Pushing The Frontiers of Structured Commodity Finance

1. Pushing The Frontiers of Structured Commodity Finance Lamon Rutten Coordinator, commodity marketing, risk management and finance United Nations Conference on Trade and Development Asia Pacific Countertrade Association 2001 Conference Singapore, 12-14 September 2001

2. Structure of the presentation Context – a changing environment provides threats and opportunities Developments in commodity finance – Basle II and other currents The increasing relevance of structured finance Pushing the frontiers of structured commodity finance: securitization new risk-takers new tools for reaching new clients Conclusion

3. The context: threats………. The walls are coming down…. “as soon as you hear the sound of the trumpet, then all the people shall shout with a great shout; and the wall of the city will fall down flat” (The Bible, Joshua 6:1-5 RSV) Investors Banks Insurers Traders

4. The context: threats………. Come gather 'round people, wherever you roam And admit that the waters around you have grown And accept it that soon you'll be drenched to the bone.If your time to you is worth savin'Then you better start swimmin‘ or you'll sink like a stone For the times they are a-changin'. Bob Dylan Investors Banks Insurers Traders

5. The context: threats………. and opportunities Through improved technology, many more people can be reached more easily and more cheaply. People/companies increasingly develop economic networks that can act as the basis for financing. The tools for risk management (including price risk) have much improved. The barriers posed by government rules and regulations are becoming less cumbersome. Money is abundant – only risk-carrying capacity is scarce.

6. Developments in commodity finance Consolidation of the commodity trading/processing industry Consolidation of the banking industry Increasing competition from institutional investors Severe lack of appetite for traditional (unsecured) commodity financing Increased country risk awareness by banks Increased demand for risk capital, with BIS 2005.

7. The new Basle agreement will make risk capital more expensive Risk weight Capital required Breakeven spread Examples of per 100 $ change (bp) countries Triple B Current 100 8.0 - China Standardized 50 4.0 -50 Korea IRB approach 40 3.2 -60 Egypt Double B Current 100 8.0 - Brazil Standardized 100 8.0 - Colombia IRB approach 379 50.4 +1115 India Single B Current 100 8.0 - Argentina Standardized 100 8.0 - Jamaica IRB approach 630 50.4 +3709 Pakistan Based on Reisen & Griffith-Jones, 2001 It is expected that, in order to avoid a possible downgrading of their own rating, banks will tend to opt for the Foundation Approach - that is, the Internal Ratings (IRB) approach. So solvency requirements for risk to emerging countries will increase strongly. Lending for these countries will become less, and what arrives will be more costly and more pro-cyclical.

8. …. and will particularly widen the gap between AA and lesser ratings…. Now, a big gap between BBB (investment grade) and BB. The interest rates on securities depends on the tenor and currency of the issue, they change over time, and not all equally-rated issues get equal interest rates, even if offered on the same day – investors’ perspectives may differ from those of the rating agencies. The following therefore only gives a first impression of how interest rates relate to ratings – expressed here as basis points premium over LIBOR. AAA AA A BBB BB B + 30bp + 50 bp + 70 bp + 120 bp + 225 bp + 400 bp BBB and up are investment-grade ratings. As can be seen, when issues are not investment-grade, interest rates quickly become higher. In the future, Basle II will reduct the risk weightings of AA- or better from 100 percent to 20 percent, by 2004. A and BBB-rated countries, companies and asset-backed securities will be faced with rising interest rate premiums.

9. Through use of structuring techniques, financiers can control their level of risk Without structured finance: With secured finance: With structured finance: financier financier financier Will he produce? Will the collateral disappear? Will he reimburse? $ Potential borrower Potential borrower Potential borrower goods

10. An example – migrant remittances-based finance In-country Offshore International Bank (arranger) US$ 40 million Debt Service Reserve account Debt Service Reserve Account build-up (over first 6 months) Assignment of all receivables from migrants’ remittances Acknow-ledgement of assignment of receivables Debt service Collection account Sighting account US$ 3 mn/month Surplus over US$ 3 mn/month Development Bank Money Transfer Company Money Transfer Agency Agreement Orders for money transfer (hard currency) Country risk can be mitigated through structured finance arrangements Migrant workers

11. Do these structures really work? Yes, they do. An example: In Dec. ’99 and Oct. 2000, Asia Pulp and Paper (APP) received 2 x 125 million US$ in 5-year finance. APP rating: CCC+. Transaction rating: AA (Aa3). The rating was so high because monoliner Centre Solutions provided a wrap. In March 2001, APP announced a debt payment standstill. In April, it indicated it had a debt of 13.4 billion US$ (a number that has gone up since). A large number of banks in the region – both foreign and domestic – have suffered heavy losses in the company. But those providing the 250 million US$ do not need to worry: “Financial risks insurer Centre Solutions does not expect any problems for the investors in a trade receivables transaction, totalling USD 250 million, originated by Asia Pulp & Paper Co Ltd.” http://www.vinodkothari.com/secnewsapril01.htm

12. Pushing the frontiers of structured commodity finance Securitization – look for the money. Risk-carrying capacity as a product – look for the ability to carry risk. Monoliners as well as institutional investors will become increasingly aggressive. Growing use by financiers of technology as a “delivery tool” enabling them to reach a new clientele at low cost. Look for the clients. Those willing to pay the highest rates are generally ignored by banks because of the costs of reaching them. Technology has made it possible to change this.

13. Securitization Now: structured financings are generally driven by the client. Near future: a) financiers will be the drivers – structured finance will be a tool to generate paper which banks or investors can finance, and financiers will develop ways to generate more paper. Examples: Warehousing/inspection companies now intervene in the context of individual, often one-off financing deals. When will an AAA-rated entity take over a reputable warehouse company with the explicit objective of generating paper for investment purposes (by local or international investors) – that is, go out to developing countries and find stocks of goods that it can take under control? Banks can generate a diversified portfolio of commodity-related loans, put these into a Special Purpose Vehicle, and securitize them (done by SG, in 2000 – by the end of 2000, 790 million US$ had been placed). Groups of institutional investors, including private banks, are likely to start looking for ways to invest directly into commodity trade – e.g., by setting up structures similar to hedge funds.

14. Risk-carrying capacity • Because of Basle II, banks actually have an interest in moving risks out of their books. Likely developments: • Banks will make more use of special purpose vehicles as conduit for their own commodity financing operations. • Banks will face increasing direct competition from investors who are not constrained by Basle II or internal bank rules. • Monoliners (specialized financial guarantee companies, set up by insurance firms) will become increasingly aggressive. The number of such firms has been increasing in recent years. And if they accept a deal, it automatically becomes AA or AAA-rated – and that is where, in the future, the low-cost finance is. Now, these monoliners more or less arbitrage between a rating agency’s assessment of a deal structure, and their own assessment. In the future, it is not unlikely that they will take a more pro-active role in the actual structuring of transactions – that is, become like investment banks. • Owning the capacity to carry risk (e.g., build a portfolio) or to manage it (e.g., through collateral management) is likely to become increasingly profitable in the years to come.

15. Technology provides new delivery tools for finance Example: selling goods “with financing attached” Buyer makes successful bid Buyer B2B-exchange- approved warehouse Goods come “packaged” with automatic financing possibility This system has been implemented in an Asian exchange. A seller puts his products into a warehouse approved by the B2B exchange. The offer is put on the web, and a buyer successfully bids. He pays 20% of the value, and if he wishes, a bank that cooperates with the B2B exchange automatically finances the remaining 80% (so that the seller can be immediately paid). As long as the goods are in the warehouse, the finance remains in place. The bank relies on the creditworthiness of the B2B exchange and its clearinghouse - there is less work and less credit risk than when lending through individual loans to individual traders. Note that funds do not need to come from banks: institutional investors could also put their money in a scheme such as this.

16. Another example: reaching farmers without having branch offices Provides smart card Farmer Banks Deposits commodities Can withdraw money and eventually, get information with smart card Agreements Warehouse company Charges the smart card Input provider Farmer can buy inputs (or, for example, diesel) on credit Automatic Teller Machine Installation and management of automatic teller machines

17. Conclusion Although there is an abundant supply of money, there is also a large body of companies and other entities which pay very high rates to obtain finance. So where is the arbitrage? The new Basle rules do not make it easier for the supply and demand to meet, but - greater use of structuring techiques, - increasing use of the potential of the capital market, - the steadily improving sophistication of the market for risk transfer, and - the possibility to use new technologies to reach customers will allow money to flow where it is most needed, to everone’s benefit. Like water, the money will flow through the paths of least resistance – so there is likely to be a good reward to those who successfully invest in facilitating the financing process.