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Wednesday, December 14, 2011

Estimating RCBC's Profits from the PEACe Bonds

Much has been written about how CODE-NGO has extracted PHP 1.827 billion in gross profits from the PEACe Bonds. From this bonanza, the PHP 1.338 billion Peace Foundation was born. Yet there have been hardly any articles in the mainstream press as to how much profit RCBC, CODE-NGO's financier, extracted from the transaction. RCBC Capital did extract a PHP 239 million underwriting commission. But this amount is peanuts when you consider the fact that RCBC Capital's parent, namely RCBC itself, risked PHP 11.996 billion or roughly 90% of its capital to earn a measly PHP 239 million or 1.8% of its capital. Given that interest rate fluctuations could cause the value of the PEACe Bonds to decline by PHP 1.275 billion over the course of a year, this seems foolhardy. Why? Because RCBC's risk was more than five times the potential reward. If its profits were limited to underwriting commissions, the transaction's rewards were definitely not worth the risk.

But RCBC did make money on the transaction. Lots of money. As much as PHP 4.0 billion! How? By reselling the PEACe Bonds to institutional investors at even higher prices.

According to Jaime “Jimmy” Panganiban, RCBC's Treasurer,

“We have a contracted sale for PHP 1.2 billion [out of the PHP 35 billion worth of PEACe Bonds, which is the issue's face value upon maturity], Panganiban said. But given the publicity about the PEACe Bonds, we're not aggressively [selling them in the secondary market]. He admitted that there is demand or keen interest in the bond.1

The bonds were sold to RCBC's corporate clients outside the Yuchengco group of companies.2 Mr. Panganiban said that RCBC has been selling the bonds, which RCBC acquired at an effective cost of 34 centavos per bond unit (PHP 1.00 at maturity in 10 years), for 40 to 45 centavos to undisclosed corporate buyers.3 This translates to an effective yield to maturity rate (YTM) of 8.170% to 9.370%.

In terms of profit, this means that RCBC, by selling PHP 1.2 billion or 10% of the PEACe bonds it acquired from CODE-NGO for PHP 11.996 billion, realized a trading gain anywhere from PHP 201.32 million to PHP 374.94 million from this one transaction alone. If it continued to sell the rest of its holdings at this price, it would reap an additional trading gain ranging from PHP 1.812 billion to PHP 3.374 billion, bringing its total potential profit on the entire PEACe to PHP 2.013 billion to PHP 3.749 billion, just from reselling the PEACe Bonds. If you add back the underwriting commission, RCBC could have earned as much as PHP 4.0 billion on the PEACe Bonds.

But here's the kicker. There could have been even more profits in the offing for RCBC! Why? Two reasons. Time and Interest Rates. The prices of zero coupon bonds go up as the bond nears its maturity date. The closer the bond is to its maturity date, the closer the zero-coupon bond's value approaches par or face value. Interest rates also significantly affect the prices of zero-coupon bonds. The lower the interest rate, the higher the bond price. And interest rates did go down substantially after the PEACe Bonds transaction. And as interest rates go down, bond prices go up. So estimating RCBC's profits are also very dependent on when RCBC sold down the PEACe Bonds to other institutional investors because the bond's time to maturity and prevailing interest rates would have changed.

According to RCBC Treasurer Jimmy Panganiban, RCBC did not aggressively sell the PEACe Bonds in the secondary market because of the controversy they generated. Given that they held at least 90% of the bonds in October 2001, it is safe to assume that all the subsequent PEACe Bond transactions registered with the Bureau of Treasury's Registry of Scripless Securities were RCBC's.

Based on this chart from PCIJ's blog (, it seems that RCBC had rid itself of its entire PEACe Bond inventory by July 2002. Or given that they recently admitted holding on to PHP 1.4 billion or 4% of the PEACe Bonds, they could have disposed of the inventory they wanted to dispose a month earlier, or June 2002.


PEACe Bond Sales PEACe Bond Sales

Face Amount Face Amount
Month (In PHP ) (In PHP)
October 2001 3,500,000,000 3,500,000,000
November 2001 3,900,000,000 7,400,000,000
December 2001 3,900,000,000 11,300,000,000
January 2002 7,500,000,000 18,800,000,000
February 2002 5,900,000,000 24,700,000,000
March 2002 3,800,000,000 28,500,000,000
April 2002 1,800,000,000 30,300,000,000
May 2002 2,100,000,000 32,400,000,000
June 2002 1,900,000,000 34,300,000,000
July 2002 700,000,000 35,000,000,000

Jaime Panganiban, RCBC's Treasurer, said that RCBC sold at least 10% of their PEACe Bond holdings at YTMs ranging from 8.170% to 9.370% soon after the PEACe Bond auction, meaning October 2001. If RCBC had sold the last 90% of their holdings at the upper end of this YTM range, meaning at 9.370% YTM by October 2001, RCBC would have reaped PHP 2.013 billion in gross profits. But they didn't. Instead, they held on. Holding on to the bonds proved beneficial to them. The bonds accrued interest and went up in value. Even if interest rates or YTMs remained constant, at the 8.170% to 9.370% YTM range, the bonds would go up in value. By how much?

If YTMs remained at 9.370% (the upper end of its previous selling range) and the bonds were fully sold by July 2002, the profit would have been PHP 2.397 billion or 19.07% higher than the expected profit of PHP 2.013 billion, had the bonds been sold in October 2001 at a 9.370% YTM.

Price to Cost to

PEACe Bond Sales Institutional Investor RCBC

Face Amount At 9.370% YTM At 11.000% YTM RCBC's Profit
Month (In PHP) (In PHP) (In PHP) (In PHP)
October 2001 3,500,000,000 1,400,808,914 1,199,551,372 201,257,542
November 2001 3,900,000,000 1,572,378,050 1,336,642,957 235,735,093
December 2001 3,900,000,000 1,585,390,220 1,336,642,957 248,747,263
January 2002 7,500,000,000 3,071,244,165 2,570,467,225 500,776,940
February 2002 5,900,000,000 2,433,809,634 2,022,100,884 411,708,750
March 2002 3,800,000,000 1,580,510,528 1,302,370,061 278,140,467
April 2002 1,800,000,000 754,167,503 616,912,134 137,255,369
May 2002 2,100,000,000 886,331,364 719,730,823 166,600,541
June 2002 1,900,000,000 808,555,110 651,185,030 157,370,080
July 2002 700,000,000 300,078,982 239,910,274 60,168,708
Total 35,000,000,000 14,393,274,470 11,995,513,717 2,397,760,753

If YTMs remained at 8.170% (the lower end of its previous selling range) and the bonds were fully sold by July 2002, the profit would have been PHP 4.096 billion or 9.26% higher than the expected profit of PHP 3.749 billion, had the bonds been sold in October 2001 at a 8.170% YTM.

Price to Cost to

PEACe Bond Sales Institutional Investor RCBC

Face Amount At 8.170% YTM At 11.000% YTM RCBC's Profit
Month (In PHP) (In PHP) (In PHP) (In PHP)
October 2001 3,500,000,000 1,571,466,450 1,199,551,372 371,915,078
November 2001 3,900,000,000 1,762,315,981 1,336,642,957 425,673,024
December 2001 3,900,000,000 1,775,062,487 1,336,642,957 438,419,530
January 2002 7,500,000,000 3,435,519,404 2,570,467,225 865,052,179
February 2002 5,900,000,000 2,719,977,161 2,022,100,884 697,876,277
March 2002 3,800,000,000 1,764,520,502 1,302,370,061 462,150,441
April 2002 1,800,000,000 841,197,011 616,912,134 224,284,877
May 2002 2,100,000,000 987,703,548 719,730,823 267,972,725
June 2002 1,900,000,000 900,100,051 651,185,030 248,915,021
July 2002 700,000,000 333,746,968 239,910,274 93,836,694
Total 35,000,000,000 16,091,609,563 11,995,513,717 4,096,095,846

This profit calculation assumes that interest rates remained constant. But interest rates didn't remain constant. Instead, to RCBC's great benefit, they declined.

If the YTMs at which the PEACe Bonds were sold to investors declined with interest rates (with a floor of 7% - the yield of reserve eligible securities at the time of the PEACe bonds auction), RCBC's interest rate spread would be as follows:

Bureau of Treasury Institutional Investor Cost to

Month (In %) (In %) (In %) (In % Spread)
October 2001 12.750% 8.170% 11.000% 2.830%
November 2001 12.750% 7.459% 11.000% 3.541%
December 2001 12.750% 7.000% 11.000% 4.000%
January 2002 12.750% 7.000% 11.000% 4.000%
February 2002 12.750% 7.000% 11.000% 4.000%
March 2002 12.750% 7.000% 11.000% 4.000%
April 2002 12.750% 7.000% 11.000% 4.000%
May 2002 12.750% 7.000% 11.000% 4.000%
June 2002 12.750% 7.000% 11.000% 4.000%
July 2002 12.750% 7.000% 11.000% 4.000%

At these rates, RCBC's profits on the PEACe Bonds could have been as high as PHP 5.684 billion or 51.61% higher than the PHP 3.749 billion estimate had the PEACe Bonds been sold in October 2001 at an 8.170% YTM.

Price to Cost to

PEACe Bond Sales Institutional Investor RCBC

Face Amount At Fluctuating YTMs At 11.000% YTM RCBC's Profit
Month (In PHP) (In PHP) (In PHP) (In PHP)
October 2001 3,500,000,000 1,571,466,450 1,199,551,372 371,915,078
November 2001 3,900,000,000 1,886,177,955 1,336,642,957 549,534,998
December 2001 3,900,000,000 1,983,066,738 1,336,642,957 646,423,781
January 2002 7,500,000,000 3,834,638,625 2,570,467,225 1,264,171,400
February 2002 5,900,000,000 3,033,232,123 2,022,100,884 1,011,131,239
March 2002 3,800,000,000 1,965,741,899 1,302,370,061 663,371,838
April 2002 1,800,000,000 936,280,243 616,912,134 319,368,109
May 2002 2,100,000,000 1,098,355,944 719,730,823 378,625,121
June 2002 1,900,000,000 999,923,267 651,185,030 348,738,237
July 2002 700,000,000 370,426,091 239,910,274 130,515,817
Total 35,000,000,000 17,679,309,335 11,995,513,717 5,683,795,618

It's highly possible that the floor of 7.000%, the current yield for liquidity reserves at the time of the PEACe Bond auction declined along with a general decline in interest rates. As such, it's very possible that RCBC's total gross profit from selling the PEACe Bonds could be even greater. However, access to that information is not yet available.

1“Raid on the Treasury - JPE on the PEACe Bonds Scandal, by Butch Fernandez and Erik de la Cruz, Reporters, February 13, 2002, Today Newspaper.
2“Internal Revenue bureau defends tax break for PEACe bonds,” by L.M. Gallardo with C.E. Yap, February 13, 2002, Businessworld
3“Enrile sees wholesale ruse in CODE-NGO deal,” by Angie M. Rosales and Jun Vallacera, February 13, 2002, Daily Tribune

Friday, November 11, 2011

PEACe Bonds: RCBC's Slow Road to Financial Ruin

RCBC, CODE-NGO's financier and the largest PEACe Bond beneficiary, now claims that the BIR's belated imposition of a 20% Final Withholding Tax on the PEACe Bond's final bondholders will lead to the bank's “financial ruin.”1 Why? Because BIR's October 7, 2011 ruling will “unduly expose” it to “unjustified third-party claims.”

Now, who are these third party claimants? Its fellow banks, of course. Nine of them, to be exact: Banco De Oro Unibank, Bank of Commerce, BPI Family Bank, China Banking Corporation, Metropolitan Bank and Trust Company, Philippine Bank of Communications, Philippine National Bank, Philippine Veterans Bank, and Planters Development Bank. These nine banks were left holding the bag because the BIR chose to collect back taxes on the PEACe bonds from the final bondholders, instead of CODE-NGO/RCBC, the main beneficiaries of the “erroneous” 2001 Banez Rulings, even though the government found CODE-NGO/RCBC liable for the PHP 4.86 billion in unpaid taxes.

A previous post, “A Tax on the PEACe Bonds - Who is Left Holding the Bag? ( predicted this would happen:

“Unless the government recreates the chain of sales and resale from CODE-NGO/RCBC to the final bondholders, the final bondholders would have to recreate this process via a chain of litigation, meaning the final bondholder would have to sue the previous bondholder to collect the 20% FWT that the final bondholders are not liable for, and that the previous bondholder would have to collect from its previous bondholders, and so on and so forth, until the chain of sale is retraced back to CODE-NGO/RCBC, the original bondholders. Needless to say, this would create a gigantic legal mess.”

RCBC also admitted that it was one of the final bondholders. It holds PHP 1.4 billion or 4% of the PEACe bonds. So now, RCBC is the tenth bank left holding the bag on the PEACe Bonds.

Now how will this lead to the RCBC's financial ruin? Let us count the ways...

As Final Bondholder

The first and most direct way is through its holding of the PEACe Bonds.

RCBC holds PHP 1.4 billion or 4% of the PEACe Bonds. As such, it is liable for 4% of the PHP 4.86 billion tax due on the PEACe Bonds. This amounts to a mere PHP 194.40 million or 0.60% of the bank's Capital Funds of PHP 32.412 billion as of December 31, 2010.

The loss will sting RCBC like an antbite. But it certainly will not kill it.

All Roads Lead to RCBC

But RCBC is not just liable to pay only PHP 194.40 million of the PHP 4.86 billion in back taxes. It is liable to pay the entire PHP 4.86 billion in back taxes. Under BIR Ruling No. 370-2011, “RCBC is held liable to pay 20% final tax on the entire PHP 24.3 billion discount, which is the present value of the original discount to date, or approximately PHP 4.86 billion.”

So if the BIR does not work to extract this sum from RCBC, you can be sure that nine of RCBC's fellow banks will work to extract this sum, via litigation, from RCBC. Hence, RCBC's claim in its Supreme Court petition that the BIR's October 7, 2011 ruling raises “the possibility that petitioner-intervenor RCBC may be called upon to pay third parties” and this “immeasurably damages petitioner-intervenor RCBC's financial standing and reputation.”

Barring a BIR collection, collection of this sum via litigation of third party banks will be a slow process, given how slowly the wheels of justice turn in the Philippines.

But if it does happen soon enough, how will RCBC be affected?

Taking PHP 4.86 billion from RCBC is tantamount to a 15% hit to RCBC's capital funds of PHP 32.412 billion as of December 31, 2010. But not all of RCBC's capital funds are common equity. RCBC has PHP 207 million in Preferred Stock. It also has PHP 4.883 billion in Hybrid Perpetual Securities (a quasi-debt quasi-equity investment instrument that the company can count as part of its regulatory capital base). We also have to back out the PHP 426 million in “goodwill” on RCBC's books. If you net all of these out, RCBC's tangible common capital funds amounts to only PHP 26.896 billion. So a PHP 4.86 billion hit in PEACe Bond back taxes amounts to a more damaging 18.07% hit to RCBC's capital funds. This hit will certainly wound RCBC but not necessarily kill it.

Overstated Capital

The trouble is that things are not what they seem. RCBC's auditor, Punongbayan & Araullo, has been issuing a qualified auditor opinion for years on RCBC's financial statements.  The qualified opinion indicates that  everything in RCBC's financial statements is kosher except for the fact that RCBC has unbooked losses relating to the sale of its Non-Performing Assets (NPAs) to various Special Purpose Vehicles (SPVs).  According to the auditor, RCBC

“deferred the recognition of the losses resulting from the sale of the NPAs transferred and the additional allowance for impairment on such NPAs had these not been derecognized, such losses and additional allowance for impairment are instead being amortized over a period of 10 years in accordance with MB Resolution No. 135.”

In other words, RCBC booked these losses as deferred charges and put them in the “Other Assets” bucket of its balance sheet.

How big are the unbooked losses? Note 11.2 “Special Purpose Vehicle (SPV) Transactions” of RCBC's audited financial statements has some answers: PHP 6.072 billion as of December 31, 2010.

“Had the Parent Company...derecognized the allowance for impairment related to the NPAs transferred that qualified for derecognition at the time of sale...Deferred Charges (part of Other Resources account in Note 15) would have decreased by P6,072 and P 7,047 in 2010 and 2009, respectively; ...and Surplus would have decreased by P6,072 and P7,047 in 2010 and 2009, respectively.”

What this is saying is that RCBC's actual common capital funds is PHP 20.824 billion - PHP 6.072 billion or 22.58% lower than the PHP 26.896 billion figure arrived at in our last calculation. So a PHP 4.86 billion hit to its capital in the form of unpaid PEACe Bond taxes would amount to a 23.34% - or almost a 25% of its capital.  Thus, RCBC's tangible common capital base would be reduced to only PHP 15.964 billion.  This is definitely a major but not necessarily fatal wound.

Heightened Risk of Insolvency

On a standalone basis, RCBC having a common capital fund of PHP 15.964 billion is meaningless. But relative to the rest of its balance sheet, this figure speaks volumes. Because roughly PHP 16 billion in capital (as opposed to the original PHP 32 billion) will have a harder time supporting an asset base 20 times bigger - roughly PHP 320 billion as of year end 2010.

Moreover, the quality of this asset base is suspect. A substantial amount is held in the form of risky assets whose values are often indeterminate.  Moreover, these assets have the potential to deteriorate substantially.  Losses on these assets will further eat into the bank's capital base. These assets take the form of classified loans, acquired real estate, and other miscellaneous assets such as real estate assets held for sale.

To absorb losses, the bank must have a substantial capital cushion consisting of the bank's tangible common capital plus its loss reserves. A ratio of Distressed Assets to Capital Cushion of greater than 1:1 puts the bank at a heightened risk of insolvency. Why? Because if these distressed assets were written down to zero, the bank's shareholders would be wiped out and the bank would be insolvent. Prior to adjustments, RCBC's ratio was already high at 1.17 to 1. In other words, the bank was already relatively weak and was well within the danger zone of insolvency. Netting out the deferred charges and the PEACe Bond taxes only serves to lower the bank's capital cushion and heighten its risk of insolvency. The ratio climbs by 21.37% to 1.42 to 1. So the imposition of the PEACe Bonds Tax will only serve to further weaken an already weak bank.

Rizal Commercial Banking Corporation
Distressed Assets and Capital Cushion
As of December 31, 2010

Distressed Assets

Unadjusted Amount
(In PHP Million
Adjustments for Deferred Charges & PEACe Bond Taxes
(In PHP Million)

Adjusted Amount
(In PHP Million)
Classified Loans

Acquired Real Estate

Other Assets
Total Distressed Assets

Capital Cushion

Common Capital
Allowance for Losses

Total Capital Cushion

Distressed Assets/Capital Cushion Ratio



Reputation and Goodwill

Quantitatively, the bank will be badly hurt by the tax.  But it will not be dead.  But there is a qualitative aspect to this as well: confidence, or rather, the lack of it.  RCBC claims that the imposition of the tax may immeasurably damage RCBC's "reputation and goodwill in the financial community." Investors may lose confidence in RCBC as an intermediary. Investors may question RCBC's “judgement on the stability of transactions it participates in, or underwrites and the reliability of the parties involved in the transaction.”

In Banking and Finance, confidence is everything. And once that confidence is lost, no one will continue to business with RCBC. RCBC is right. The run on the bank may have already started.

1“RCBC files petition vs. PEACe bond tax,” by Ina Reformina, November 4, 2011, ABS-CBN News
2PHP 6,072 million in Deferred Charges
3PHP 6,072 million in Deferred Charges plus PHP 4,860 million in PEACe Bond Taxes

Friday, November 4, 2011

The PEACe Bonds Controversy Explained - with Transcript and Charts

Here's a rough transcript of the Youtube video, "The PEACe Bonds Controversy Explained".  I also included a bunch of charts and graphs.

For the video, click on the link below:

What are the PEACe Bonds?

The PEACe Bonds are Poverty Eradication and Alleviation Certificates Bonds. They were designed by the Caucus of NGO Networks (CODE-NGO) and its financial advisers for poverty alleviation programs. The bonds are ten-year zero coupon bonds issued by the Bureau of Treasury of the Philippine Government.

What is a zero coupon bond?

A zero coupon bond is a debt paper that will not make any interest payments (coupons) to the bondholders until the debt matures. Because of this, it is usually sold at a steep discount to the face value of the bond paid at maturity.

So how much did the government raise in terms of the PEACe Bonds?

The government raised PHP 10.169 billion when the bonds were auctioned on October 16, 2001 and issued on October 18, 2001. Because the bonds were sold at an effective interest rate of 12.75% per year for ten years (12.75% yield to maturity or YTM for short), the government will have to pay back the bondholders PHP 35.000 billion when the bond matures ten years later, on October 18, 2011.

Will the government use the PEACe Bonds to fight poverty?

No. The PEACe Bonds proceeds will be used to fund the government's general operations. It is the PHP 1.338 billion net profit that CODE-NGO made from selling the bonds that will go to fight poverty. The profit was used by CODE-NGO to form the endowment of the Peace Equity and Access for Community Empowerment Foundation (The Peace and Equity Foundation). The Foundation is a non-profit institution that will implement poverty alleviation programs.

How did CODE-NGO earn this profit?

CODE-NGO bought the bonds, through RCBC - a government securities eligible dealer (GSED) for PHP 10.169 billion pesos from the Bureau of Treasury at a Treasury Bond auction conducted on October 16, 2001. CODE-NGO then simultaneously resold the bonds to RCBC Capital, under a firm underwriting commitment, for PHP 11.996 billion pesos, making roughly PHP 1.827 billion pesos in gross profits.

Did CODE-NGO have the money to buy PHP 10.169 billion pesos worth of the PEACe Bonds?

No. CODE-NGO didn't have the money to buy the bonds. RCBC did. The bank, which is a GSED had the money to buy the bonds.

So, RCBC put up all the money and let CODE-NGO make PHP 1.827 billion pesos with no money down? Why then did they need CODE-NGO?

RCBC needed CODE-NGO to supply the bond's special features.

What are the PEACe Bonds' special features?

Special features are what makes the bonds more attractive to investors. For instance, the Monetary Board can make the bonds eligible for use as liquidity reserves or for compliance with Agri-Agra laws. They can also take the form of rulings from the Bureau of Internal Revenue on exemptions from taxes such as withholding tax or capital gains tax. These features expand the uses for the PEACe Bonds and, consequently, their potential market.

How will CODE-NGO supply the bond's special features? Does CODE-NGO have that level of financial expertise?

No, it didn't. But it had financial advisers who did have that financial expertise, namely, Cesar Mayo of Capex, Inc. and Bobby Guevarra of SEED Capital Ventures. What CODE-NGO had, in spades, was connections. The Chairwoman of CODE-NGO at the time of the PEACe Bonds issue was Marissa Camacho Reyes, who is the sister of the Finance Secretary at that time, Jose Isidro Camacho. The former chairwoman of CODE-NGO prior to Ms. Reyes was Dinky Soliman, who became the Secretary of the Department of Social Welfare under the Arroyo administration.

Did CODE-NGO make use of those connections?

It certainly did! CODE-NGO lobbied hard with the Arroyo government to sweeten the bonds with tax exemptions and eligibilities. At one point, even Secretary Camacho hosted a meeting between CODE-NGO and the Bureau of Treasury to iron out aspects of the bond issue.

But didn't CODE-NGO buy the PEACe Bonds through a Treasury Bond auction? Whatever CODE-NGO lobbied for could have gone to someone else if CODE-NGO had lost the Treasury Bond auction. So, it won the PEACe Bonds fair and square, right?

Yes, CODE-NGO could have lost the auction and have gotten nothing for all that work. But they didn't. Moreover, they captured 100% of the auction. No one else won. And they did it at a price that still made them a lot of money.

How did CODE-NGO win everything? Wasn't the bidding competitive?

This is not clear. But there was something wrong with the bidding process. For instance, the bids were all over the place and the bids did not improve over time.

The difference in interest rates, or yield to maturities (YTMs) between the top wining bid of 12.248% and the bottom losing bid of 18.000% was very wide: 5.752%. In terms of bid differentials, it was the worst 10 year Treasury Bond auction on record from 1998 to 2011.

This bid differential, of 5.752%, was more than ten times the normal historical bid differential of 0.422% in the 10 year Treasury Bond auctions from 1998 to 2001.

What does the bid differential mean?

The wide range in YTMs or interest rates assigned by the bidders to the bonds means that the bidders were assigning widely disparate values to the bonds. The bond value of the top winning bid with a 12.248% YTM was 71% higher than the bond value of the bottom losing bid with a YTM of 18.000%.

How could the bond values for the same bond vary by that much?

This is also not clear. If the normal bid differential of 0.422% was applied to the bids, the difference in bond values between the top winning bid and the bottom losing bid would only be about 4.05%. This indicates that the bidders didn't know exactly how to value the bonds. It could also indicate that the other bidders colluded to give the auction to CODE-NGO/RCBC.

So the bidding could have been rigged?

Of course we don't know for sure. But it certainly looks that way. At the very least, it should have been declared a failed auction. Instead, the Bureau of Treasury accepted the auction results, primarily because the yield to maturity of 12.75% was lower than the effective yield of the previous 10-year treasury bond auction held just the week before.

So, CODE-NGO lobbied hard with the Arroyo government for the PEACe Bond's special features. Then, RCBC, as a GSED, bought the PEACe Bonds for CODE NGO in a dubious Treasury Bond auction. Simultaneously, RCBC Capital, RCBC's investment house subsidiary, took the bonds off CODE-NGO's hands and left CODE-NGO with a gross profit of PHP 1.827 billion pesos?


So, what did RCBC get out of this deal? Did it do this on a pro-bono basis? For charity?

No. Definitely not. It earned an underwriting commission of PHP 240 million when RCBC Capital bought back the PEACe Bonds from CODE-NGO.

So, RCBC Capital earned PHP 240 million in underwriting commissions. Is that all? What happened to the bonds, after RCBC Capital bought them from CODE NGO? Did RCBC/RCBC Capital get rid of them?

RCBC more than got rid of them. RCBC acknowledged, at the time of the congressional inquiry in February 2002, that they sold 10 percent of the bonds, PHP 1.2 billion worth, or PHP 3.5 billion in face amount, to other institutional investors, at a profit ranging from PHP 201 million to PHP 375 million.

So, RCBC made PHP 240 million from underwriting the bonds and maybe another PHP 375 million pesos from selling 10% of the PEACe Bonds. That's only PHP 615 million. Meanwhile, they were still holding on to 90% of the bonds. Wasn't it risky to hold on to the bonds?

Of course it was risky to hold on to the bonds. Remember, these are zero coupon bonds. They are very, very sensitive to fluctuations in interest rates. As interest rates go up, prices for normal coupon bearing bonds go down, and zero coupon bonds go down in price even more dramatically. If interest rates fluctuated upward by its normal historical average fluctuation of 1.330% a year, RCBC could have lost PHP 1.275 billion on the 90% of the PEACe Bonds that it kept.

What other risks did the PEACe Bonds pose to RCBC?

There was the risk that RCBC could have been stuck with the bonds for a very long time because of the controversy surrounding the PEACe Bonds. The PEACe Bonds could have severely affected the bank's liquidity. Remember, RCBC was holding on to PHP 10.8 billion worth of the PEACe Bonds. That's a lot, considering that the entire bank only had PHP 13.3 billion worth of capital at that time. The bank also had PHP 14.2 billion worth of non-performing loans on its books as well as almost PHP 6.6 billion worth of foreclosed real estate. If you add everything up, RCBC could have been holding on to almost PHP 31.6 billion worth of illiquid assets. That's almost 2.4 times its capital base of PHP 13.3 billion. That's a lot of risk to take, for one single transaction, in one single investment instrument.

But RCBC is a strong bank.  It could afford to take that risk.

Not at that time.  RCBC was the weakest private commercial banks in terms of the ratio of its distressed assets (non-performing loans, acquired real estate) to bank capital.  In 2001, RCBC's ratio was 1.56 times its capital base of PHP 13.339 billion.  Only government-owned or semi-government owned and controlled banks such as UCPB, PNB, and Land Bank had higher ratios of distressed assets to capital.

So why did RCBC take that risk?

Why would RCBC take that risk? The short answer is because the reward was commensurate to the risk. It means that RCBC expected to make a lot of money from this deal. In fact, it expected to make a lot more money that its client, CODE-NGO. Remember that RCBC could have made as much as PHP 375 million from selling just 10% of the PEACe Bonds issue. If RCBC managed to sell the rest of the bonds they held, or 90% of the entire PEACe Bonds issue, at that price and at that level of profit, RCBC could make as much as PHP 3.374 billion in gross profits, in addition to the PHP 615 million that it earned from underwriting and selling just 10% of the bonds. In other words, RCBC's total gross profits, could have been as much as PHP 4.0 billion from this one transaction alone.

So RCBC's gross profits on this deal could have been double that of CODE-NGO's PHP 1.827 billion in gross profits?

Yes. Now if you add up the roughly PHP 1.8 billion in gross profits that CODE-NGO made plus the PHP 3.8 billion in gross profits that RCBC could have made from selling the PEACe Bonds down to institutional investors, that adds up to PHP 5.6 billion in gross profits.

That's an astounding amount of money left on the table.

Absolutely! It means that, had the Bureau of Treasury cut out all these middlement and sold the bonds directly to their ultimate buyers, the institutional investors, the government could have garnered those savings for itself. The government would have gotten an additional PHP 5.6 billion from the PEACe Bonds deal.

No wonder the PEACe Bonds deal still stinks after all these years!

Thursday, November 3, 2011

The PEACe Bonds Controversy Explained

For those of you who find my previous post, "Revisiting the PEACe Bonds",  too long to read, you can now watch the cute and cuddly Pawz Bears give a concise explanation of what the PEACe Bonds controversy is all about.

For the sake of brevity, I left out explanations of the implications of the eligibilities and sweeteners that CODE-NGO/RCBC actively sought for the PEACe Bonds.  These have been discussed in my previous post, "Revisiting the PEACe Bonds", and elsewhere on other blogs and news websites.  I have also left out discussions of the controversial decision of the Bureau of Internal Revenue to belatedly impose a 20% Final Withholding Tax on the PEACe Bonds.  This has also been discussed in a previous post, "A Tax on the PEACe Bonds - Who is Left Holding the Bag?", as well as elsewhere on the web.

To watch the video, click on the video link below.

Monday, October 24, 2011

A Tax on the PEACe Bonds - Who is Left Holding the Bag?

In a ruling dated October 7, 2011 (BIR Ruling No. 370-2011), the Philippine Bureau of Internal Revenue (BIR) ruled that “the PHP 24.3 billion discount on the issuance of the PEACe Bonds should be subject to 20% Final Tax on the interest income from deposit substitutes,” as provided in Section 27(D)(1) of the TaxCode of 1997.

This ruling reversed three previous BIR Rulings made under former BIR Commissioner Rene G. Banez of the Arroyo Administration on the PEACe Bonds issued in 2001. (No. 020-2001 dated May 31, 2001 and No. 035-2001 dated August 16, 2001 and No. DA-175-01 dated September 29, 2001).

Rulings under the Negotiated Sale Mode of Purchase

The May 31 and August 16 rulings were made at the time that CODE-NGO was attempting to enter into a negotiated sale of the PEACe Bonds with the Bureau of Treasury. Under this scenario, the bonds would be sold by the government to a single entity, RCBC (as a Government Securities Eligible Dealer or GSED) who would then resell the bonds to another single entity, CODE-NGO. CODE-NGO would then simultaneously resell the bonds to RCBC Capital (with a firm underwriting commitment from RCBC Capital).

The May 31, 2001 ruling said that the PEACe Bonds were not considered to be a “public” borrowing, even if the bonds would fund the government, because the PEACe Bonds were to be issued to a single entity, CODE-NGO. Since the bonds complied with the “19-Lender Rule,” the bonds were not to be classified as “deposit substitutes.” Under Section 22 (Y) of the 1997 Tax Code, the borrowing of funds can be classified as deposit substitutes “if the funds are obtained from twenty (20) or more individuals or corporate lenders at any one time.”

However, lingering questions remained on the meaning of the word “public” and the interpretation of the phrase “at any one time.” Hence, there was a need for a second clarificatory ruling on August 16, 2001. The ruling stated that since the bonds will be “issued only to one entity, that is, RCBC,” there is no borrowing from the public. The ruling also stated that “the phrase 'at any one time' covers only the origination or original issuance of the bonds regardless of whether sale or trading is made in the secondary market.” This ruling effectively allowed RCBC/RCBC Capital to resell the bonds in the secondary market without losing the tax-exempt status of the bonds.

However, the ruling required that CODE-NGO/RCBC warrant that it is acquiring the bond for its own behalf. The ruling stated that:

“a representation or warranty should be made to the effect that the bonds are acquired upon their original issuance by the original purchaser thereof, for and on its own behalf, or on behalf of a single purchaser only, and in the latter case, that the purchaser is acquiring such bonds for its own account and not for the account of other entities.”

Ruling under Treasury Bond Auction Mode of Purchase

CODE-NGO's proposed mode of purchase, through a negotiated sale with the Bureau of Treasury proved to be problematic for the Treasury. The exclusive purchase offer would have raised the local financial community's fears of a crony deal in the making. This was primarily because the approval for such an offer lies within the Department of Finance headed by Secretary Jose Isidro Camacho, a brother of CODE-NGO chairperson, Maria Socorro Camacho-Reyes. On July 12, 2001, National Treasurer Sergio Edeza wrote a memo to Secretary Jose Isidro Camacho questioning the propriety of issuing the bonds directly to CODE-NGO because CODE-NGO was not a Government Securities Eligible Dealer. Sometime in July/August 2001, Secretary Camacho hosts the infamous “meeting between CODE-NGO and the Bureau of Treasury wherein both he and his sister are present.

On September 26, 2001, it became apparent that a negotiated sale was no longer possible when the Bureau of Treasury announced that the PEACe Bonds will be sold via auction to be held on October 2, 2001. As such, there was the possibility that the bonds may not be issued to a single entity, since there was a possibility that CODE-NGO may not win all of the PEACe Bond issue.

Very Narrow Definition of the phrase “at any one time”

Hence, there was a need for a third clarificatory ruling that was made on September 29, 2001. In that ruling, the BIR issued a ruling reiterated that the “the phrase 'at any one time' covers only the origination or original issuance of the bonds in the primary market regardless of whether sale or trading is made in the secondary market.” It also stated that the determining factor of whether or not the bonds were considered deposit substitutes was the number of purchasers/lenders at the time of origination/issuance.

It stated that:

“Corollarily, if the proposed PEACe Bonds are issued to less than twenty (20) individual or corporate lenders, the borrowing shall not be considered as “public” borrowing. Hence, the instrument shall not be classified as “deposit substitutes.” However, in the case of PEACe Bonds, since the determining factor in ascertaining whether or not such bonds are deposit substitutes is the original issuance to more than twenty (20) individuals or corporate lenders, it holds to say that the issuance to less than 20 individual or corporate lenders will necessarily exclude them from the coverage of “deposit substitutes.” Such being the case, the time element, i.e., “at any one time” required in “public borrowing” shall not apply in the instant case.”

The September 29, 2001 ruling also removed the August 16 ruling's requirement that CODE-NGO/RCBC make a representation/warranty that it was acquiring the bonds “for and on its own behalf, or on behalf of a single purchaser only”

Implications of the 2001 Rulings

These BIR ruling is very crucial. By defining the phrase “at any one time” to mean at the time the PEACe Bonds were first auctioned off to the GSEDs, it allowed the bonds to be sold in much smaller chunks in the secondary market without losing its tax-exempt status. Furthermore, there was no need to implement a tracking system to ensure that the bonds were held by no more than 19 investors throughout the life of the bond.

If the ruling deemed the phrase “at any one time” to mean for the life of the bonds, from date of issuance to date of maturity, the bonds will have to be sold in no more than 19 very large chunks of PHP 1.842 billion in face value or over PHP 535.2 million in cash value (at the time of issuance). Any investor who bought the bonds for resale at a later date will have to find another investor with the cash to buy at least PHP 535.2 million worth of PEACe Bonds in one transaction. That investor, in turn, must have the willingness to hold the bonds until maturity (10 years later) or have the capability to find another buyer just like him. The “19-Lender Rule” was meant to be throughout the life of the bond, it would severely limit the universe of potential bond buyers to very large institutional buyers of which there are very few. The limited market means that anyone who buys the bonds had better be prepared to tie up a very large amount of cash until maturity (when the bonds are repaid ten years later) if he is unable to resell the bonds. This market invariably boils down to two types of investors:

  1. Insurance Companies or other large financial companies with similar long term obligations; or
  2. Banks that need to fund the more “permanent” core of their liquidity reserve requirements with higher yielding instruments.

By eliminating the 19-Lender constraint in the secondary market, the ruling vastly expanded the market for PEACe Bonds without negating its tax-exempt status because the bonds now had more uses.

Retail Products

It allowed for the creation of retail products based on the zero-coupon bonds. According to RCBC Treasurer Jaime Panganiban, RCBC has thought of creating “principal protected products” not found locally.1

“I can create from these bonds a fund with a principal-protected product where your upside potential is unlimited and your worse return is 100 percent of your principal, because it's guaranteed by government, though we're not saying we have advanced product knowledge because these products you can easily find abroad,” he says.

Washing NPLs from a bank's own books

Since the bonds could now be sold in much smaller chunks, the bonds could ostensibly sold down to the level of a bank's own delinquent borrower and simultaneously be repurchased from the borrower in a cashless debit-credit accounting transaction that allows the borrowers delinquent loans to be reclassified from an NPL to a receivable from the borrower that is connected to the PEACe Bond and not the loan (See my previous post for a more detailed description of this process).

2004 and 2005 BIR Rulings

BIR's October 7, 2011 ruling was not the first time the BIR reversed the 2001 PEACe Bond Rulings. The BIR Rulings made in 2001 were first reversed in 2004 under BIR Commissioner Guillermo L. Parayno (also of the Arroyo Administration) by BIR Ruling No. 007-04 dated July 16, 2004, BIR Ruling No. DA-491-04 dated September 13, 2004 and BIR Ruling No. 008-05 dated July 28, 2005.

BIR's July 16, 2004 ruling (No. 007-04) stated that:

“since the object of the issuance is to obtain the required government funding, the issuance and subsequent distribution (exchange and trading) of Government debt instruments and securities in the secondary market to other market participants, specifically, the investors, is in itself a public borrowing of the government...It is, however, in the secondary market that the investing public makes the indirect investment in the borrowing entity, in this case, the Government.

...the mere issuance of government debt instruments and securities is deemed as falling within the coverage of “deposit substitutes” irrespective of the number of lenders at the time of origination.”

...the phrase “at any one time” in relation to public borrowing is deemed to refer to the flotation of the debt instrument or security. In other words, since the actual number of bondholders or investors may be at maturity date of the financial instrument, more than 20 individuals or corporation[s], the said direct lenders (origination) and indirect investors (secondary market) are deemed to be what constitute “public.”

Furthermore, the ruling stated that it “effectively modifies and supersedes BIR Ruling Nos. 020-2001 dated August 16, 2001 and DA-175-2001 dated September 28, 2001, as well as other BIR rulings dealing on the matter.”

BIR Ruling No. DA-491-04 dated September 13, 2004

This BIR ruling reiterated BIR Ruling No. 007-04, stating that the matter of determining the number of lenders does not come into play insofar as government debt instruments and securities are concerned.” The ruling reinstated the applicable provision of Revenue Regulations (Rev. Regs.) No. 17-84 which defined “deposit substitutes” to include “all borrowings of the national and local government and its instrumentalities... as evidenced by debt instruments denoted as treasury bonds, bills, notes, certificate of indebtedness and similar instruments...Consequently, the interest income derived therefrom by the corporate or institutional lender shall be subject to the twenty percent (20%) final tax imposed under Section 27(D)(1) of the Tax Code of 1997.

BIR Ruling No. 008-05 dated July 28, 2005

This BIR ruling determined that the twenty percent (20%) final tax is required to be withheld upfront.

Prospective or Retroactive? Or was it overlooked?

It is unclear as to whether Rulings No. 007-04, DA-491-04, and 008-05 were meant to be applied retroactively or prospectively. Given the lack of uproar at that time, it is safe to assume that the ruling was presumed to be prospective. In a petition before the Court of Tax Appeals, RCBC said that the BIR itself signaled that the 2004 ruling will only cover future bonds2.

It is also a distinct possibility that this ruling may have been overlooked at the time it was issued because the bondholders were not set to receive any imputed interest income until the bond matured six to seven years later. The banks affected claim to be utterly surprised by BIR's stance. However, BIR Commissioner Kim Henares strongly doubts this: “I don't believe that banks don't know about it because if you look at the history of the trading of that bond, right after we issued the 2004 ruling, the trading became markedly decreased.”3 A chart of the PEACe Bonds trading volumes provided by the Philippine Center for Investigative Journalism shows that trading in the bonds dropped to almost zero after the BIR issued its July 16, 2004 ruling. Trading only resumed in February 2006, but only sporadically and in much smaller volumes.

BIR Ruling No. 370-2011 dated October 7, 2011

The current BIR ruling states that BIR Ruling No. 007-04 makes the case that the Tax Code is clear that:

“the term “public” means borrowing from twenty or more individual or corporate lenders at any one time,” wherein “the word 'any' plainly indicates that the period contemplated is the entire term of the bond, and not merely the point of origination or issuance.”

2001 Rulings Erroneous (or Anomalous?)

Furthermore, the current ruling stated that the 2001 Rulings took the PEACe Bonds:

“out of the ambit of deposit substitutes and exempting it from the 20% Final Tax, an exemption in favour of the PEACe Bonds was created when no such exemption is found in law. Thus, the 2001 Rulings are null and void and cannot be given legal effect for being contrary to law. It is a basic principle in administrative law that the interpretation given by an administrative agency cannot run contrary to the law which it seeks to implement.”

The current ruling deemed 2001 Rulings erroneous but given the other controversial aspects of the PEACe bonds such as the information asymmetry, the wide bids, the vast gap in YTMs at the point of auction to the point of sale to institutional investors, the purported cronyism, it is easy to think of this “error” as anomalous.

The ruling went on to state that CODE-NGO should be held liable to pay the 20% Final Tax on interest income it realized from its purchase of the PEACe Bonds. Had CODE-NGO paid this tax at the time of issuance, it would have paid PHP 1.4 billion in addition to the PHP 10.169 billion purchase price of the PEACe Bonds. But since no final tax was paid by CODE-NGO upon issuance of the PEACe Bonds, CODE-NGO is liable to pay 20% final tax on the entire PHP 24.3 billion discount, or approximately PHP 4.86 billion.


The ruling said that CODE-NGO/RCBC may not invoke the principle of non-retroactivity because Section 246 of the 1997 Tax Code allows for retroactivity in cases where:

  1. the taxpayer deliberately misstates or omits material facts from his return or any document required of him by the Bureau of Internal Revenue;
  2. the facts subsequently gathered by the Bureau of Internal Revenue are materially different from the facts on which the ruling is based; or
  3. the taxpayer acted in bad faith.

The BIR said that there is:

“ample legal authority to conclude that the non-retroactivity principle does not apply when the ruling involved is null and void for being contrary to law, such as the 2001 Rulings. Well-entrenched are the principles that the Government is never estopped from collecting taxes because of mistakes and errors of its agents and there are no vested rights in a wrong interpretation of the law.”

Wrong Target

Although the ruling found CODE-NGO liable for PHP 4.86 billion in taxes, it decided to collect this tax by withholding 20% of the PEACe Bonds imputed interest income prior to its payment on the maturity date. Since neither CODE-NGO nor RCBC holds the bonds, the parties affected will be the final bondholders, in other words, those institutional investors who bought the bonds in the secondary market after CODE-NGO/RCBC had sold them down.

The Department of Finance issued two directives which compounded the problem:

  1. The Department of Finance issued a Memorandum dated October 11, 2011 which barred the sale and transfer of the PEACe Bonds from October 12, 2011 until the bonds were redeemed on October 18, 2011. Institutional investors who were uncomfortable with the October 7, 2011 ruling could not rid themselves of the PEACe Bonds they held.
  2. The BIR issued Ruling No. DA-378-2011 dated October 17, 2011 which revised the previous October 7, 2011 ruling to withhold the taxes due not only from CODE-NGO/RCBC but also to all subsequent bondholders. As a consequence, all subsequent bondholders were made liable for the 20% Final Tax.

Left Holding the Bag

A total of nine banks have reportedly been adversely affected. Eight of these banks, namely Banco De Oro, Bank of Commerce, China Banking Corporation, Metropolitan Bank & Trust Company, Philippine Bank of Communications, Philippine National Bank, Philippine Veterans Bank, and Planters Development Bank, have petitioned the Supreme Court to annul the October 7, 2011 BIR Ruling. The ninth, BPI Family Bank, declined to participate in the petition but stated that it held around 5% of the PEACe bonds4. RCBC, in a separate petition, also questioned the propriety and legality of the BIR ruling5 but did not indicate as to whether it still held some PEACe Bonds.

The eight banks asked for and received the immediate issuance of a temporary restraining order (TRO) and/or Writ of Preliminary Injunction. The PHP 4.86 billion tax to be withheld was placed in escrow while the balance of PHP 30.14 billion was paid out to the bondholders. The banks have argued that the imposition of the 20% Final Tax on the PEACe Bonds was:

“extremely prejudicial to the bondholders, including petitioners who relied in good faith on the BIR declaration that the bonds are exempt from final tax...Such unilateral imposition of the 20 percent final withholding tax on the interest/discounts realized on the government bonds only on the eve of its maturity with nary any prior consultation with the petitioners and other bondholders also amounts to confiscation of the petitioners’ property without due process... Threatened refusal of the government to pay the full face value of the government bonds to its contractual undertaking and material representation at the time of their issuance, operates as a fraud on investors to their grave or irreparable injury or prejudice, which, in turn, adversely affects their perception of the Philippines as an investment destination,”

According to the petitioning banks:

“The repercussions of the Government's threatened intent of reneging on its commitment on the Government Bonds have far-reaching implications which are too important to ignore. There will be heightened perception that the Philippine Capital Markets are volatile and unpredictable...The Government will suffer from damaged credibility in terms of investor confidence (whether current or prospective, local or foreign) relative to the legitimacy of its commitments which, by reason of the 2011 BIR Ruling, may now be perceived as subject to arbitrary reversals and/or modifications.”

The petitioning banks also added that the unilateral amendment of a material term of the contract between the bondholder and the government was never agreed to by the petitioners, thus a violation of the contract. Moreover, the imposition of a 20% Final Withholding Tax (FWT) on the eve of the bond's maturity was done “without any prior consultation with the petitioners and other bondholders or a hearing amounted to confiscation of the petitioners' property without due process.”

Flawed Ruling

There are also strong indications that BIR did not give a lot of thought to the mechanism of collecting back taxes on the PEACe Bonds. BIR collection mechanism is flawed because:

Final Bondholders

  1. It extracts the back taxes from the funds that will be remitted to the final bondholders upon maturity, while the main beneficiaries and proponents of the erroneous 2001 rulings, namely CODE-NGO and RCBC, get away Scot-free.
  2. Moreover, the ruling extracts the 20% FWT irregardless of the length of time the bond was held. Therefore, it disproportionately punishes the more recent bondholders who will bear brunt of the taxes even though they earned the least of the imputed interest. As an example, an investor who decided to park PHP 1.0 million of his money in the supposedly risk-free PEACe Bonds for a month or two before maturity will lose 14.19% of his principal even though he earned a few months of imputed interest. Similarly, because the ruling takes away 14.19% of the bond's redemption proceeds at maturity irregardless of the bondholder's holding period, an investor who bought the bonds at its accreted value one year before its maturity will lose 2.92% of his capital instead of earning the expected 12.75% YTM on the bond. Those bought the bonds at their accreted value and who held the bonds longer will only lose the imputed interest and not principal.

Given that interest rates have gone down substantially since 2001, the bonds were most likely purchased at a premium to their accreted values, therefore it is highly likely that investors who have held the bonds for less than four years will suffer a loss of principal as well.

Subsequent Bondholders

Under BIR Ruling No. DA 278-2011 dated October 17, 2011, the BIR has found “RCBC/CODE-NGO” and “all subsequent holders” of the PEACe Bonds liable for the 20% FWT. This implies that the 20% FWT may be netted out from the sale and resale of the bonds and that the bondholder may only be liable for the taxes on the imputed interest accreted during the time the bond was held by the investor. In other words, an absolute 20% FWT becomes a 20% FWT proportionate to the imputed interest earned by the bondholder.

This arrangement is more equitable to the final bondholders. The 20% FWT would only then cut into the imputed interest earned by the bondholder over the life of his holding period and not into the principal, whether or not the bond was purchased at its accreted value or at a premium to its accreted value.

Under an absolute 20% FWT, the bond's 12.75% YTM would now range from 11.13% YTM if the bonds were bought at time of issuance to -14.19% YTM if the bonds were bought right before maturity. If the 20% FWT were proportionate to the imputed interest earned, the bond's revised YTMs would not decline so drastically: from 11.13% YTM if the bonds were bought at time of issuance to 10.26% YTM if the bonds were bought right before maturity.

Collection Problem

However, there is a problem with this scenario: The government claims it does not even know who the final bondholders are unless they come forward to claim the redemption proceeds of the bond at maturity date (although the Registry of Scripless Securities “RoSS” under the Bureau of Treasury is primarily tasked with monitoring and maintaining official records of ownership of government securities). According to BIR Commissioner Kim Henares:

“We don't have the list of the banks holding the PEACe Bonds. Supposedly under the bank secrecy law, it is supposed to be confidential. The instruction is to hold the 20% of the PHP 25 billion,”6

If this is the case, only the final bondholders would be affected. Unless the government recreates the chain of sale and resale from CODE-NGO/RCBC to the final bondholders, the final bondholders would have to recreate this process via a chain of litigation, meaning the final bondholder would have to sue the previous bondholder to collect the 20% FWT that the final bondholders are not liable for, and that previous bondholder would have to collect from the previous bondholder, and so on and so forth, until the chain of sale is retraced back to CODE-NGO/RCBC, the original bondholders. Needless to say, this would create a gigantic legal mess.

The only advantage to the current ruling is that it reduces the cash outflow of the government by 20%. But in the long run it will turn off potential investors because the bond buyers, who bought the bonds in good faith, were harmed and the bonds themselves did not prove risk free. In the future, buyers of government securities will attach a higher risk premium to government debt, especially government debt securities with all the extra features, to compensate themselves for the regulatory risk that the government will rescind these embellishments when the bonds mature, leading to higher interest rates for the entire country.

The BIR should have assessed CODE-NGO/RCBC for the PHP 4.86 billion in back taxes which would have wiped-out the endowment of the PEACe Foundation and put a big dent in RCBC's earnings and capital. But the ruling would not have angered the rest of the investment community and the country would not have to pay for the arbitrariness of the ruling in terms of higher debt costs. No one else but CODE-NGO/RCBC would have been affected and given how controversial the transaction is perceived to be even ten years later, the action would have been seen as just.

Impact on Bank's Bottom Line

The surprise imposition of the 20% Final Withholding Tax will affect the bottom line of the banks. None of them have properly accrued for the presumed tax liability and none of them have prepared themselves to receive less cash from the redemption payment of the PEACe Bonds.

To assess this impact, an analysis was made of the affected bank's holdings of government debt securities. With the exception of BPI Family Bank (who already disclosed ownership of 5% of the PEACe Bonds7), the analysis makes a critical assumption that each bank's PEACe Bonds holdings would be proportionate to their holdings of government debt securities as indicated in their latest available audited financial statements.

Under this scenario, the most adversely affected bank is Planters Development Bank with a 4.92% hit to their capital base, followed by Philippine Bank of Communications, with a 3.43% hit to capital, followed by Philippine National Bank (2.42% hit), and China Banking with a 2.06% hit to their capital. Of course, depending on the circumstances, each bank may have much higher or much lower PEACe Bonds holdings than dictated by their government debt securities holdings. So this analysis, with the exception of BPI Family bank, is just a guesstimate.

Affected Banks
Analysis of Impact of 20% Final Withholding Tax
on Affected Bank Capital
As of December 31, 2010

Total Holdings of Government Debt Securities8
(In PHP B)

PEACe Bonds Holdings
(In PHP B)

(In PHP B)

Capital Funds
(In PHP B)9

Capital Affected
(In %)
Banco De Oro
Bank of Commerce
BPI Family Bank
China Banking Corporation
Metropolitan Bank and Trust Company
Philippine Bank of Communications
Philippine National Bank
Philippine Veterans Bank
Planters Development Bank

Nevertheless, at least five of the nine banks listed above have very high absolute and relative amounts of Distressed Assets as detailed in previous blog posts in the blog “Why Banco Filipino Failed” ( The posts can be found here and here .

These five, as indicated in the table below, have a high amount of Non-Performing Assets or Distressed Assets on their balance sheets relative to their Total Capital Cushion, which is their ability to absorb losses from the deterioration of the value of their Distressed Assets. These five, namely Bank of Commerce, Philippine Bank of Communications, Philippine National Bank, Philippine Veterans Bank, and Planters Development Bank, have a Distressed Assets to Total Capital Cushion Ratio greater than 100%, which indicates a heightened risk of insolvency. A sixth bank, namely BPI Family Bank, has a ratio of 93.73%, which is borderline close to the 100% danger line.

Affected Banks
Distressed Assets to Total Capital Cushion
As of June 30, 201117

Distressed Assets
(In PHP B)18
Capital Cushion
(In PHP B)19
Distressed Assets/
Total Capital Cushion (In %)20
Banco De Oro Unibank
Bank of Commerce
BPI Family Bank21
China Banking Corporation
Metropolitan Bank and Trust Co.
Philippine Bank of Communications



Philippine National Bank
Philippine Veterans Bank
Planters Development Bank22

NPL Washing

The high incidence of distressed and near distressed banks (six out of nine banks) indicates that these banks may have used the PEACe Bonds for their ability to “window dress” bank NPLs (see a previous October 7, 2011 post “Revisiting the PEACe Bonds under the section “What else can RCBC do with the PEACe Bonds?,

Most likely, the affected banks used the PEACe Bonds to wash NPLs from their own books in cashless debit-credit accounting transactions.23

From “What else can RCBC do with the PEACe Bonds?:

For instance, an NPL that is on the bank's books for PHP 1.0 billion may only have a recoverable value of PHP 500.0 million (Step 1). The bank can sell a PHP 1.0 billion Face Value PEACe Bond (with a discounted value of PHP 500.0 million) to the delinquent borrower (Step 2). But on the books of both the bank and the delinquent borrower, the amount owed to the bank is recorded at the face value of the PEACe Bond, which is PHP 1.0 billion (Step 3). The bank then simultaneously buys back the PEACe bond from the delinquent borrower (Step 4). The repurchase of the PEACe Bond creates a payable on the right side of the bank's balance sheet and puts the bank in a situation where its has itself a shadow indebtedness to the borrower in the same exact amount as the NPL. The bank then offsets its account payable to the borrower against the NPL (of the same amount) of the delinquent borrower on the asset side (Step 5). This way, the indebtedness of the borrower remains on the accounts receivable portion of the asset side of the bank's balance sheet but it is no longer an NPL and is not connected to a loan. Thus the bank's balance sheet is laundered in a way by simply removing the stain of non-collectibility or ageing. The new receivable derived from the sale and repurchase of the PEACe Bond is after all exactly that - new.

Overstated Capital

Although the estimated impact of the abrupt imposition of the 20% FWT on bank capital is estimated to be only a 1.72% reduction in bank capital, five of the banks in question are distressed and their capital is already overstated. In some cases, the overstatement is so severe, that any additional reduction in capital from the 20% FWT may severely impair the bank's actual capital beyond the point of solvency. (See “BSP's Ampaw Accounting System”

The reason for the overstatement is that the BSP has granted regulatory relief to these banks and allowed them to:

  1. Defer the booking of realized losses arising from:

  • The Sale of Non-Performing Loans to Special Purpose Vehicles (SPVs);
  • The Acquisition by a Bank of Bank of another weaker Bank with substantial Non-Performing Assets;
  • Large Credit and Impairment Losses on financial assets of banks that are undergoing a BSP-approved Rehabilitation Plan

  1. Amortize the realized losses over a period of 10 to 20 years

As a result of this regulatory relief, losses were not realized on these banks books. Instead, the unrealized losses were swept into the “Other Assets” accounting bucket as deferred charges. Although the BSP mandated regulatory relief allowed the banks to look stronger than they are, such bookings do not comply with Philippine Financial Reporting Standards (PFRS). As a result, banks that availed of the regulatory relief show a qualified auditor's opinion that:

  1. States that the bank's booking of deferred charges does not comply with the provisions of GAAP/PFRS/PAS
  2. Discloses the impact such compliance would have on the bank's financial statements had the losses been recognized.

Banks with Qualified Auditor's Opinions on Deferred Charges
As of December 31, 201024

Deferred Charges
Unadjusted Capital Funds
Adjusted Capital Funds
% Reduction in Capital Funds
Bank of Commerce25
PHP 4.4 B
PHP 7.6 B
PHP 3.2 B
Philippine Bank of Communications26
5.9 B
3.6 B
-2.3 B
Philippine National Bank
5.6 B
33.3 B
27.7 B
Philippine Veterans Bank27
1.1 B
5.0 B
3.9 B
Planters Development Bank
1.6 B
3.7 B
2.1 B
PHP 18.6 B
PHP 49.6 B
PHP 34.6 B


Although the Aquino Administration has given some thought as to the errors of the 2001 Banez rulings on the PEACe Bonds, it seems that it has not given much thought as to the methods by which these “errors” could be rectified. Instead of targeting CODE-NGO/RCBC, the main beneficiaries and proponents of the 2001 rulings, for collection of unpaid taxes, it chose to extract these back taxes from the final bondholders. More so, it did this in a manner that disproportionately punishes the the investors who acquired the bonds on a more recent basis. The 2011 BIR rulings are undoubtedly flawed. As to whether they will weaken an already weakened banking system remains to be seen. But they have already achieved the unintended consequence of seriously damaging the government's credibility not only with regards to the sanctity of its contractual obligations but also with regards to its ability to thoroughly think through the ramifications of its decisions.

1“Code-NGO under pressure to use P1.4-B gain well,” by Margarita H. Debuque, February 22, 2002, Philippine Daily Inquirer
2“Vanishing trade in PEACe Bonds: The truth, the banks, and the BIR,” by Roel Landingin, October 25, 2011, Philippine Center for Investigative Journalism
4“Banks seek SC stay order on bond tax,” October 17, 2011, Businessworld
5“RCBC asks court to review BIR ruling on tax bonds,” October 17, 2011, Manila Bulletin
6“BIR: P35-B PEACe bonds should be subject to tax”, October 17, 2011, ABS-CBN
7“Banks seek SC stay order on bond tax,” October 17, 2011, Businessworld
8Unless otherwise indicated, the banks holdings of Government Debt Securities is from their Audited Financial Statements as of December 31, 2010.
9Unless otherwise indicated, the banks Capital Funds figures are from their Audited Financial Statements as of December 31, 2010.
10Bank of Commerce latest Audited Financial Statements are as of December 31, 2009
11Bank of Commerce latest Audited Financial Statements are as of December 31, 2009
12The figures for BPI Family Bank's Government Debt Securities are not available. The figures supplied are from the banks's total investment securities holdings as of March 31, 2011 based on their Published Statement of Condition in the BSP website,
13BPI Family Bank acknowledged that it held 5% of the PEACe Bonds.
14The figures supplied are from the banks's total investment securities holdings as of March 31, 2011 based on their Published Statement of Condition in the BSP website,
15Philippine Veterans Bank's latest Audited Financial Statements are as of December 31, 2009.
16Philippine Veterans Bank's latest Audited Financial Statements are as of December 31, 2009.
17Unless otherwise indicated, the figures are based on the individual bank's Published Statement of Condition as of June 30, 2011 found in the BSP Website:
18Includes Classified Loans and Other Risk Assets, Acquired Real Estate, Non-Current Assets Held for Sale, and Other Assets. Distressed Assets may drop significantly in value if the assets such as Non-Performing Loans continue to deteriorate.
19Includes Stockholders Equity Less Other Capital Accounts Plus Allowance for Credit and Impairment Losses. This measures the bank's ability to absorb losses.
20A Ratio of Distressed Assets to Total Capital Cushion greater than 100% signals a higher risk of insolvency.
21Based on BPI Family Bank's Published Statement of Condition as of March 31, 2011 found in the BSP Website:
22Based on Planters Development Bank's Published Statement of Condition as of March 31, 2011 found in the BSP Website:
23“Laundering out losing loans,” by Dean de la Paz, March 7, 2002, Businessworld
24Unless otherwise indicated, all figures are from the individual bank's audited financial statements as of December 31, 2010.
25Audited Financial Statements as of December 31,2009. The bank has since been acquired by San Miguel Corporation
26The bank has since been acquired by the Roberto Ongpin Group.
27Audited Financial Statements as of December 31, 2009.