Estimating RCBC/Yuchengco Group's Profits from the PEACe Bonds

Editor's Note: This is an update to a previous post entitled "Estimating RCBC's Profits from the PEACe Bonds" that incorporates new and better information.

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 and/or RCBC's parent, the Yuchengco Group of Companies, 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 of PEACe Bond Transactions sourced from the Registry of Scriptless Securities, it seems that RCBC had rid itself of its entire PEACe Bond inventory by March 2002.  Or given that RCBC had recently admitted to holding on to PhP 1.388 billion or roughly 4% of the PEACe Bonds Issue (See "With a PEACe Bonds Tax, PBCom is Left Holding the Bag"), they could have disposed of the inventory they wanted to dispose of even earlier, possibly by February 2002.  However, it is not clear if the PhP 1.388 billion in PEACe Bonds held by RCBC were held until maturity or were repurchased from other institutional investors.

	Number of Transactions	Face Amount	Cumulative Face Amount
Date	#	(In PhP Billions)	(In PhP Billions)
October 2001	8	10.96	10.96
November 2001	20	3.82	14.78
December 2001	17	3.83	18.61
January 2002	29	7.41	26.02
February 2002	34	5.65	31.67
March 2002	22	3.53	35.20

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 March 2002, the profit would have been PHP 2.00 billion.

	PEACE Bond Sales	Price to Institutional Investor	Cost to RCBC
	Face Amount	At 9.370% YTM	At 11.000% YTM	RCBC's Profit
Date	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)
October 2001	10.96	4.39	3.76	0.63
November 2001	3.82	1.54	1.32	0.22
December 2001	3.83	1.56	1.34	0.22
January 2002	7.41	3.03	2.61	0.42
February 2002	5.65	2.33	2.01	0.32
March 2002	3.33	1.38	1.19	0.19
Total	35.00	14.23	12.23	2.00

If YTMs remained at 8.170% (the lower end of its previous selling range) and the bonds were fully sold by March 2002, the profit would have been PhP 3.71 billion.

	PEACE Bond Sales	Price to Institutional Investor	Cost to RCBC
	Face Amount	At 8.170% YTM	At 11.000% YTM	RCBC's Profit
Date	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)
October 2001	10.96	4.92	3.76	1.16
November 2001	3.82	1.73	1.32	0.41
December 2001	3.83	1.74	1.34	0.4
January 2002	7.41	3.39	2.61	0.78
February 2002	5.65	2.61	2.01	0.6
March 2002	3.33	1.55	1.19	0.36
Total	35.00	15.94	12.23	3.71

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
	YTM	YTM	RCBC	RCBC's Profit
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%

At these rates, RCBC's profits on the PEACe Bonds could have been as high as PhP 4.91 billion or 30.97% higher than the PhP 3.749 billion estimate had the PEACe Bonds been sold in October 2001 at an 8.170% YTM.

	PEACE Bond Sales	Price to Institutional Investor	Cost to RCBC
	Face Amount	At Fluctuating YTMs	At 11.000% YTM	RCBC's Profit
Date	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)	(In PhP Billions)
October 2001	10.96	4.92	3.76	1.16
November 2001	3.82	1.85	1.32	0.53
December 2001	3.83	1.95	1.34	0.61
January 2002	7.41	3.79	2.61	1.18
February 2002	5.65	2.91	2.01	0.9
March 2002	3.33	1.72	1.19	0.53
Total	35.00	17.14	12.23	4.91

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

RCBC's 2002 Internal Office Memo on the PEACe Bonds

INTER-OFFICE MEMORANDUM

________________________________________________________________________

TO : ALL ASSOCIATES

FROM : Financial Markets Group

SUBJECT : The "PEACe BONDS"

DATE : January 30, 2002

________________________________________________________________________

What are the PEACe Bonds?

Peace Bonds are 10-year zero-coupon (no recurring interest payments) treasury bonds with certain

eligibilities designed to raise funds for poverty alleviation programs. These funds are raised from

proceeds of the sale of government securities in the private secondary market. The bonds were

conceptualized by the financial advisers of CODE-NGO, the largest network of development NGOs in the country.

What government securities are used for the PEACe Bonds?

Ten-year zero-coupon bonds issued by the Bureau of the Treasury on October 16, 2001 were the securities used for the PEACe Bonds. The Bureau issued P 35B worth of zero-coupon bonds from total bids of over P 135B.

What are the eligibilities attached to the PEACe Bonds?

PEACe Bonds have the following eligibilities:

Tax Exempt status by law per BIR Ruling 020-2001 issued May 31, 2001

Eligibility as Liquidity reserves issued by the Bangko Sentral ng Pilipinas per Resolution Nos. 878, 1261 and 1545 dated June 7, 2001, August 9, 2001, and September 27, 2001 of the Monetary Board later consolidated under BSP Circular No. 307 dated October 18, 2001.

Eligibility as capital and reserve investments of insurance companies under Sections 203 and 204 of the

Insurance Code issued by the Insurance Commission dated November 16, 2001.

How were the PEACe Bonds offered?

The bonds were offered to authorized securities dealers in an open public auction conducted by the

Bureau of Treasury on October 16, 2001. The notices were issued one week in advance of the auction as compared to the usual 3-day notice required by law.

Who can request for eligibilities with the above regulators? (BIR, BSP, IC)

From time to time the BIR, BSP and the Insurance Commission receive requests from government,

quasi-government and private corporations for certain eligibilities to be provided to certain instruments and/or transactions. The merits on whether to grant these eligibilities/requests are deliberated upon by these agencies on a case-to-case basis in their regular meetings. It is therefore not unusual for private corporations to request and be granted eligibilities by these agencies.

How was CODE-NGO able to sell the PEACe Bonds?

Following the concept of their financial advisers, CODE-NGO then proceeded to engage the services of an underwriter, RCBC Capital Corporation to purchase (underwrite) the bonds at a pre-determined price at a future date.

How was CODE NGO able to acquire the bonds?

In an auction administered by the Bureau of Treasury, CODE NGO was able to purchase the entire zero-coupon offering through its authorized government securities dealer, Rizal Commercial Banking Corporation.

Was the winning bid disadvantageous to the government?

No. On the contrary, CODE-NGO?s winning bid in the open auction for the 10-year zero-coupon bonds resulted in interest savings for the government. At the time of the bidding the prevailing rate for 10-year government securities was 16.93% gross or 13.544% net. The winning bid that enabled CODE NGO to purchase the bonds was 12.75% or .794% lower than the prevailing rates. The auction itself attracted P 137B in bids from various bidders in the financial market.

How was CODE NGO able to subsequently sell the PEACe Bonds?

CODE NGO subsequently sold the PEACe Bonds through an underwriter for eventual resale in the secondary financial markets thus raising P 1.3B currently held in trust for the permanent endowment of the PEACe foundation. The underwriter is RCBC Capital Corp., the investment arm of RCBC.

Was it unusual for RCBC as a Government Securities Eligible Dealer (GSED) to bid on behalf of CODE NGO?

Not at all. Most if not all GSEDs bid for resale in the secondary market. In fact, in a clarificatory note published in Businessworld on January 22, 2002. National Treasurer Sergio Edeza said: “Only GSEDs can participate in an auction. However, these GSEDs sell bonds in the secondary market after every auction. Any interested party can always buy government securities in the secondary market from Government Securities Eligible Dealers. The BTr does not in any way exercise control or regulate the trading of government securities in the secondary market. All transactions in the secondary market for government securities are the business of GSEDs.”

What was the nature of the funds that were raised through the PEACe Bonds?

The funds that were raised were ALL PRIVATE FUNDS. During the auction the funds that were delivered to the Bureau of Treasury were ALL PRIVATE FUNDS. The funds subsequently raised through the secondary sale of the PEACe Bonds were ALL PRIVATE FUNDS. NO Government Funds were used in the entire process.

RCBC does not engage in questionable transactions. Neither will it involve itself in a “scam” nor engage in “insider trading.” The auction was conducted by the Bureau of Treasury and was open to all Government Securities Eligible Dealers (GSEDs). The secondary private placement of the PEACe Bonds was done after the auction. It was a normal, private secondary market transaction using private funds.

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 (http://pcij.org/blog/2011/10/25/vanishing-trade-in-peace-bonds-the-truth-the-banks-the-bir), 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.

		Cumulative
	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
	YTM	YTM	RCBC	RCBC's Profit
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

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? (http://systemisbroken.blogspot.com/2011/10/tax-on-peace-bonds-who-is-left-holding.html) 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	27,108		27,108
Acquired Real Estate	7,303		7,303
Other Assets	8,865	6,0722	2,793
Total Distressed Assets	43,276	6,072	37,204
Capital Cushion
Common Capital	26,896	10,9323	15,964
Allowance for Losses	10,157		10,157
Total Capital Cushion	37,053	10,932	26,121
Distressed Assets/Capital Cushion Ratio	1.17		1.42

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