On a late-January afternoon, a group of settlements clerks, Brady bond traders, inter-dealer brokers, and other footsoldiers of the emerging-markets universe straggled into a small conference room on the 28th floor of JP Morgan Chase in Manhattan.
| Michael Chamberlin | ||||||
They were invited there by the Emerging Markets Traders Association (EMTA) to discuss the trading of Mexican Value Recovery Rights (VRRs). What wasn’t said, what didn’t need to be said, was that nearly everybody in the room expected the Brady market to be hit by utter chaos in a matter of days.
VRRs are warrants embedded in Mexican Brady bonds which pay out once the price of oil reaches a certain level. Mexico’s Brady bonds – like all Bradys – are restructured bank loans, which involved commercial banks granting significant debt relief. In return, the banks asked for extra payments should Mexico receive any unexpected windfall from its oil revenues.
The problem arose after 1992, when the VRRs became detachable from the underlying Bradys. EMTA practice was that bonds should always be traded with their VRRs attached, but often, through laziness or ignorance, they weren’t. The Bradys and the VRRs had two different ISIN numbers, and both the buyer and the seller needed to send identical VRR settlement instructions to Euroclear/Clearstream. Because matched settlement instructions were received in most cases concerning the bonds only, only the bond trades would settle.
The VRR part of the trade would fail, even though, in many cases, it was probably intended by both the parties that VRRs be included with the bonds. And when buyers received the bond only, they generally neither knew nor cared that they were meant to have a worthless warrant too.
So began the chain, where bonds sans VRRs would make their way from desk to desk, with a failed VRR trade each time. Nearly every failed trade constituted an obligation on the part of the seller to provide a VRR – and any unpaid income accruing to that VRR.
“Over the course of the past five, six, seven years, the market has succeeded in creating quite a mess for itself,” Michael Chamberlin, EMTA’s executive director, told the January group. One bank has identified more than 300 separate counterparties with which it has failed trades; most estimates put the nominal amount of VRRs involved at over $1 billion. Even if VRRs are only worth 4 cents per dollar, that’s a lot of money which needs to be reconciled, especially if it comes out of the trading desk’s P&L.
Just to make things more complicated, reconciliation of failed trades is a non-trivial matter, because the few stripped VRRs tend to be jealously hoarded by their holders.
Stripped VRRs are scarce because EMTA instituted a new market practice in 1997 “to staunch the bleeding,” says Chamberlin. A new instrument was created, with one ISIN number, which included the bond and the VRR. It wasn’t long before stripped VRRs were unfindable for anybody wishing to reconcile failed trades.
Even so, the problem was academic until late 2000, when VRRs started moving into the money. At that point, aggrieved investors threatened to launch buy-ins, where they would pay any amount necessary for VRRs, and then force the institution which sold them the Bradys to reimburse not only the cost of the VRRs, but also all past payments on the bonds as well as their lawyers’ fees.
Just one buy-in would force the counterparty to do the same to everybody with whom it had failed trades, rapidly dragging in the entire market.
EMTA’s solution to the problem is risky, but something has to be done. The bonds and VRRs will be completely stripped, and traded separately. The hope is that a market will develop in VRRs.
“At some point in the future when there is a verifiable, more liquid market in the warrants, you could perhaps generate a price the entire market could agree to,” says Chamberlin, raising the prospect of an orderly global buy-in three or six months down the line. “That would avoid the sort of potential chaos you might get if a lot of people tried to do it individually.”
Dealers aren’t optimistic. For all Chamberlin’s calls that the market “chill out for a while on the buy-ins,” there’s a chance that someone will take advantage of the nascent market in VRRs to try to get in there first.
Even the best-case outcome is not much better. The street as a whole is short VRRs. Mexico has been buying back its Brady bonds as part of its liability management and insists VRRs be included in all of its buy-backs. It also refuses to print any new VRRs. Anybody holding stripped Bradys who wanted to tender them had to borrow VRRs from somewhere, and many still haven’t been able to cover their shorts.
And the market in VRRs is going to be far from liquid for the foreseeable future. Banks are reluctant to trade instruments which they can’t be sure they can settle. At the same time, with so many competing claims on VRRs, once one of the instruments enters the netting system, it’s far from obvious where it will emerge. “There’s a significant likelihood that a few things will get screwed up in the early days,” says Chamberlin.
Optimism was certainly in short supply at 1 Chase Plaza. If the ending of the meeting is any indication, there is trouble ahead in the Brady market.
“Is this going to fly?” Chamberlin asked the meeting; no one answered. “Would anyone of you, care to comment on any of this?” he continued gamely. “If only to make us think that we’re doing the right thing?” Silence.
