• Central Bank of Brazil surprises markets and lowers SELIC 50 basis points.
• Banks increase reserves and provisions for bad debt to record levels.
• FGC Helps to Sanitize the Financial System

What are the implications for investors?  New-issue investors need to evaluate carefully the issuing entity’s portfolio for the quality of debt underwriting and the entity’s ability to service the loans.  Investors that currently hold FIDCs need to monitor the credit portfolio’s performance carefully.

We see weakness in consumer loans issued by banks and finance companies and we have no doubt that this is the single thread that unites some of the otherwise contradictory economic news in the Brazilian press. 
Both the Central Bank of Brazil (BCB) and the Fundo Garantidor de Crédito (Credit Guarantee Fund, FGC) have been working behind the scenes to contain the growing problems from NPLs and to prevent a full blown credit crisis in Brazil.

FIDCs do not have this government protection.  FIDC credit quality has deteriorated since the beginning of the year according to data we pulled from Orbis, a structured finance database and news service from Uqbar.  Of the 250 FIDCs in the Orbis system with data for the last seven months, 77% have seen increases in provisions for bad debt (PDD – Provisões Devedores Duvidosos).   PDD increased more than 100% since the beginning of the year in 29 FIDCs.  Fifteen of those deals were either multiple market or multiple segment deals.  Due to lack of transparency in the Brazilian ABS market, it is better to look directly at the credit markets themselves to understand these trends.

Putting Together Pieces to Understand Brazil’s Credit Markets

The August 30 meeting of the COPOM, the monetary committee for Brazil’s central bank (BCB), dramatically altered the general perception of the economic picture in Brazil when they cut SELIC by 50 basis points.  Most analysts were caught by surprise; however, our calculations show that the market had been forecasting approximately an 80% chance of a 25 basis point interest rate cut on August 29.   The COPOM has since been criticized from many corners for lowering the rate even though Brazilian inflation has not yet retreated.

The market now expects the COPOM to cut SELIC to about 10.25% by June 2012, while analysts polled by the BCB survey are divided between 10.50% and 10.75% as the low, as you can see in the first graph below.  Both the market and economists now view the BCB as very accommodative.  The BCB conveniently cites the growing problems in Europe as the motive for cutting rates.  We don’t believe that’s their main motivation.  In our view, the BCB and the Brazilian Government are more worried about the growing problems with consumer credit at home and about protecting the banking system.   This explains why the BCB cut rates at the risk of losing control of inflation and some credibility with the international financial community.

We have been warning that the Brazilian financial system is showing signs of strain due to the extraordinarily high growth in consumer credit balances and the high level of consumer NPLs since May 2011.  Government’s efforts to rein in the growth this market have failed.  We also pointed to the evidence that payments on consumer loans are not sufficiently large enough to amortize the principal. As a result loan balances continue to grow in spite of declining issuance (See our Second Quarter Review).

The Brazilian press continues to point to the overall low levels of non-performing loans and occasional reductions in the levels of non-performing loans.  We put these reports in the basket labeled “misleading statistics.” As with FIDCs, the overall numbers in the financial system are obscuring some important developments in the sub-sectors.  Most importantly, there is a growing number of NPLs on the consumer portfolios of both banks and non-bank finance companies.

Smaller Brazilian banks have encountered difficulties in managing their balance sheets since the 2008 global credit crisis.  These banks find it difficult to sell parts of their credit portfolios to the larger banks because the large banks have tightened up their credit underwriting standards, especially after the Banco PanAmericano scandal.  The graph below indicates two dangerous trends.  First, NPLs continue to run much higher than 2008/2009.  Second, the lagged but sudden increase in NPLs in bank portfolios indicates that the problems in consumer credit portfolios for non-bank finance operations seem to be affecting or “contaminating” the bank consumer credit portfolios.

Estado de São Paulo announced in a September 15 edition that the Fundo Garantidor de Créditos (FGC) had realized “sanitation operations” of around R$7.5 billion this year to clean up problems with some medium and small sized banks.    The most recent operation transferred Banco Matone to Grupo JBS, thanks to support of R$850 million from the FGC.  The other big “sanitizing operation” for 2011 was a R$1.5 billion package help BMG absorb Banco Shahin.  That leaves roughly R$5 billion more in other operations that have been used to shore up other banks.  FGC currently has resources of a little more than R$26.8 billion.  This means that the fund has spent about 25% to 33% of its resources to prop up the financial system this year.

It is clear that the BCB and the Brazilian government are trying to avoid a panic.  An editorial in Estado de São Paulo points out that the FGV’s operations have two advantages promoted by Brazil’s Central Bank:  they don’t involve public money and they are discreet.  The operation’s discretion prevents depositors from panicking about the financial health of other banks.    The editorial points out that this helps reduce systemic risk in the Brazilian financial system.

At the end of August we produced a report that analyzed the recent actions taken by Brazilian banks to shore up reserves and increase provisions for non-performing loans.  (See “At What Height Does A Bank Seawall Protect From a Credit Tsunami?”)  The biggest Brazilian private and government banks have been increasing loan loss provisions and reserves to almost unheard of levels.  Caixa Econômica Federal is provisioning 300% of NPLs.   Given that banks recover on average 30% to 40% of bad debt, with the range spanning from 5% to 60% of the value of loan, a provision of 300% of NPLs seems like overkill unless the bank knows something that the public doesn’t.  Brazilian banks execute “renegotiation operations” that banks in other countries would normally consider bridge loans for defaults.  The BCB would know if banks are entering into these types of agreements frequently.

Summarizing the condition of the FIDC Market

This brings us to the FIDC market in Brazil.  The statistics are deceptively reassuring.  As the graph below demonstrates, the overall PDD level has been fairly stable.  It appears that the problems in the consumer credit market have not yet affected FIDCs in general.  As with the banking system, we believe the overall statistics are hiding the problems.  Statisticians often quote the paradox of a person drowning in a river that is on average 5 inches deep.   We believe that the distributions are skewed and that the averages are hiding problems.

We used data from Orbis to calculate the percent change PDD from January to July 2011 and plotted the data in the histogram in the fourth graph below.  We took out all of the deals with extraordinary changes over 500% to error on the side of caution in our calculations.  PDD increased by more than 25% in more than 47.6% of the FIDCs over this period, even with our conservative approach.

Part of this artificial stability stems from the issuer’s ability (and common practice) to buy back loans that are more than 90 days past due.  However, the CVM has passed new rules (Instruction 489) that will severely limit the balance sheet options for issuers who repurchase substantial amounts bad loans from FIDC credit portfolios.  In addition, the banks will not have the balance sheets to continue this practice if the credit markets continue to deteriorate.   We believe this picture will worsen as the economy slows down more.

As stated in the opening, new issue investors need to evaluate carefully the issuing entity’s portfolio for the quality of debt underwriting and the entity’s ability to service the loans.  Investors that currently hold FIDCs need to monitor the credit portfolio’s performance carefully for the near future.

As bank portfolios deteriorate in quality and larger banks rein in issues, smaller banks will have more incentive to sell loans into FIDCs. Investors in FIDCs backed by short term credit, such as factoring receivables, need to be especially vigilant.  These revolving FIDCs experience large turnover and the credit quality can drop dramatically in one month. Any sudden jumps in PDD or sharp increases in late payments (Créditos Vencidos e Não Pagos – CVNP) should be investigated quickly.   This information can be found on the Informe Mensal on the CVM website.

According to the CVM website, 23 FIIs with a total value of R$561 million where registered in 2008. In 2010, 39 FIIs were registered with a total value of R$9.7 billion. As of August 2011, 26 FIIs have been registered with a value of R$4.8 billion versus 16 FIIs in the same period of 2010 with a value of R$2 billion. In 2008 there were R$4.7 billion CRIs issued, R$3.8 billion in 2009, and R$8.53 billion in 2010, almost twice as high as the previous record in 2008. (CVM data)

The Comissão de Valores Mobiliários (CVM – the Brazilian equivalent of the SEC) had restricted FII to investments in pure real estate. The rules were relaxed in 2009 to allow FIIs to buy other types of real estate securities, such as CRIs, as well as the pure real estate. The new regulations also allowed CRI-backed FIIs to pass-through the tax advantages embedded in CRIs. This was one of the main factors in the growth in the market for FIIs.

However, there are recent signs that the market is cooling off. The performance of the FII market has fallen in the last four months according to Uqbar (a Brazilian firm that tracks the FII market and provides data through its Orbis service). In 2010 the 22 most actively traded FIIs returned a capitalization weighted average of 21.2% (Data from Uqbar, LatAm Structured Finance calculation). Just the price appreciation of FIIs was 13.2% in 2010. In April 2011 the average 12 month price return was 16.5%, in May and June 14.6%, and dropped to 12.2% in July.

Like the market for FIIs, real estate in Brazil is experiencing some hiccups after increasing steadily over the last few years. On August 31, 2011, Estado de São Paulo reported that the unit sales in the city of São Paulo fell 31% in the first half of 2011 and fell 28% in the São Paulo metropolitan area. While the level of activity is cooling off some, the São Paulo real estate market is still seeing lots of activity with 80% of the listed property being sold in 6 months or less. However, the market makers warn that this level of activity can only be maintained with continued economic growth and the availability of credit.

http://www.estadao.com.br/noticias/impresso,sinais-de-acomodacao-no-segmento-imobiliario,766321,0.htm

In a side article in the same edition, Ana Maria Castelo, an economist with Fundação Getúlio Vargas (FGV), writes that Porto Alegre and Belo Horizonte also experienced weaker real estate sales. She notes that this slow down started before the growing global credit problems and arises from domestic factors. Demand in 2010 was overheated and credit expanded very rapidly. This increased building activity also drove up prices and construction costs increased 7.71% in the last twelve months. Castelo argues that this is still not a bubble because the growth is sustainable and that Brazilian real estate will continue to perform well despite these recent setbacks. “Prices may not increase as dramatically, but they will not fall. Buyers will become more cautious as the prices continue to increase and financing will be limited by the level of income.”

http://www.estadao.com.br/noticias/impresso,nao-temos-bolha-o-mercado-vai-continuar-aquecido,766325,0.htm

The market for FIIs and CRIs in Brazil should be followed closely if the investor is planning on entering at these levels. The Brazilian economy is still growing but the growth is slowing dramatically. While delinquencies on real estate for business and residential purposes are at multi-years lows, Brazil is experiencing a bubble in the consumer credit markets and non-performing loans in this sector are rising rapidly. Banks are cutting back on credit and tightening their underwriting criteria. It is time to use some caution and look at the possibility of muted price gains for the foreseeable future in the Brazilian real estate market and the market for securities backed by real estate and real estate debt.

Click here to access the post.

Singapore investment fund Temasek Holdings has set up a new investment company called Seatown Holdings. According to the statement, Temasek’s senior managing director and chief strategist Charles Ong will be the chief executive of the new company. Mr Ong said Seatown is a global investment company, wholly-owned by Temasek Holdings. It is not immediately clear how Seatown’s mandate will be different from Temasek’s own investment role. Remember, Temasek’s investment mandate is to protect the monies of Singapore, including the pension monies (CPF) of its residents. Temasek set up Fullerton Fund Management a few years ago to manage 3rd party money. I suppose the real question to ask is how different would Seatown be from Fullerton Fund Management’s mandate. Or even, how different is it from GIC’s mandate? Some news reports say that in addition to investing the city-state’s own assets, Seatown will eventually open its doors to Singapore’s citizens, allowing them to co-invest with the sovereign fund.

I did some research and found a flowchart from this blog, where the author interpreted the money flow within this organisation. See the chart below (click on it for a larger version).

A spokesman said he had no further details beyond the statement. Temasek said it has seconded a small core team and is still in the process of building up the Seatown team. Earlier, Dow Jones reported that the new company will have an investment capital of around US$3 billion and would focus on investments in emerging markets with an emphasis on Asia.

Update: April 2011

It’s already doing deals. Seatown jumped in alongside its parent when the latter invested more than $600 million in convertible preferred shares of Chesapeake Energy Corp. of Oklahoma City. It also invested when Temasek bought shares in Chinese pork producer China Yurun Food Group Ltd. And the new fund firm is actively engaged in Asian debt markets, where its sheer size and ample dry powder make it one of the biggest investors in a region where other debt funds have less uninvested cash to play with. This plays to the strengths of Mr. Ahmad, a veteran of Credit Suisse Group and former hedge fund manager with a background in credit.

Seatown is the latest in a string of investment vehicles Temasek has helped bring into being. It provided about US$800 million in capital to Hopu Investment Management Co., making it the US$2.5 billion China-focused private equity firm’s largest investor. Hopu is run by Richard Ong, a former banker at Goldman Sachs Group Inc. and brother to Charles Ong of Seatown, and Fang Fenglei, chairman of Goldman’s joint-venture securities firm in China. Charles was formerly Temasek’s chief strategist and, before that, its chief investment officer.

Mr. Israel said that while it’s still early, Temasek is satisfied with the results of Seatown’s investments. He said the aim is for Seatown to manage money for institutional investors in three to five years, with the possiblity of letting retail investors in possibly in eight to 10 years, after one or two market cycles have put the company to the test.

Update: August 2011

Charles Ong and Nasser Ahmad, co-chief executive officers of Seatown Holdings, are leaving the hedge fund set up by Singapore’s Temasek Holdings.

If you’re in the Asian (inc. Japan) equities long/short business, there’s probably $1mm to $2mm for you from this new FOF so go ahead, send your pitch books now!

1. Turnaround, Restructuring, Bankruptcy Specialist (VP level & Director Level), 6-7 years experience or more – New York
2. Infrastructure Analyst/Senior Analyst (Infrastructure Advisory firm) – Washington
3. Marketing/Communications Manager, 5 years plus experience – New York
4. HR Manager/Director (Generalist) 5-7 years experience, financial experience preferred – New York

If (and only if) you match the requirements and are interested in either of the roles above, drop me an email.

Nobody (usually) wants to be the lead seed investor, but many will soon follow.  Herd mentality is strong amongst hedge fund seed investors. As with all larger seed investors, RMF Global Emerging Managers probably makes four or five seed investments each year. It would probably invest seed capital in the underlying hedge funds rather than the investment companies that manage them (usually in the form of a non-recourse working capital loan). Without a doubt, it will also agree to an arrangement sharing some of the underlying fund’s management and performance fees. I’m almost certain that other seed investors will be coming on to the bandwagon soon. Mr Hurschler however, is warning other seed investors not to take too much advantage of the current availability of hedge funds looking for seed funding.

Here’s my summary of what possibly attracted RMF to this deal:

1. Good pedigree - Stanley Ku used to work at Fortress and Goldman Sachs
2. Good reputation/branding - Stanley Ku is a “very well respected money manager in Asia”
3. Liquidity & Transparency - The fund invests in highly liquid assets (mainly G7 Government Bonds and related highly liquid products with fully transparent pricing), and the entire portfolio is designed to be liquidated in 48 hours
4. Strategy - Fixed-income arbitrage
5. Team - Experienced team, and history of working with each other (The 8 seasoned team members have 127 years of combined industry experience, 94 of which have been spent working together.) [p.s. I really don't understand the purpose of considering the number of years of "combined industry experience". What is the industry norm? If there were 2 managers with 30 years experience each, does it give 50% less brownie points than a team of 8 with a combined industry experience of 127 years, even though the smaller team's average industry experience is 100% more?]

About RMF Global Emerging Managers

• It’s a relatively new seeding fund, and its launch was covered in the media in November 2007 (Google search link)
• The fund targets entrepreneurial managers with substantial hedge fund management experience whose operations have good growth prospects and solid operational infrastructure. (source)
• The fund aims to deliver hedge fund returns enhanced by revenue-sharing schemes with the managers; in addition to delivering performance returns, the managers will share with investors a fixed proportion of their gross revenues for a defined period. (source)

(Some) Terms of the Deal (source)

• Certain beneficial rights not available to other investors (rights to further investments? redemption rights? etc.)
• Ability to run shadow risk management and fund administration systems
• Most Favoured Nation status
• Share of the performance allocations (on gross performance? probably…)
• Man will not be able to redeem its investment from 5:15’s fund until June 30, 2011
• …and more!

Keeping a look out for other seed investors now… something’s definitely brewing!

FRM`s Patric de Gentile-Williams comments on the current state of hedge fund seeding

• - The environment for hedge fund seeders has changed dramatically over the last 12 months
  - There are now fewer seeders in the market
  - Even established funds are looking for seed capital after redemptions have hit their funds
  - Some start ups have suffered as their original seeders have withdrawn from the market
  - Investors are more stringent than ever before on issues such as corporate governance, use of third party administrators and transparency

Just as some investors pulled assets out of the hedge fund industry in 2008, the amount of capital and the number of firms in hedge fund seeding also reduced. However it is important to stress that this reduction is due to stresses in the parent businesses of the seeders not in the seeding business itself. Today far fewer players are active in providing seed capital to hedge funds. This, combined with the increased difficulty that hedge funds face in raising capital, has created a favourable environment for the remaining seeders.

The full article can be found here

Go with the flow or drown in the flood is really the best way to describe what Michael highlights in his book.

If you’re a Market Wizards fan, you’re definitely going to like the interviews and case studies that Michael puts in this book. Just the case studies and interviews conducted by Michael inTrend Following (Updated Edition) is akin to Market Wizards on steroids. There is so much data in this book that an amateur would miss if taken lightly. The case studies, side bar quotes, and the personal stories and philosophy of successful trend followers are extremely good reads and useful in a trader’s business. Fund managers and investors would also find this book a good read, as it explains reasonably well the reason why most lost (a lot of) money in 2008.

Learn more about the book and the other interesting stuff Michael has on his website, http://www.trendfollowing.com/

I was reading through some career portals (no, not looking for a job) when I came across an old article on Vault.com.

It talks about how Investor Relations people spend their days in the office (if they’re ever in the office). I also have a short comment on it after the article extract so read on.

A Day in the Life: Hedge Funds Investor Relations

7:00 a.m.: Arrive at the office, read The Wall Street Journal on the way into work to brief on current events in the market. Read industry magazines/journals to find out the latest news.

8:00 a.m.: After having coffee and bagel, check e-mails and phone messages from clients. Respond to client’s questions concerning performance of the fund and general market conditions.

9:00 a.m.: Work on writing the monthly newsletter. This involves getting all the analytics of the fund, which are obtained from the operations manager. It also requires the fund manager to summarize market conditions for the month and indicate which of the firms’ securities were impacted and which were not. You assist the fund manager in gathering the market data.

10:00 a.m.: Get called into a meeting with a potential investor by the hedge fund manager. Present the terms and conditions of investing with the fund  lockup periods, minimum investment, etc. The manager has already gone over the returns of the fund and his investment philosophy.