's cash flow. Telefonica would not disclose the size of its hedging operations, but said its derivatives portfolio is significant. Executives said: "We are not immune to the effects of a devaluation, but we will be less affected than the market thinks." There should be no need to write down the value of its assets in the event of a devaluation of the Argentine peso, which has been pegged to the dollar for a decade. Telefonica said it has budgeted for a rise in unpaid telephone bills as the crisis in Argentina bites. Operating revenues at TASA, Telefonica's Argentine subsidiary, were down 5 per cent in the first nine months of the year. Mr Alierta, however, is bullish about prospects in Brazil, where Telefonica has invested Dollars 17bn. Telefonica owns Telesp, which has 12m clients and is the largest fixed-line operator in the prosperous industrial state of Sao Paulo. Early next year it hopes to pool its mobile interests in several Brazilian states with Portugal Telecom's big mobile operation in Sao Paulo. "With 1,200 lines per employee, Telesp is probably the most efficient operator in the world," Mr Alierta said. He is particularly enthusiastic about the potential for broadband communications in Brazil." Armey Would Split Derivatives Issue From Stalled Bankruptcy Reform Bill BNA - December 19, 2001 Despite opposition from House Judiciary Committee leadership, House Majority Leader Richard Armey (R-Texas) told BNA Dec. 18 he wants the House to take up contract netting legislation apart from the stalled bankruptcy reform bill (H.R. 333) to which it is attached. "I think it is time to move netting," Armey said, using another name for the derivatives bill. "They [members of the Judiciary Committee], see netting as a very important kind of a driving engine within their bill. And I appreciate their point of view, but I think this is something that needs to get completed, and I have talked to the committee about it repeatedly." House Judiciary Committee Chairman James Sensenbrenner (R-Wis.) is against consideration of financial derivatives legislation apart from bankruptcy reform legislation, which has been stuck in conference for months, a Sensenbrenner aide told BNA Dec. 14. Contract netting language intended to reduce uncertainty and limit systemic risk in derivatives transactions was added to the bankruptcy bill at a time when Republican leadership was optimistic the legislation could pass this year and that its inclusion could help speed the process, House staff told BNA. "Hindsight is 20-20," a House Republican aide told BNA. "Who knew the [bankruptcy] bill would be grounded again?" Sensenbrenner and House Financial Services Committee Chairman Michael Oxley (R-Ohio) met with Federal Reserve Board Chairman Alan Greenspan Dec. 13 to discuss the importance of legislation addressing banks' use of financial derivatives (239 DER A-28, 12/14/01). Oxley strongly supports passing derivatives legislation this year, according to his spokeswoman, especially in light of the recent collapse of Enron Corp., which traded heavily in derivatives. Even if a derivatives bill fails to pass Congress again this year, its separate consideration would indicate just what poor odds Republican leadership places on bankruptcy reform passing in the foreseeable future. Presumably, if the House took up a derivatives bill, it would vote on an independent contract netting bill (H.R. 3211) that Rep. Pat Toomey (R-Pa.) introduced on Nov. 1. Its language is identical to language contained in numerous contract netting bills offered as far back as 1998, when then-House Banking Committee Chairman James Leach (R-Iowa) championed the issue. Currently, no companion bill exists in the Senate. Although Democrats, particularly members of the House-Senate conference on H.R. 333 who oppose bankruptcy reform, are likely to support passage of a contract netting bill, it is unclear whether key Republicans would. A spokeswoman for Sen. Chuck Grassley (R-Iowa), a member of the bankruptcy reform conference, told BNA that the senator is likely to oppose separating contract netting from H.R. 333. Derivatives are financial contracts used by parties wishing to hedge the risk of fluctuations in interest rates, foreign exchange rates, or indexes. Their value is based on the performance of an underlying asset. Seven large commercial banks account for about 96 percent of all derivatives, the most common of which is an interest rate contract. **End of ISDA Press Report for December 19, 2001** THE ISDA PRESS REPORT IS PREPARED FOR THE LIMITED USE OF ISDA STAFF, ISDA'S BOARD OF DIRECTORS AND SPECIFIED CONSULTANTS TO ISDA ONLY. THIS PRESS REPORT IS NOT FOR DISTRIBUTION (EITHER WITHIN OR WITHOUT AN ORGANIZATION), AND ISDA IS NOT RESPONSIBLE FOR ANY USE TO WHICH THESE MATERIALS MAY BE PUT. Scott Marra Administrator for Policy and Media Relations International Swaps and Derivatives Association 600 Fifth Avenue Rockefeller Center - 27th floor New York, NY 10020 Phone: (212) 332-2578 Fax: (212) 332-1212 Email: smarra@isda.org
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