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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.