Over the last several months, Russia and other countries of the Commonwealth of Independent States have engaged in protracted battles to manage the depreciation of their currencies. Some have been more successful than others, but all have fewer resources to keep the fight going than they did only late last year.
This has upped the ante for a cluster of structured, existing-asset deals from Russia, Kazakhstan and Ukraine, primarily backed by mortgages and auto loans. With collateral in dollars and borrowers' income most often in local currency, an appreciating dollar is making payments harder for borrowers to honor.
This has more people talking about the prospect - however dim - of authorities re-denominating foreign currency loans into local currency. This is a way for a government to curry favor with cash-strapped borrowers facing foreign currency debt, but it carries a high toll for creditors who could receive far less in foreign currency terms than they'd agreed to initially with the borrower. By extension, the impact on structured deals with dollar collateral could be brutal.
"Re-denomination in the CIS is a very low risk, [but] we shouldn't ignore it," said Christophe de Noaillat, senior vice president at Moody's Investors Service. "Even if the risk is a one percent probability, it can impact a transaction, especially the highest rated tranches."
Moody's published a report last month that provided different re-denomination scenarios. As a hypothetical, the agency used a basic ABS structure where Class A shares have a 20% enhancement from a subordinated tranche and an 'A2' rating when there is no re-denomination risk. In such a case, creditworthiness erodes when you introduce re-denomination risk and falls fast when you dial up that risk even by small gradations. For instance, with an only 1% probability of re-denomination in the first six months of the deal, a long-term probability of likewise 1%, and a loss on assets incurred by re-denomination of 50%, the rating on Class A would drop to 'Baa3'. Bump up the probability of re-denomination in the first six months to 5% and hold everything else constant, and the rating would notch dramatically down to 'Ba2'.
While the scenario is an extreme one, the loss assumption isn't so farfetched. Russia's ruble has slipped about 30% since mid summer, while Ukraine's hryvnia has shed more than 50% of its value. Kazakhstan, meanwhile, after holding firm during months of onslaught, gave in on Feb. 4 and cut the tenge's value by 18%.
Analysts see chances of more depreciation ahead, as the pressure is still on. Ukraine in particular is feeling the heat, as the country has been teetering on the brink of default since about November. "Downward pressure on the exchange rate is most intense in Ukraine, given they are very close to the net international reserves imposed by the IMF program," said Frank Gill, director of European sovereign ratings at Standard & Poor's. "Moreover, there has been a steady decline in local currency deposits levels... as retail depositors convert local currency deposits into foreign currency."
Since November, the country has had an agreement with the IMF to receive $16.4 billion in funds.
Dwindling Ammunition
The other two CIS countries with structured deals are better positioned. "Russia and Kazakhstan have a lot more ammunition than Ukraine," said Tim Ash, head of CEEMEA research at Royal Bank of Scotland. But even that ammunition has dwindled fast. In the case of Russia, foreign reserves totalled $382 billion as of Feb. 20, down about a third since peaking in August. And pumping dollars into the market, combined with jacking interest rates up, has managed only to stave off selling and not smother it.
In the case of Russia, one view is that the government won't be as gung-ho about keeping depreciation within certain limits, having given corporations with heavy dollar debt the opportunity to swap into rubles. "[Russia could argue]: we managed the FX; we let anyone who wanted to close FX positions over the past three months do it," Ash said. More recently, the Bank of Russia has focused on hiking interest rates in a bid to defend the currency.
Should these currencies plumb further depths, the chatter over re-denomination will likely pick up, even if the prospects remain remote. For some, they are "nil."
"Government authorities can't influence both corporate and private individuals' decision into which currency they prefer to take a loan," said Levan Zolotarev, senior vice president at Russian Standard Bank (RSB).
At any rate, RSB doesn't have to entertain any kind of re-denomination talk, as its loan portfolio is entirely in Russian rubles.
"We never planned to issue loans to our customers in foreign currency," he added, saying that RSB drew a lesson from recent crises in Turkey and South Korea, where banks passed on foreign exchange risk to their borrowers but had to ultimately deal with the mismatch problem themselves.
Borrowers in Russia with foreign currency debt have had opportunities to swap into rubles, said Irina Penkina, associate director at S&P. VTB 24, for instance, has had a program in place since December. "This isn't driven by political concerns," Penkina said. "It's purely commercial." But it's unclear whether many people have chosen to swap out of their dollar debt, even though their payments in ruble terms have risen dizzyingly over the last several months. "The re-denomination usually comprises significant fees, and the rates are much higher," Penkina said. "It depends on how people think about the devaluation of the ruble compared to the dollar."
In Russia, about 20% of mortgages are denominated in currencies other than the ruble, with the share higher in Moscow and St. Petersburg. Consumer loans are almost all in rubles.
While precise stats for other CIS countries are hard to come by, the denomination of deposits gives an indication of how strongly their consumers lean on foreign currencies. Before the crisis intensified in mid last year, foreign currency deposits as a share of total deposits in the banking system were about one-third in both Kazakhstan and Ukraine. And the crisis has only pushed more people to keep their money away from tenge or hryvnia.
Fitch Ratings and Moody's rate a number of deals from Russia, Kazakhstan and Ukraine that have dollar collateral but borrowers earning income in local currency. In the CIS, S&P doesn't rate any transaction where the denomination of collateral and salary of the borrower doesn't match up. But this isn't due to a blanket policy.
"It's not that we've made a decision not to rate dollar-denominated ABS in the CIS," said Zeynep Adalan, head of the EEMEA structured finance group at S&P. "These are more difficult to hedge. Even if the borrower earns an income in dollars, at any point their company might decide not to pay them in dollars."
In a report in December, Fitch said that it had stopped giving any credit to securitizations in the CIS where the borrowers reported foreign currency income, such as in Red & Black Prime Russia MBS and Ukraine Mortgage Loan Finance.
Mega-Devaluation Vs. Re-denomination
While potentially catastrophic, the damage wrought by a re-denomination isn't necessarily worse than that of a mega-devaluation. The case of Argentina, the only country to have re-denominated en mass, provides an illustration. In 2002, the government converted dollar obligations into pesos at 1 to 1.4. At that point, the currency had crashed to around 3.86 to the dollar from a previous parity, translating into a devaluation approaching 300%, although the peso would later hover closer to 3.3 to the dollar.
As a result, the re-denomination led to losses on the underlying collateral of up to 75% in some cases. But it didn't automatically trigger defaults.
A number of the transactions that technically defaulted were deals with onshore trusts, in which the government re-denominated not only the collateral but also the ABS bonds themselves. Investors balked at the modified terms and conditions, leading to defaults. "But we can't say for sure what would have happened in these cases had investors accepted the changes," said Juan de Mollein, head of the Latin America structured finance group at S&P.
MBS under a program originated by Banco Hipotecario Nacional serve as an example. Investors rejected the terms of the re-denominated paper and also filed lawsuits. Payments on interest and principal halted in 2004, with the trustee accumulating collections into an escrow account ever since. "Up to the last payment in 2004, our calculation was that investors had lost 36% in interest payments and 32% in principal payments," de Mollein said.
But what investors would be getting today had they accepted the terms and let the deal run its course is difficult to say.
And while the lost payments of over 30% up to 2004 look appalling, they wouldn't have necessarily remained that way for the life of the transaction. In the nadir of Argentina's 2002-2003 crisis, delinquencies above 90 days peaked at 25% but fell to 5% within a few years. Also, another Argentine transaction, a securitization of oil and gas royalties originated by the province of Salta, shows that the damage inflicted by re-denomination isn't irreparable.
And here the domicile of the trust issuing the notes appears to matter, de Mollein said.
Initially $234 million with an 11.5% coupon, Salta's transaction floated in 2001. Because the issuing trust was offshore, the government couldn't re-denominate the bonds, which remained in dollars. In addition, investors didn't formally challenge the re-denomination of the underlying, onshore assets. Still, the deal withered, as not only were all of the underlying royalties re-denominated into pesos but the government froze the royalty charge for three years. To add insult to injury, energy exploration in Salta all but halted. The transaction was downgraded by both S&P and Moody's as its collateral base dwindled and failed to make principal payments. But in the past few years, it has fully caught up with the principal payments.
CIS Assets Hang Steady
For existing asset deals from the CIS, depreciating currencies have yet to dent performance. One reason for this is that, in most cases, property values, local currencies or both appreciated sharply after the collateral was originated. "Since in Kazakhstan and Russia we had a booming property market in 2007, for portfolios originated in 2005-2006, we disregarded the peak," said Jaime Sanz, head of emerging market structured finance at Fitch. "The LTVs were already a lot lower than we thought, so there was a lot of buffer there."
But, he added, the question remains: "What if there's another 30% depreciation in these currencies?"
For existing asset transactions in the CIS, there has been negative downgrade action from all the agencies over the past several months. But the cause has been sovereign and counterparty downgrades, and not asset deterioration. All the same, in some cases the downgrades have already pushed notes to sub-investment-grade ratings, with acute damage incurred by mortgage and auto loan deals from Ukraine thanks to the declining fortunes of the sovereign.
Whether the region's currencies keep getting hit or not, the deal landscape looks grim. But one arguably beneficial impact that the crisis could eventually have is to boost the domestic market, at least in Russia, and give originators more opportunities for tapping investors interested in a ruble portfolio.
"Russia has a very poor domestic investor base, and it will not emerge overnight," said RSB's Zolotarev. "[But] going forward I see restrictions from regulators to borrow abroad and an acceleration of regulatory measures to motivate Russian investors to invest domestically."
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