Mantega Magic: Opportunities for Brazilian ABS

The Brazilian government has made it abundantly clear that it plans to enter into a bold new era of designing and engineering financial markets. Based on President Dilma’s publicly stated vision, the public banks have embarked on a state mission to lower credit spreads in Brazil and steer the economy away from a recession. This new mandate for the public banks could have far reaching implications for Brazil’s credit markets.

Finance Minister Guido Mantega has been charged with this initiative. We believe that this strategy is already mucking up Brazil’s credit markets. Credit behavior has become murky within Brazil’s financial markets as the public banks continue to increase their lending in the face of a slowing economy and raising defaults.  While the stated objective is the reduction of credit spreads, the Brazilian government is covertly using the public bank balance sheets to shore up the Brazilian economy and help the private banks maintain clean balance sheets.

The result is that the Banco Central do Brasil (BCB) data shows that percentage of bad loans in bank portfolios is declining slightly for businesses and increasing only slightly for consumers. On the other hand, the data from the credit agencies, such as Serasa Experian, shows that bad loans in the financial system have surpassed the levels seen in 2008 and 2009, and that the problem has only begun to get better. All the pieces of the puzzle are not entirely in place, but the public banks seem to be absorbing much of the bad credit from the private banks.

We see opportunities for FIDCs designed for small and micro-sized companies in Brazil amid this situation. We feel that Brazil’s public banks will not have the balance sheet to serve the entire market, but they will lower spreads enough to force the banks to focus on only the largest, most profitable companies. This will leave an entire sector of the economy without access to normal bank credit channels and opportunities for structured finance.

GDP and Industrial Production are Key Factors

Brazil’s GDP and Industrial Production have disappointed analysts now for about a year (See Exhibit 1). There has been no clear sign that the slowdown in Brazil’s economy has reached a final resting point. This is important because we do not see the outlook for credit improving until the economy bottoms out. Just the day before we released this report consumer inflation, as measured by IPCA-15, came in well below economist’s estimates and indicates the further reductions in economic growth. This bottom is important because every downturn in Industrial Production is followed by deteriorating credit conditions and that credit quality tends to worsen for six months after the bottom of the economic downturn.

(See Exhibit 2)

Exhibit 1

 

 

 

Exhibit 2

 

 

Questionable Loan Performance Data

With economic data declining and coming in much worse than expected, we would expect to see late payments and defaults increasing.  However, BCB data indicates that the credit markets are fairly stable. The BCB data shows that late payments on consumer credit has been increasing mildly over the last year and that business credit performance has not deteriorated at all. (See Exhibit 3)

 

Exhibit 3

 

 

Better Performance on the Horizon

To be fair, there are several reasons to expect credit performance to improve in the near future. In the March 18th Estadado de São Paulo interview, the president of the Federation of Brazilian Banks (Febraban), Murilo Portugal pointed out that the Cupom has lowered the SELIC rate 275 basis points since August 2011 and has stated that it plans to reduce the rate another 75 basis points to 9.0%. In addition, the government has increased the minimum salary and introduced other incentives to the consumer. However, Mr. Portugal felt that defaults would peak in the second half of 2012.

The headlines in the March 15th Serasa Experian news release read “The Worst Moment for Late Payments from Consumers is Behind Us.” Serasa Experian also cited the factors that Mr. Portgual discussed and explained that its indicator “Perspective for Late Payments of the Consumer” fell 1.3% in January 2012, touching 99.7 points. Based on the methodology used for construction, the indicator has the tendency to predict the cyclical movements six months in forward. This means that Serasa Experian is also expecting the level of defaults to decline in the second half. However, Serasa Experian’s own data does not completely corroborate their model.

 Indisputable Evidence

The one tamper-proof measure of nonperforming loans shows that problem loans are at historically high levels. This is the credit performance data from Serasa Experian in Brazil. Why?  Serasa Experian records the actual registration of nonperforming loans with private agencies called “cartórios”  that are licensed by the government. The other source of this data, the BCB database, measures accounting provisions that finance companies have set aside to comply with the BCB’s regulations. The BCB data shows accounting provisions, Serasa Experian measures the creditor’s genuine decision to classify a loan as nonperforming and initiates the default process, which is the registration of the debt with a “cartório.”

 

In early/mid 2010, Serasa/Experian’s index for nonperforming consumer loans passed the  worst levels seen in the 2008/2009 global credit crisis. The index for nonperforming business loans rose above 2008/2009 levels in early 2011 and continues to rise in early 2012. The consumer nonperforming loan index has shown signs of coming off the highs seen in 2011, but still remains at elevated levels in 2012. (Exhibit 4)

 

Exhibit 4

 

Furthermore, the number of actual number of bankruptcies resolved through court ordered recovery has also reached 2008/2009 levels. (Exhibit 5)  There are many signs of ongoing problems.   In the March 23rd edition of Valor Econômico, Silvia Rosa writes that there were 595 requests of judicial recovery (one form of bankruptcy) for the 12 months ending in February 2012.  That was 29% higher than the previous period. The growth in bankruptcies has seen a surge in vulture funds operating in Brazil to restructure companies.  Bottom line: we do not see a really healthy credit system in Brazil.

 

Exhibit 5

 

President Dilma Rousseff has publicly stated that she wants to use Brazil’s public banks to force interest rate spreads to tighten. Exhibit 6 shows that the public banks have been obeying; debt at public banks as a percent of GDP has grown 17.7% since January 2010, while debt as a percentage of GDP has only grown 8.3% for the private banks over the same period.

The private banks are concerned, and rightly so, that this growth is coming from lax underwriting standards. Our conclusion is that Brazil’s actions have already begun to jam up its credit markets.  In the March 2nd edition of DCI, Tendências Consultoria observes that the total of credit over 60 days past due equals R139.2 billion, however, credit operations that have been canceled sum to R1$80 billion. 

In otherwords, banks are canceling lines of credit and leaving firms without financing. This is what happens when preads are not increasing and defaults are rising. (Exhibit 7) On March 23rd, Banco do Brasil was down 3.23% and market rumors attributed the fall to concerns over future problems in its consumer loan portfolio.

Valor Econômico also released a story about constraints that consumer loan debt service  on household budgets. (Alicia Martins, Aumento das dívidas deve retirar fôlego do consumo, March 23rd )  The journalist quotes several economists who are concerned about the level of consumer debt.  One subject of deep concern, which we wrote about last year in our third quarter review of the Brazilian credit markets, is that the debt load continues to grow for outstanding loans.  Sérgio Vale, economist at MB Associates, discusses this problem in Martins’article.  He concludes that household budgets are being pressured as much by principal payments as by interest.  This indicates that the debt service is not sufficiently large enough to amortize the outstanding principal and that it will need to increase in order to see true reductions in consumer debt.

Exhibit 6

 

 

Exhibit 7

 

 

Consider some other facts:

  • Brazils social security fund, FGTS, bought 30% of all securitized mortgages that were issued in Brazil in 2011.
  • There is a push to force government investment portfolios to move out of investments with returns based on SELIC and into investments indexed to inflation.

 

Opportunity for FIDCs and other Structured Finance in Brazil

Brazil has decided to pull out all stops to cushion the economic slow down and prevent a recession. It is difficult to predict if Brazil will succeed in this effort. The odds are against it, but Brazil has pulled off this kind of feat before. It has also failed spectacularly.

We doubt that the Brazilian government has the balance sheet to save the Brazilian economy by forcing the credit spreads lower in Brazlian financial markets . It does, however, have the balance sheet to muck up the markets and cause distortions in the credit allocation process.

Banks will not have much incentive to serve the small and medium-sized companies if they are forced to tighten spreads significantly with no improvement in the economic outlook and significant probability of higher losses. If banks cannot widen their spread to receive compensation for greater risk, they will just stop making loans to smaller and riskier companies.

Businesses and financing companies have used structured finance to fill this gap before. Structured finance, such as FIDCs, offers flexible solutions to help creditors manage credit risks. Some banks have already structured loans as FIDCs to reduce the default risk through overcollateralization. Credit risk will continue to increase with the worsening economic environment. Investors with the background to offer creative structures should be able to earn significant returns in this market.

 

Vernon Budinger, Principal

Latin America Structured Finance Advisors, LLC

vbudinger@latamsfc.com

 

Jason Smith, Portfolio Manager

Latin America Structured Finance Advisors, LLC

jsmith@latamsfc.com

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