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BUFN 722

BUFN 722. ch-16 Sovereign Risk. Introduction. In 1970s: Expansion of loans to Eastern bloc, Latin America and other LDCs. Beginning of 1980s: Poland and Eastern bloc repayment problems. Debt moratoria announced by Brazil and Mexico. Increased loan loss reserves. Introduction (continued).

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BUFN 722

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  1. BUFN 722 ch-16 Sovereign Risk BUFN722- Financial Institutions

  2. Introduction • In 1970s: • Expansion of loans to Eastern bloc, Latin America and other LDCs. • Beginning of 1980s: • Poland and Eastern bloc repayment problems. • Debt moratoria announced by Brazil and Mexico. • Increased loan loss reserves BUFN722- Financial Institutions

  3. Introduction (continued) • Late 1980s and early 1990s: • Expanding investments in emerging markets. • Peso devaluation. • More recently: • Asian and Russian crises. • MYRAs • Brady Bonds BUFN722- Financial Institutions

  4. Credit Risk versus Sovereign Risk • Governments can impose restrictions on debt repayments to outside creditors. • Loan may be forced into default even though borrower had a strong credit rating at origination of loan. • Legal remedies are very limited. • Need to assess credit quality and sovereign risk BUFN722- Financial Institutions

  5. Sovereign Risk • Debt repudiation • Since WW II, only China, Cuba and North Korea have repudiated debt. • Rescheduling • Most common form of sovereign risk. • South Korea, 1998 • Argentina 2001(severe ongoing economic problems at time of writing) BUFN722- Financial Institutions

  6. Debt Rescheduling • More likely with debt financing rather than bod financing • Loan syndicates often comprised of same group of FIs • Cross-default provisions • Specialness of banks argues for rescheduling but, incentives to default again if bailouts are automatic BUFN722- Financial Institutions

  7. Country Risk Evaluation • Outside evaluation models: • The Euromoney Index • The Economist Intelligence Unit ratings • Institutional Investor Index BUFN722- Financial Institutions

  8. Country Risk Evaluation • Internal Evaluation Models • Statistical models: • Country risk-scoring models based on primarily economic ratios. BUFN722- Financial Institutions

  9. Statistical Models • Commonly used economic ratios: • Debt service ratio: (Interest + amortization on debt)/Exports • Import ratio: Total imports / Total FX reserves • Investment ratio: Real investment / GNP • Variance of export revenue • Domestic money supply growth BUFN722- Financial Institutions

  10. Problems with Statistical CRA Models • Measurements of key variables. • Population groups • Finer distinction than reschedulers and nonreschedulers may be required. • Political risk factors • Strikes, corruption, elections, revolution. • Portfolio aspects BUFN722- Financial Institutions

  11. Problems with Statistical CRA Models (continued) • Incentive aspects of rescheduling: • Borrowers and Lenders: • Benefits • Costs • Stability • Model likely to require frequent updating. BUFN722- Financial Institutions

  12. Using Market Data to Measure Risk • Secondary market for LDC debt: • Sellers and buyers • Market segments • Brady Bonds • Sovereign Bonds • Performing LDC loans • Nonperforming LDC loans BUFN722- Financial Institutions

  13. Key Variables Affecting LDC Loan Prices • Most significant variables: • Debt service ratios • Import ratio • Accumulated debt arrears • Amount of loan loss provisions BUFN722- Financial Institutions

  14. *Mechanisms for Dealing with Sovereign Risk Exposure • Debt-equity swaps • Example: • Citibank sells $100 million Chilean loan to Merrill Lynch for $91 million. • Merrill Lynch (market maker) sells to IBM at $93 million. • Chilean government allows IBM to convert the $100 million face value loan into pesos at a discounted rate to finance investments in Chile. BUFN722- Financial Institutions

  15. *MYRAs • Aspects of MYRAs: • Fee charged by bank for restructuring • Interest rate charged • Grace period • Maturity of loan • Option features • Concessionality BUFN722- Financial Institutions

  16. *Other Mechanisms • Loan Sales • Bond for Loan Swaps (Brady bonds) • Transform LDC loan into marketable liquid instrument. • Usually senior to remaining loans of that country. BUFN722- Financial Institutions

  17. Pertinent Websites BIS www.bis.org Heritage Foundation www.heritage.org Institutional Investor www.institutionalinvestor.com IMF www.imf.org To learn more about the Economist Intelligence Unit’s country ratings, visit: The Economist www.economist.com Wall Street Journal www.wsj.com World Bank www.worldbank.org Web Surf BUFN722- Financial Institutions

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