Code-NGO under pressure to use P1.4-B gain well Codes: QC A04 Author: Margarita H. Debuque Source: Philippine Daily Inquirer Date Published: 02/22/02 Starting Page: internet edition THE SUPPOSEDLY miniscule probability (0.0007 percent) of a dealer cornering all the bids assumes random events with an equally probable chance of occurring. But when human behavior is factored in, such as when an institution wants desperately to win all the offers or at least a majority, Bureau of Treasury (BTr) officials say such a calculation is inappropriate. "We cannot stop a GSED (government securities eligible dealer) if it wants to bid aggressively because that's favorable to us and anyway this is not the only case when a single bank won the entire auction," National Treasurer Sergio Edeza says. "In one auction, in fact, just one bank won all the 91-day Treasury bills while another bank won all the 182-day T-bills. But we can't question that because that's the lowest rate and to have done otherwise would not be good government." Oppositionist senators further insinuate that they know of at least one bank willing to bid at a price with a yield of 11.0 to 11.5 percent, better than the tenders of winner Rizal Commercial Banking Corp. (RCBC), and even identified this financial institution as "the Metrobank group". The bank's officials, however, have refused to testify in the Senate finance committee's inquiry, the senators said. One senator claims the said bank faxed a bid lower than RCBC's winning rates to the Treasury's Securities Origination Division at the appointed time but officials intercepted this such that it never registered in the auction's records. Sources in the BTr and the Department of Finance privy to the details of the auction say the dealer (Metrobank) did submit a bid but while its valuation was "competitive" it was never within the range claimed by the oppositionist senators. Edeza said this value never entered the bureau's fax machines and that if it did, the auction committee would have awarded it "outright". "It is our job to borrow at the lowest rate available, but no such bid was ever submitted," he said. Senate finance committee chair John Osmeña said the committee was investigating the possibility of collusive behavior among the GSEDs, which he said was a common practice in public works auctions. "There's something suspicious when there's one bank willing to buy at 11 percent and other buyers pricing it at 13 (percent)," he said. "Either they didn't know enough about the bonds or they had an agreement that they would all split the bonds at 11 percent." Allegations of rigging in the Oct. 16 auction of the 10-year zero-coupon bonds either through manipulation by government officials or collusion by participants to favor a participant has cast doubt on the entire Treasury system, prompting industry leaders to rally behind the BTr. They say one need only make a post-auction analysis to ascertain the bidding was legitimate and the private transaction regarding the PEACe bonds "aboveboard". Three points are often made: The issue was four times oversubscribed; 15 GSEDs, including five foreign banks, tendered 45 bids; and no one objected to the issuance. The Money Market Association (MART) says it has not received a single complaint on the auction of 10- year zero-coupon bonds from its members. Regardless of whether the bidding was actually rigged or not, however, some politicians and NGOs believe the result of the auction reflects a gross compromise of the government. Code-NGO's windfall gain of 1.4 billion pesos from the trade of PEACe bonds, they say, implied that the government was unable to minimize the country's borrowing cost. "You can see that the market price was at 11 percent and not 13 percent because there was a ready, willing and able buyer at 11 percent," said Senator Sergio Osmeña, referring to RCBC Capital's commitment in its underwriting contract to buy the 10-year zero-coupon bonds from Code- NGO at that rate. "They (Treasury) should have gone around the banks and found the best possible deal. You are not supposed to look at some rate from Bloomberg." Edeza, a former treasurer of the Metrobank and the Bangko Sentral ng Pilipinas (BSP), maintains that the 11-percent rate paid was agreed between two private entities and hence a secondary-market transaction. The BTr deals only in the primary market, which consists mainly of GSEDs that act as wholesalers of government securities. "At the end of the day, the proof of whether a rate is correct is the auction," Edeza said. "That is why we said we should go into an auction. That is why we insisted. Because if that rate is true, then we would have seen someone or at least all the market bidders bid at that level (11 percent)." The BTr says the government actually saved three billion pesos in interest cost since the prevailing secondary market rate for 10-year Treasury coupon bonds (based on Bloomberg's MART 1 series, which GSEDs use as their benchmark) was 16.93 percent at the time of the auction. To make this rate comparable to zero-coupon bonds, accounting for the 20- percent final withholding tax and the present value of the coupon payments translates to a rate of 14.14 percent. Even pricing in the liquidity reserve feature gives a yield of 13.64 percent, Treasury officials say. This is almost 90 basis points higher than the winning bid of 12.75 percent that RCBC paid. Edeza added that a bank treasurer always prices the liquidity reserve feature mindful of the fact that this value could easily be eroded by actions of monetary authorities. The BSP has cut the liquidity reserve requirement twice, to the current 7.0 percent of deposits and deposit substitutes. At the time of the zero coupon bonds auction, the requirement for secondary reserves was at a high of 11 percent. Still, some groups contend the Treasury should have rejected the bids because the gap between the purchase price (12.75 percent) and the price of the bond on the secondary market (11 percent) was too wide. "Instead of using 14.14-percent interest rate as the benchmark, the Treasury should have aimed for an amount closer to nine percent – the going yield of financial assets that are eligible to be used as bank reserves mandated by the BSP," said the Freedom From Debt Coalition in a position paper. The group further claimed that because of the tax exemptions, foregone tax could amount to as much as P1.44 billion, which they compute as the present value of a 20-percent tax applied on the zero coupon bonds, while the bond issuance could only add to the country's debt burden. Treasury officials say that this latter argument is not correct since the yield that the BTr got on the bonds was much lower than the prevailing market rate on a net-to-net basis. "The 12.75 percent is net of tax already, and if you compare that with the net rate of a regular bond which is 13.5 percent net (16.93 percent less 20 percent withholding tax), it's nearly a full percentage point. So didn't we save money there? Didn't we collect our taxes effectively?" Edeza said. The BTr added that the auction of the 10-year zero-coupon bonds, consistent with Finance Secretary Jose Isidro Camacho's vow to introduce novel instruments to the domestic market, was part of the existing borrowing program to cover its operating expenses and debt service and did not mean further debts of the national government. Sources say the public coffers were also quite lean then as program loans were not entering the country and government had to depend bond floats. The discourse will continue and there will be valid points made on all sides. But if one stripped the debate to the core, one will see that, in truth, only one basic question needs to be answered to settle the issue. The speculation will continue as long as one thing remains unexplained – the unusually large profits of Code-NGO, what they did to deserve it, and the willingness of RCBC to give it away. Corollary to this is to ask whether the rate committed by RCBC, at 11 percent, was the "true" market rate, and if it was, why this failed to surface despite an auction. Given the apparent absence of any major irregularity in the bidding for the issues underlying the PEACe bonds, the missing piece of the puzzle lies mainly with the financial institutions that allowed the NGO such large trading margins in the first place. Some things desperately need to be clarified now by these companies. Why, barring pure altruism, would RCBC and RCBC Capital turn over roughly 1.4 billion pesos to an NGO? Why would they sign an underwriting agreement allowing the latter to earn huge profits without shelling out any cash? Why, when the Treasury decided on an auction, did they not simply walk away and keep their money? Under the negotiated deal Code-NGO and its financial advisers were pursuing in March, the answers come easy. In that context, the RCBC group would not only have sole access to the issue that it could sell down or place in its bank's reserves, yielding much more (15 to 15.5 percent) than what other reserve eligible instruments could offer (then about 8 to 9 percent), but it would have bought them at a reasonable price as well (11 to 11.6 percent). With all the eligibilities that the bank believed Code-NGO could have gotten from the government (and did), this rate would have compared favorably with the prevailing market rate for ordinary 10-year Treasury bonds, then hovering at about 14.5 to 14.75 percent, or equivalent to a rate of well over 11.5 percent if the effects of the tax exemptions and reserve eligibilities are accounted. Given prevailing market conditions during the auction, however, the bank's motivations are much more difficult to surmise. The market rate for 10-year Treasury coupon bonds was then beginning to approach 17 percent. Adjusted for the special eligibilities, the BTr said this translated to about 13 to 13.5 percent during the time, close to what other players in the market were bidding (which was reportedly within a range of 13.25 to 13.5 percent). In this scenario, RCBC Capital's commitment to bid 12.75 percent in behalf of Code-NGO and then buy the same bonds at 11 percent seems much less easy to understand. The conclusion that could be made at the outset is that RCBC, by tagging a higher price on the 10-year zero-coupon bond (effectively, 11 percent), valued the instrument's reserve eligibility feature and its "other properties" much more highly than did other banks that bid for the issue. When the PEACe bonds transaction was finished, the bond issues immediately went back to the vaults of RCBC. Only 10 percent (about 1.2 billion pesos) of the issues had been sold to institutional investors, majority of which, reports say, comprise the insurance companies of the Yuchengco group, which also owns RCBC. RCBC treasurer Jaime Panganiban says that contrary to what people might believe, the RCBC group did not buy at a loss in the PEACe bonds transaction, and offers his reasons. One, he says, is that they had "a fallback" in the form of bank reserves. "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 seven percent)," he says. "In other words, even if we didn't touch the issue and we just placed it in our reserves, we already have a 4-percent carry." Another reason is that the bank has thought of uses for the instruments among which are "principal- protected products" not found locally. "I can create from these bonds a fund with a principal-protected product where your upside potential is unlimited and your worse return is 100 percent of your principal, because it's guaranteed by government, though we're not saying we have advanced product knowledge because these products you can easily find abroad," he says. Panganiban adds that RCBC considered the present situation where most banks, because of a high NPL ratio, find themselves with a negative tax position. "The PEACe bonds, aren't they tax-exempt, so I have a tax enhancement on that?" he notes. The matter of treatment of income taxes is still being debated. At this point, the bank really does not need to do any explaining about losses regarding the PEACe bonds as interest rates have dropped drastically since November, leaving it with a treasure trove the same way banks that had bought other types of issues at a high rate are now making a virtual killing. In many ways, this is a lucky break for the bank's officials. Claiming it expected interest rates and inflation rates to fall, Panganiban says the RCBC group simply took a calculated albeit risky gamble that paid off. "The thing is if we had not taken that risk, if someone had bid below our bid, Code-NGO, even if it got all the rulings and exemptions, would have gotten nothing; RCBC would not have gotten anything. Isn't that fair?" Given the many uses of the zero-coupon bonds that the bank claims, this still does not answer the question, however, of the willingness of RCBC officials to let Code-NGO have the lion's share of the profit. All these benefits and even greater could have been enjoyed by the bank if it had simply bid on its own at the lower rate. RCBC deigns to call the profits that accrued to Code-NGO a donation. "We are not a charitable institution," Panganiban asserts. Moreover, treating the transaction as such, sources say, would make it liable to its stockholders and open to minority suits. The answer apparently lies in the contract and Code- NGO's insistence that they meet a funding target of one billion pesos. RCBC admits that it did not revalue the contract that it made in March, when prevailing bond market prices were lower, because it saw "no need to do so." "We gave them that rate (about 11 percent) as a hurdle rate given that they deliver all that we asked for (the tax rulings and eligibilities); that was around March," Panganiban says. "When the decision to auction came, we looked at the market and saw it had not really changed by much so we said, okay, we can use this rate at the date of issue." Sources note the RCBC group was locked in by their contract, but officials deny this, saying that they merely honored their commitment, implying they could have easily walked away and bid on their own if they wanted. We had a contract that said we will buy from you at the secondary market if you can sell the bonds for us at 11 percent and that contract never specified if it is to be negotiated or bid out," Panganiban says. "It's not that we can't break our contract, but we had an underwriting commitment and this is how we treat our clients." He muses that they are actually strengthening market standard practices in investment banking. "Our business is based on trust. We'd like to think that we are setting the market practices in honoring commitments. To show the example of how an investment bank deals with its clients." This is where the intangibles must have entered, observers note. It thus became a matter of accepting smaller profits, since the bank was not really losing from the deal anyway as RCBC simply had to switch assets in its vaults, in exchange for "goodwill." Seen this way, rather than a public issue, it becomes a matter between the bank and its stockholders. The PEACe bonds controversy will not yet reach an end as hearings in the Senate finance committee are scheduled to continue. From the debate that will surely follow, the issue will be threshed out even further. But the broad strokes already show the gray areas that need to be examined in the context of public governance such as the level of lobbying acceptable even if this be for a good cause and the point at which legitimate entrepreneurial activity becomes rent-seeking. The good news is the vigilance that civil society has shown even toward its own members, and the steps, albeit halting, some arms of government have taken to defend systems that are transparent and fair. With the 1.4 billion pesos now in Code-NGO's hands, they face severe public pressure to use the money well, and while it is a private fund, the public nature of its creation has made it just as accountable.