Cracks in the group of 19 foreign banks negotiating with the Russian government had been evident for some time. Hardly surprising given the differences in their positions with large banks such as CSFB and Deutsche Bank too exposed to walk away and smaller banks, with less at risk, spoiling for a real fight. But no-one was prepared for the bombshell decision by Deutsche and Chase Manhattan to accept the latest offer for a portion of their holdings, concerning in Chase’s case solely its own-account securities.
Since Deutsche, together with CSFB, was head of a six bank team chosen by the Russians to conduct the negotiations on behalf of the others, its unexpected move over the last weekend of February has caused the most consternation.
“I have never seen conduct like this before, it falls somewhere between brazen and stupid,” says an executive with another bank involved in the discussions. “Any bargaining power that the committee had has been completely underminded. The case for litigation has been strengthened, for banks continuing with the negotiations it becomes the primary source of leverage.”
But it’s not only other banks in the group that are dismayed. Amidst the chaos that followed Deutsche’s acceptance, and its offer to resign as head of the six bank negotiating team, it became apparent that Deutsche’s own executives, including those involved in the discussions, were taken by surprise. While splits between the London and Frankfurt parts of the bank had already been reported, and denied by Deutsche, this decision appears to have been made at the most senior level and without reference to the negotiators.
“We were just as surprised as anyone else,” says a Deutsche banker who did not wish to be named. “The decision was taken at a very senior level and even some of the direct negotiators were not consulted even though they accept the inevitability of this decision.” Deutsche Bank said officially: “We confirm that we have exchanged part of ours and our clients holdings. We see no conflict between our decision to carry out this exchange and our role as co-chair of the western creditors.”
The disarray shows up the new reality of international banks involved in debt negotiations. Not only are the interests of individual banks so different that presenting a common front is almost impossible, but within the largest banks there are also competing interest groups. Commercial bankers taking a long-term view on the Russian market have a different stance from traders in the investment banking division whose bottom line will take a direct hit from the losses. Asset managers who have to justify their actions to clients may take a different view on recovery from those trading on the bank’s own account. Yet all of them in the new consolidated banks – Deutsche is currently merging with Bankers Trust – are under one roof.
Most miserable deal in history
Whether the Russian negotiating team, which has endlessly prolonged the discussions and given away nothing, was initially aware of the strength of their position is unclear. What is certain is that governments that find themselves in similar positions in future will realize. As it stands the latest Russian terms, worth as little as three or four cents in the dollar, will go down in history as some of the most miserable ever achieved from the creditors’ point of view. If they now set a precedent it is debateable whether the fruit of the discussions justified the cost of staging them, tying up valuable executives for months.
In the Russian case a bad deal for creditors was rejected by the banks only for them to wind up with a worse one. Officially the latest stance was to have the deadline for acceptance extended into April until complete clarification was received of exactly was on offer. That was the state of play when Deutsche threw a spanner into the works by putting in its paperwork in time to meet an earlier deadline for proprietary trades of March 5. For client business the earlier deadline is March 15.
Another bone of contention has been whether foreign and domestic creditors, known as the Moscow Club, will receive equal treatment. This issue emerged very soon after last August 17 when the government gave up defending the rouble and announced a dramatic solution to the problem. This “triple whammy”, as creditors term it, comprised a simultaneous 90-day moratorium on domestic government debt, implementation of capital controls and a devaluation of the rouble.
One legal advisor to the creditors says: “The Russians veered from their promise of equal treatment and favoured the domestic creditors a little during the negotiations. The Moscow Club managed to get a larger portion of cash than the western creditors did in their settlement.”
At first there was hope that a deal could be struck quickly. One banker says: “When we [the western banks] started meeting in early September there was a real feeling of optimism. We all had hopes of getting a half decent settlement.”
Of the 19 foreign banks, the Russians chose a group of six to negotiate with them directly: they were Deutsche Bank, Credit Suisse First Boston, Merrill Lynch, Crédit Lyonnais, Lehman Brothers and Chase with Deutsche and CSFB as leaders.
What threw the negotiating team off balance from the beginning was the Russians’ attempt to put the GKOs in the same package as the restructuring of forward foreign-exchange contracts known as non-deliverable forwards (NDFs). This was the first menu for restructuring the debt proposed by the Russians. The deal consisted of a seven-year dollar bond with a coupon starting at zero and going up to Libor.
While some of the details of the deal remain ambiguous, it seems to consist of the following elements:
* A “cash” tranche equivalent to 10% of the principal of the GKOs would consist of three rouble payments. One-third would be paid at the time of the exchange of the GKOs. A further third of the tranche would consist of government bonds maturing this month. The final third would be in the form of government bonds maturing in June. Each of the government bonds would bear annual interest of 30%.
* The second slice would be 20% of the principal investment swapped into three-year securities which can be used either to pay off tax arrears in Russia or to buy equity in Russian banks.
* The final tranche, consisting of the remaining 70% of the principal investment, would be swapped into a series of government bonds maturing at between three-and-a-half and five-and-a-half years. The annual coupon for the first year would be 30%. In subsequent years it would decrease by five percentage points a year down to 10%.
The Moscow Club was offered a similar deal but with a 30:20:50 split on the principal investment (though its members still haven’t been paid their 30% cash and are considering going to court for it).
While the first deal bundling the GKOs with NDFs would probably have been worth over 10 cent of the dollar value of the original investment before the devaluation, the second deal is valued by most analysts as only being worth around four cents.
Like Vietnam all over again
Such a deal would be extremely unfavourable by past standards. “Historically, when sovereigns default the average pay-out is 50%,” says a director at one of the 19 banks. “For the Russians to offer 4% to 6% would be as bad as Vietnam in the 1970s.”
The reason the deal is worth so little is that once cash is placed in a transit account it will be inflated away. So will all future payments. One source says: “Russian inflation will hit 100% by the end of the year. A coupon stepping down to 10% is derisory. Not only is the starting coupon of 30% less than a third of the inflation rate, it is less than the 50% rate that the Russians are using to calculate the exchange value of old GKO’s.”
A legal advisor who has worked closely with many of the banks said prior to Deutsche and Chase’s acceptances: “The western creditors feel the agreement is unacceptable as it has been forced on them in unfair negotiation. They want a larger cash portion with more generous repatriation arrangements. The investment paper is useless as the Russian banking sector is in ruins. They want corporate shares in blue chips, something they can buy and hold to at least get something out of this. The final portion of 70% domestic bonds is very unattractive. These bonds are trading at super-low discounts and it is uncertain if they will even be paid in the future.”
However, given Russia’s worsening macroeconomic situation, many doubted even then that the Russians would come up with anything better. A Russia specialist at one of the 19 banks says: “Put it this way, Russia’s nominal GDP in 1997 was around $460 billion, and was headed towards $470 billion in 1998 before the default. But in 1999 it will only be around $170 billion. So the ratio of external debt to national income has rocketed from about a third to about 90%. Without significant policy changes that encourage a return of foreign and flight capital, the rouble will remain weak in real terms and the debt burden will remain excessively high for the foreseeable future. The tax take is less than or equal to their debt burden. In some ways it is like looking at an African country.”
But bankers complain that the way the Russians have conducted the negotiations does nothing to restore confidence in the country. “The Russians have shown no seriousness about working out mutually agreeable solutions,” says a senior member of the group of 19. “The terms started out bad in August and since then have only got worse.”
A source familiar with the negotiations says: “To say it was a negotiation would be to infer a bilateral exchange. The Russians were shown many ideas by the negotiators which would bring value to the investors – 50 or 60 at least. We tried everything. We showed them deals of up to 20-year maturities, callables, puttables, anything that said if their situation improved they would be able to pay. We even went as far as trying to get their cashflow indexed to Russia’s GDP.”
In the meetings with the Russians there have been typically around 20 people in the room. The six banks field between 12 and 14 people, while Russia’s legal and financial advisers make up the rest of the numbers. The meetings have lasted from Wednesday afternoon until Friday, and have taken place every other week from the first IMF meeting with the Russians until mid-December.
A banker close to the negotiations says: “The most infuriating thing was that Kasyanov would never turn up on time. [The negotiators] would be waiting for him for two or three hours, then he would come in to the room. It was so frustrating because we knew he would only say ‘no’.”
One source close to the negotiations says: “The negotiators would come into the room and make a presentation. They [the Russians] would take it into another room for an hour or two, come back out and say ‘no’. In the end the meetings were simply stopped. They knew what the foreign banks wanted and it was just a question of them sorting it out.”
One story has Kasyanov simply running his fingers down a list of 10 proposals, saying: “No, no, no, no, no, no, no, no, no, no. But I like the font you are using.”
A legal advisor to many of the bankers says: “The Russians have behaved menacingly. They have been bargaining in horribly bad faith. Kasyanov has been banging on tables, shouting at the negotiators saying ‘accept this deal or you will get nothing’, and ‘stop being so greedy’. The negotiators have been extremely offended by this behaviour. These bankers are not exactly pussycats in a boardroom themselves but the Russians have behaved appallingly.”
A veteran negotiator, Kasyanov haggled for the Russians in the Paris and London Club debt workouts too. A survivor of the Soviet era, he is a civil servant rather than a political appointee. A lawyer who worked with him in the Paris and London Club negotiations says: “Kasyanov is incredibly sharp. All of the Russians on that team are sharp. It would be a mistake to assume that they are not completely in control of what is going on. They face some very significant political constraints. At the ministry of finance they are deciding whether to provide heating to towns or pay off creditors. That sort of thing would make anyone pretty hard-nosed.”
One source close to the Russian negotiators says: “The lack of a term sheet is interesting. It implies that there is a political problem. Officials [at the central bank and the ministry of finance] will not go beyond the political consensus. Kasyanov, as half-official half-politician, finds that his neck will be on the chopping block if he outruns the politicians. Maybe it is simply not clear who is in charge within Russia, and who he should take his lead from. In the Paris Club negotiations there was significant interest from the upper echelons of Russian government so the deal went through relatively quickly.”
Unlike the London and Paris Clubs, the Moscow Club and the group of 19 are made up of securities traders who assess their holdings daily and immediately record a loss. While the London Club deal could stretch maturities without overly harming present value, to do so for the 19 and the Moscow Club would mean a greater loss. A director at one of the six negotiating banks says: “The types of people Kasyanov is dealing with are completely different. Kasyanov had never met a mark-to-market problem like this before.”
But this is not the only view of Kasyanov. A Moscow-based lawyer familiar with the negotiations says: “Kasyanov has been very clever in using the time constraints that the western creditors are under. Since it was obvious to the Russians that after August 17 they would not be getting any foreign money anyway there was no need to settle on good terms with a favourable deal. It would only cost more money. By procrastinating, procrastinating, procrastinating and eventually giving the group of 19 a slightly worse deal they have actually saved money, and the banks which take the deal will be happy to have anything.”
A head of fixed-income in Moscow says: “The Russians have been negotiating in Soviet fashion, trying to wear down the banks. What they haven’t yet understood is that most of the 19 banks have simply written off the debt. The people involved in the group of 19 have largely inherited their positions. The people who took on the exposure in the first place are all pursuing other careers now. From my point of view, if I can get anything out of this it will be a bonus, good for me. And if I can’t get anything it doesn’t matter. I can turn around and say it is not my fault. I didn’t ask to take on this worthless paper in the first place.”
Criticism of the banks leading the discussions was fairly vocal even before the latest events. Some of the 13 banks excluded from the talks by the Russians have complained that Deutsche and CSFB, the two banks with the largest exposure, have been pursuing their own interests in the negotiations. A director at one of the 19 banks says: “The main problem in Deutsche is that it is a divided institution. London wants the money back and Frankfurt is keen to sweep the problem under the table.”
Deutsche and CSFB both tried to tender their resignations as talk leaders in December. Deutsche wanted to avoid suggestions that it was not contributing enough time or effort to the negotiations because of its takeover of Bankers Trust. Both banks were asked by their fellow banks to stay on to avoid prejudicing the negotiations.
Some bankers were keen for the six negotiating banks to distance themselves from the Russian delegation to show that they were not happy with the way the talks were progressing. But such tough talking may come from banks feeling comfortable because they don’t actually have to do the difficult face-to-face negotiations with the Russians. “The bank that is being most vociferous about the proposed litigation is essentially non-confrontational,” says one person close to the negotiations. “While they talk the talk in the meetings of 19, saying the negotiations should push for more, I get the impression it would be a different story if it was them in that room with Kasyanov.”
CSFB and Deutsche are both in a difficult position. Their exposure is too large for them to be able to afford to walk away. But some of the other banks are ready for a shooting war. As one head of fixed income in Moscow puts it: “With a small exposure you may as well be nasty.” If the banks do not wish to swallow the agreement the Russians are proposing, they are left with two options: walk away or sue.
Anyone who walks away risks getting a worse deal than the one now on offer. “Walking is not a viable solution,” says one banker. “You can choose either the death penalty or life imprisonment. I’d choose life every time. The death penalty would be for them to just throw you in a transit account where you would only ever get roubles at the end of it.”
From the group of 19 a sub-committee was formed in December of five banks which favour a more aggressive stance. The group, said to consist of Bank of America, Crédit Agricole Indosuez, Donaldson Lufkin & Jenrette, JP Morgan and Nomura, is now looking seriously at the possibility of taking legal action. Other banks from the group of 19 are believed to support them.
International treaties
Litigation, which is now more on the cards than ever, may not be as hopeless a cause as one might think. In 1989 Russia signed a number of investment protection treaties. Such agreements exist with the US, UK, Netherlands and Germany. The parties signing the treaties promised not to “subject investments or returns of investors … to treatment less favourable than that which it accords to the investments and returns of its own investors.” They also agree that any repayments should be made “without delay and be freely transferable,” and that investors can bring claims against the parties signing the agreement.
In London on February 19 the western creditors met to discuss the possibilities of litigation. The result was a decision to postpone any concrete decisions until the Russians produced a term sheet, specifying exactly what deal was on offer. This had still not happened when Deutsche and Chase decided to go it alone.
Support for litigation seemed to be growing among the other banks even before this. In late February, several banks sent letters to end investors in GKOs hinting that they were exploring the possibility of a lawsuit.
The major problem of litigation is that the GKOs are in Russian currency and governed by Russian law. Any cases will have to be bought against the sovereign in its own system. A fund manager in Moscow says: “The view that the Russian court will probably take is to simply point out that the western creditors made a risky investment, they made a lot of money and then got burned. It is not as if they weren’t aware of the risks.”
Should any of the western creditors attempt to pursue litigation, it will probably take them two-and-a-half to three years to get their cases heard. A danger is that by then Russia may have defaulted on its Eurobonds as well as its domestic securities. That would leave the GKO creditors behind holders of Eurobonds in the queue to recover their losses.
While all this is going on, the Russians continue to print money in “controlled emissions”, thus stoking inflation and eroding the value of the deal on offer to the foreign banks.
But there are some opportunities for those brave enough to take them. There is a small market in restructured GKO’s at 2 and 3 cents. One fund manager who was relatively unscathed by the crisis says: “I am having great fun in the Russian debt market at the moment. Lots of people have dropped out, so now if you step carefully through the Eurobond market – the Eurobonds go through Euroclear rather than the Russian banking system – you can pick up some good deals. The whole point about Russia is that it is a reversible process. They are a nation of over 140 million people and they aren’t going away. People will lend to them again.”
