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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!


  1. " 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,"

    so why didnt they do that?

    instead they held onto to the bonds.

    i THINK this is the problem you have identified w peace bonds.... the govt lost the opportunity to sell (to multiple banks), for a larger profit than what codengo got for its programs.

    this theoretical foregone profits that the govt could have gotten, its unclear how they might have extracted them.

    do you mean that these institutions that bought them in the secondary market, had they had the info as u alleged they didnt, could have won the bid directly?

  2. RCBC was forced to hold on to the PEACe Bonds because of the negative publicity regarding the deal. RCBC's Treasurer, Jaime Panganiban admitted as much. Check out:

    "Revisiting the PEACe Bonds"

    “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.

    As to how the government could have extracted greater profits on the bonds, the government could have done several things:

    1) It could have declared the Treasury Bond auction of the PEACe Bonds a failure because of the very wide range of bids. It could have greatly clarified all these eligibilities and given more time for the GSEDs to digest their implications. Although the Bureau of Treasury declared the PEACe Bonds tax-exempt, I think the GSEDs may have needed time to see the actual ruling and run this by their legal department to iron out all the implications of this. Remember, very few T-Bonds had these eligibilities.

    2) Panganiban also said that eligibilities had significant value:

    “Hindi palugi iyan because at that time, if you remember, the reserve requirement (yields of reserve eligible securities) was, I think about seven percent, which means a four percentage point difference (11 percent minus 7 percent),” he says.

    In other words, even if we didn't touch the issue and placed it in our reserves, we already have a 4-percent carry.”

    Only RCBC and CODE-NGO knew the implications of these eligibilities because only they had actual copies of the rulings.

    2) The Treasury/DOF could have found a way to make the bonds sold on a more retail basis to cut out the middlemen. Like a retail T-Bill, smaller denominations.