Debt ; Asset-backed financing ; International Monetary Fund

James T. Moser

English

Research Papers in Economics

ESSAYS ON ISSUES THE FEDERAL RESERVE BANK SEPTEMBER 2000
OF CHICAGO NUMBER 157
Chicago Fed Letter
1. Illustration of securitization
$10 million in
pledged A/R
$2 million
in reserves
$10 million
from sale of
securities
Securities
$10 million
Securitization Trust
$2 million
in originator
equity
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A modest proposal:
Securitizing multinational
LDC debt
Recent problems with the debt of
less developed countries (LDCs) sug-
gest the need for fresh approaches.
In particular, the U.S. Congress has
shown increasing reluctance to fund
International Monetary Fund (IMF)
rescues, suggesting the erosion of
political support for the existing
structural arrangements for LDC
debt workouts. In 1997, former Sec-
retary of the Treasury, William E.
Simon remarked that “[t]he House
and Senate now have a golden op-
portunity to force the long overdue
elimination of the International
Monetary Fund (IMF). There is no
longer any reason to burden taxpayers
with the expense of this outmoded
institution.”1 A year later, during the
1998 debate on an $18 billion funding
request, House Majority leader Dick
Armey stated, “I am far from con-
vinced that we should provide any
new resources for the IMF.”2 Regard-
less of one’s position in this debate,
the intended role of the IMF is an im-
portant issue. In this Chicago Fed Letter,
I explain how a recent financial inno-
vation, the securitization trust, could
become an alternative mechanism for
handling LDC financing needs.
The IMF was organized in 1946, dur-
ing a period when the bank model
was a dominant feature of the financial
architecture. That predominance is
less apparent today. Markets have
evolved new financial structures that
may be better suited for resolving LDC
debt problems than is the bank model.
One of these new structures, the secu-
ritization trust, has proven to be a very
effective vehicle for circumventing
some of the inherent problems arising
from debt finance.
The core of the approach I propose
is a shift of the current IMF negotiat-
ing and policing functions to an insti-
tution owned by syndicates composed
of debtor nations. This approach of-
fers two advantages. The first is the
lessening of the moral hazard that
arises because, in the current frame-
work, the IMF cannot credibly refuse
to provide its assistance. LDC owner-
ship of the proposed institution, be-
cause it would mutualize risks among
its beneficiaries, offers more effec-
tive control over the risk-taking in-
centives of its members. A second
advantage is that the framework pro-
posed would provide a successor to
the increasingly unpopular IMF work-
out arrangements. Under the current
arrangements, the natural conflicts
of creditor and debtor interests exac-
erbate frictions between have and
have-not countries. As Charles
Calomiris points out, “[t]he condi-
tions imposed by the IMF along with
its financial support help to ensure
that tax increases to finance the bail-
out will be forthcoming, making the
IMF an accomplice to the transfer of
wealth from taxpayers to domestic
oligarchs and global lenders.”3 Further
wealth transfers will elevate public
skepticism and further erode support
for the existing arrangement. Steps
must be taken to provide for a succes-
sor lest LDCs face a future financial cri-
sis with no access to needed liquidity.
What is a securitization trust?
Securitization trusts operate as inter-
mediaries servicing the wholesale side
of the financial markets.4 An origina-
tor pledges assets, generally assets for
which secondary markets do not exist,
to a trust that is empowered to issue
securities against the assets it holds
(see figure 1). The securities issued
by the trust generate funds that are
channeled to the originator. Essen-
tially, the originator sells the assets to
its trust subsidiary. For example, a hy-
pothetical Chi-Town Bank originates
credit cards through mail solicitations.
Households using these cards gener-
ate accounts receivable that Chi-Town
pledges to its trust operation. The trust
pays for these receivables using funds
obtained from the securities it issues.
The innovation that makes these trans-
actions attractive comes through the
way the securities are structured. The
greatest fraction of these securities—
industry jargon refers to this tranche
as the “A piece”—are highly rated
large-denomination bonds. Two fea-
tures of trusts lead to high ratings for
the A-piece securities they issue. First,
Originator
Note: A/R is accounts receivable.the originator maintains an equity
interest in the trust. Thus, losses real-
ized from the assets it pledges are
marked first against its equity stake.
In the Chi-Town example cited above,
these would be losses realized on the
credit-card accounts that were pledged
to the trust. Second, to keep the trusts’
equity-issuance costs low, “A-piece”
covenants are much more stringent
than those found in traditional debt
issuances. Indenture provisions vary,
but all are written to protect A-piece
owners from losses arising from de-
fault on trust-held assets. An early
amortization provision is frequently
included and is especially effective.
Early amortizations are event-deter-
mined pay downs of outstanding A-
piece balances. Generally, pay-down
periods are the 12 months immedi-
ately following the triggering event.
The rapidity of pay downs concen-
trates managerial attention on asset
sales and reduces their loss-recogni-
tion flexibility. Both elements heighten
incentives for originators (or trusts)
to minimize losses based on market-
determined prices. The indentures
list a number of events that can lead
to early amortization. Such events
might include ratings downgrades
or an unfavorable debt–equity ratio.
The simplicity of these triggers en-
hances transparency.
The threat of a large and rapid am-
ortization prompts originating insti-
tutions to respond to crises as they
develop. For example, Chi-Town,
our hypothetical credit-card origina-
tor, might respond by pledging addi-
tional accounts receivable to replace
accounts that have been deemed un-
collectible. The structure concen-
trates credit risk in the equity tranche
of the trust and substantially reduces
funding costs for the A-piece portion.
The success of these structures is re-
markable. Despite their very high
apparent leverage, in the 15-year his-
tory of securitization trusts, the prin-
cipal of every A-piece owner has been
paid. This is all the more remarkable
given the period’s variation in interest
rates and historically high levels of
credit card default. This success con-
tinues to contribute to the shift of
outstanding credit-card balances into
securitization trusts. At present over
50% of credit-card receivables in the
U.S. are securitized.
Background for the proposal
Presently, LDC debt defaults are nego-
tiated under the auspices of the IMF.
Though not required to do so, the
IMF typically offers to assist in a work-
out plan provided the LDC initiates
economic policies intended to im-
prove its future creditworthiness. This
arrangement has come under criti-
cism from two angles. First, funding
of the IMF has prompted concerns
regarding the effectiveness of the or-
ganization. Johnson and Schaefer5
compare the per capita gross domes-
tic product (GDP) in the first year re-
cipient nations received IMF funding
to per capita GDP in 1993. After ad-
justing for inflation, they find that
for the 89 recipients of IMF support
from 1965 to 1995, 48 countries were
no better off than before receiving
loans and, of those 48, 32 were actu-
ally worse off. This weak performance
record has decreased political support
for the IMF, and the U.S. Congress
appears increasingly reluctant to ap-
prove funding for IMF loans. Mitigat-
ing the decreased political support
has been concern about the impact
that sovereign default may have on
the world’s financial markets. In the
fourth quarter of 1998, for example,
Congress approved $5 billion in IMF
funding targeted for assistance in the
Russian debt crisis. The initial reluc-
tance of Congress to approve this
funding package was overcome by its
recognition that an unsuccessful work-
out would have significant adverse
consequences for the financial mar-
kets. In his testimony to Congress in
1998, Federal Reserve Chairman
Alan Greenspan described the reper-
cussions from problems originating
in East Asia a year earlier:
However, the most recent more
virulent phase of the crisis has
infected our markets as well.
Concerns about business profits
and a general pulling back from
risk-taking in the midst of great
uncertainty around the globe
have driven down stock prices
and pushed up rates on the
bonds of lower-rated borrowers.
Flows of funds through financial
markets have been disrupted,
at least temporarily. Issuance of
equity, and of bonds by lower-
rated corporations, has come vir-
tually to a halt; even investment-
grade companies have cut back
substantially on their borrowing
in capital markets. Banks also
are reportedly becoming more
cautious and more expensive
lenders to many companies.6
The second criticism arises from the
workout requirements imposed by
the IMF. These requirements are fre-
quently viewed as reducing the au-
tonomy of debtor nations. This is
natural, given the IMF’s interest in
encouraging capital investment in
LDCs. The credibility of their promo-
tion activities gives the IMF an inter-
est in protecting credit-supplying
institutions from default loss. IMF-
arranged workouts must obtain a bal-
ance between the write-downs incurred
by lending institutions and the im-
pact of economic policy changes im-
posed as a condition of the workout.
As in most negotiations, both parties
typically give up something to obtain
a compromise. In this case, while the
economic policy changes may have
been understood and accepted by
the negotiating parties at the table,
the necessity of their imposition is
often less well understood by the citi-
zens of the LDC. This exacerbates
the debtor country’s political insta-
bility and potentially leads to further
economic difficulty.
The proposal
I propose applying the securitization
model to LDC debt and loan markets.
The IMF in conjunction with a group
of sovereign nations would supply eq-
uity to a securitization trust with ma-
jority ownership and controlled by
the sovereign nations. Once in place,
the trust could issue debt, using the
proceeds to purchase the obligations
of the respective countries. These
debt purchases would be proportion-
al to the equity supplied by the sover-
eign countries. As in the credit-card
example, the trust’s debt covenantsMichael H. Moskow, President; William C. Hunter,
Senior Vice President and Director of Research;  Douglas
Evanoff, Vice President, financial studies; Charles
Evans, Vice President, macroeconomic policy research;
Daniel Sullivan, Vice President, microeconomic policy
research;  William Testa, Vice President, regional
programs and economics editor; Helen O’D. Koshy,
Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve Bank
of Chicago.  The views expressed are the authors’
and are not necessarily those of the Federal
Reserve Bank of Chicago or the Federal Reserve
System. Articles may be reprinted if the source is
credited and the Research Department is
provided with copies of the reprints.
Chicago Fed Letter is available without charge from
the Public Information Center, Federal Reserve
Bank of Chicago, P.O. Box 834, Chicago, Illinois
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Chicago Fed Letter  and other Bank publications are
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ISSN 0895-0164
would specify rapid amortization of
an outstanding balance conditional
on well-defined and transparent
events. For example, a ratings down-
grade for the debt issuances of the
trust could precipitate early amorti-
zation if the participating sovereigns
failed to respond by recapitalizing
the organization. Further covenants
would be limited only by the level of
financial sophistication of the partici-
pants. As in the credit-card case, a
higher level of financial sophistication
could be obtained by setting high
face values on the A-piece issuances
of the securitization trust.
This approach has the potential to
substantially reduce IMF funding re-
quirements. The aggressive use of
covenants concentrates credit risk to
a very narrow tranche and substan-
tially lessens the credit exposure of
individual debtholders relative to the
holders of debt currently outstanding.
Thus, IMF resources would be more
effectively employed. Resources of
the IMF that are now devoted to debt
funding could then be shifted toward
early warning systems to prevent invok-
ing amortization events.
Complementing these considerations,
securitizations induce vigilance on
the part of the sovereign participants.
Because each participant has an eq-
uity interest in the trust, each stands
to lose if another participant fails to
live up to the terms of participation.
This mutualizes the interests of the
members. When employed elsewhere,
mutualization has been proved to be
an effective mechanism for control-
ling credit problems. In addition,
shifting the imposition of economic
measures from the IMF to the partic-
ipating sovereign nations subverts
the autonomy argument.
Conclusion
A review of the developments of the
last five years implies that political
support for the IMF framework is de-
clining. If we fail to look elsewhere
for solutions to LDC debt problems,
we risk a further decline in political
support for the IMF and the eventual
failure of its funding. This Chicago
Fed Letter outlines one potential
alternative to the present frame-
work. Innovations in financial archi-
tecture have led to the successful
development of securitization trusts
as a cost-effective means of managing
credit risk. Securitization trusts offer
the potential to decrease the depen-
dence of debtor nations on the well-
developed countries. Greater LDC
autonomy over their economic pol-
icies can go a long way toward lessen-
ing frictions between have and have-
not nations, while simultaneously
maintaining a supply of readily avail-
able credit to meet crisis situations.
—James T. Moser
Research officer and economic advisor
1William E. Simon, 1997, “Abolish the IMF,”
Wall Street Journal, October 23, p. A18.
2Dick Armey, 1998, “The IMF and the Clinton
doctrine,” April 3, available on the Internet at
http://freedom.house.gov/library/imf/
doctrine.asp. Emphasis in the original.
3Statement of Charles W. Calomiris before
the Joint Economic Committee United States
Congress, Wednesday, October 7, 1998.
4For an excellent introduction to securitiza-
tion trusts, see Michael R. Dean, Chris
Mrazek, Richard C. Drason, Mark Sun, Kathy
Moon, and Michelle Galvez, 1999, “ABCs of
credit card ABS,” The Securitization Conduit,
Vol. 2, No. 2/3, pp. 26–37.
5Bryan T. Johnson and Bret D. Schaefer, 1997,
“The International Monetary Fund: Outdated,
ineffective, and unnecessary,” Backgrounder,
Heritage Foundation, May 6, No. 1113.
6Testimony of Chairman Alan Greenspan
on private-sector refinancing of the large
hedge fund, Long-Term Capital Management,
before the Committee on Banking and Finan-
cial Services, U.S. House of Representatives,
October 1, 1998.P
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The CFMMI rose 0.7% from May to June, reaching a seasonally adjusted level
of 166.9 (1992=100). Revised data show the index was at 165.8 in May, and
had risen 0.4% from April. The Federal Reserve Board’s IP increased 0.3% in
June, after rising 0.4% in May. June output in the region was 8.4% higher than
a year earlier, while output in the nation was 6.4% higher.
Light truck production increased slightly from 7.1 million units in May to 7.3
million units in June. Car production also increased slightly from at 5.7 million
units in May to 5.8 million units in June. The Midwest purchasing managers’
composite index (a weighted average of the Chicago, Detroit, and Milwaukee
surveys) decreased to 53.7% in July from 57.4% in June. The purchasing man-
agers’ index decreased in all three surveys. The national purchasing manag-
er’s survey decreased slightly from 53.6% to 53.4% during the same period.
Sources: The Chicago Fed Midwest Manufactur-
ing Index (CFMMI) is a composite index of 16
industries, based on monthly hours worked and
kilowatt hours. IP represents the Federal Reserve
Board’s Industrial Production Index for the U.S.
manufacturing sector. Autos and light trucks are
measured in annualized units, using seasonal ad-
justments developed by the Board. The purchas-
ing managers’ survey data for the Midwest are
weighted averages of the seasonally adjusted pro-
duction components from the Chicago, Detroit,
and Milwaukee Purchasing Managers’ Association
surveys, with assistance from Kingsbury Interna-
tional, LTD., Comerica, and the University of
Wisconsin–Milwaukee.
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Purchasing managers’ surveys:
net % reporting production growth
July Month  ago Year ago
MW 53.7 57.4 60.4
U.S. 53.4 53.6 58.7
Motor vehicle production
(millions, seasonally adj. annual rate)
June Month  ago Year ago
Cars 5.8 5.7 5.5
Light trucks 7.3 7.1 7.2
Manufacturing output indexes
(1992=100)
June Month  ago Year ago
CFMMI 166.9 165.8 154.0
IP 150.5 150.0 141.4
1997 ’98 ’99 ’00
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155
175
Tracking Midwest manufacturing activity
CFMMI
IP

A modest proposal: securitizing multinational LDC debt

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A modest proposal: securitizing multinational LDC debt

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Research Papers in Economics