InterAmerican Development Bank Private Sector Department Capital Markets Unit

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Inter-American Development BankPrivate Sector
DepartmentCapital Markets Unit
Capital Markets Development Financial Guarantee
Program Credit Risk Mitigation
Washington DC, Draft, January 2003
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Contents

• Private Sector Department
• Capital Markets
• Objectives
• Strategy
• Eligibility Criteria
• Conditions
• Application in the Energy Sector
• Section II
• Financial Guarantees
• Definition
• Program Coverage (issuers,assets and placement)
• Options under Consideration
• Pricing Approach
• Capital Markets in the Region

Section I
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Private Sector Department (PRI)

• Responsible for IDBs financing of private
  investments in infrastructure and private sector
  transactions to develop fixed-income capital
  markets in LATAM and Caribbean
• First Mandate (1995) Support Private Investment
  in Infrastructure
• Eligible infrastructure sectors
• water / sanitation
• transportation (roads, railroads, pipelines,
  ports, airports)
• energy (power generation, transmission,
  distribution)
• telecommunications
• Second Mandate (2000) Support development of
  Capital Markets in the Region
• Eligible capital market transactions
• project bonds
• corporate bonds
• asset backed securities (including mortgage
  backed securities)
• future flow s securitization

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IDB (PRI) Financial Instruments Overview
1. Cross - Border Financing Products

• A-Loans (for IDBs own account) B-Loans (for
  market participants)
• Up to US75 million or 25 of total project costs
  (in small countries can go as high as 40)
• Up to 20 years (typically in 10-15 year range)
• Market-based pricing
• Private Placement (similar structure as the A/B
  but placement among 144A institutional investors)
• Political Risk Guarantees
• sovereign (transfer convertibility) and
  selected non-commercial risks (contract
  frustration) for infrastructure development in
  the Region (up to 50 of project costs or US150
  million). Streamlined approval process (3
  months).
• Could include selected non-commercial risk
  regulatory risks such as breach of contract by
  the grantor of the concession (e.g., San Pedro de
  Macoris, IPP, Republica Dominicana)

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IDB (PRI) Financial Instruments Overview
2. Local currency Financing Products

• IDB Financial Guarantees (partial credit
  guarantees)
• credit enhancements to improve credit risk
  profiles of local issuers to enable them to
  access market financing under better conditions
  (tenor and pricing). Same limitations as the A/B
  loans.
• Instruments mechanism that cover or protect
  debt service payments to institutional investors
  (bondholders).
• Products can be structured to guarantee an
  specific layer of credit risk,in order to elevate
  the risk profile of the overall transaction and
  thereby attract investors. By guaranteeing an
  intermediate part of the debt (I.e., guaranteeing
  to pay a portion of the obligation after the
  internal cash reserves or sponsor support has
  been exhausted) the local investor maybe more
  willing to put its capital at risk for the
  remaining exposure.
• The IDB is willing to adapt its financial
  guarantee products to whatever forms make sense
  commercially and developmentally. The risk not
  guaranteed by IDB can be covered by co-insurers
  or taken by the investors.

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Local Capital Market Development

• Objectives
• Financial desintermediation is a key component of
  a sustainable economic development strategy.
• Support of good quality credit rating private
  sector instruments as a way to diversify
  investors portfolio (e.g., pension fund
  development in LATAM increased sovereign risk
  cases of Argentina, Uruguay, Brazil, Colombia)
• Develop local currency funding instruments that
  could mitigate cross-border risk (FX risk).
  Projects that are typically local currency
  generators Water sanitation, toll roads,
  irrigation, etc. will have a tough time getting
  finance in the US markets (even with the best
  build-in contracting clauses for US tariff based
  there is a tolerance to FX adjustments in a
  particular economy)

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Capital Markets Development Strategy

• In February, 1999, the IDB Board of Governors
  approved the Banks Private Sector Departments
  participation in the development of domestic
  financial markets to complement other Bank
  activities as part of a coherent strategy to
  promote domestic capital market development in
  the Region.
• Developmental Impact
• Increase Participants Private Issuers that
  today have no access to capital markets financing
  (e.g., second tier corporate issuers). Support
  new private participants in the capital markets.
• Improve Conditions Private Issuers that have
  regular access to capital markets financing but
  under limited conditions. Support private issuers
  in obtaining better terms for their funding via
  capital markets (tenor, placement, pricing).
• Liquidity Provide liquidity to the instrument
  (bond) to be issued with the support of our
  financial guarantee (enhance probabilities of
  secondary trading of the instrument).

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Capital Markets Development Conditions

• PRI Financing Capacity. The Bank is authorized
  to participate in private sector infrastructure
  transactions without government
  counter-guarantees for amounts of up to 10 of
  the IDBs outstanding portfolio (currently at US
  41 Billion). As the capital markets activity is
  developed, this additional Bank mandate should be
  taken into account in assessing the future level
  of private sector operations without government
  counter-guarantees the Bank wishes to engage in.
• Enabling Environments. A precondition for
  private sector participation in the local capital
  markets is an enabling local environment.
  Political and economic instability, weak
  regulatory structures and institutional
  capabilities, the low level of corporate debt
  market development, and the lack of transparency
  of corporate and market information are
  significant impediments to the development of
  well-functioning capital markets with a
  significant level of private sector
  participation.
• (Local Placement Chile, Brazil, Argentina,
  Mexico, Colombia, Peru and Bolivia)
• Investments. End use of resources must be for new
  investment and/or rehabilitation - not
  restructuring of existing debt nor acquisitions
  of existing assets. The Bank has to be seen to
  play a catalytic role in mobilizing additional
  private capital
• Environment. Adherence to IDB environmental and
  social guidelines

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Capital Markets Activities Areas of Interest
Utilities Bonds
Priority

• Credit Enhancement of Corporate and Project Bond
  Issues. In developed markets, financial
  guarantee insurance for bond issues is a
  well-established credit enhancement mechanism for
  providing third-party support or security for the
  payment of principal and interest. While the
  product is common in developed markets, major US
  and European insurance companies only recently
  have begun to consider opportunities in emerging
  markets.
• Future Flows Receivables / Loan Securitization.
  In a future flows securitization, a company
  creates a bankruptcy-remote special purpose
  vehicle that issues a debt instrument whose
  repayment of principal and interest to investors
  is secured by future receivables the company
  expects to generate through its normal course of
  operation. Such a transaction could be
  implemented based on, for example, public or
  private utility receivables in any number of
  sectors, including telecommunications, water and
  power. In a loan securitization, existing
  portfolios of mortgage, education, commercial and
  other types of loans may be securitized to help
  provide term funding to originating entities,
  such as commercial banks and mortgage companies.
  The IDB can support such transactions by
  providing financial guaranty insurance or through
  the guarantee of a specific tranche of the
  capital structure.

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Financing Infrastructure through Capital Markets
US / Euro
Local Currency
International Capital Markets USA 144 A / Europe
Local Capital Markets Pension Funds, Insurance Co,

• Chile, Peru , Colombia, and Mexico
• Market deficiencies
• No FX risk

• Longer tenors
• Higher Volumes (than Bank Market)
• FX risk (non-US generating projects)

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External Financial Conditions (Latin Eurobond
Index, Spread over US Treasury Bonds)
Recent level
1250
1100
Pre-Argentine Crisis
950
800
Pre-Russian Crisis
650
Pre-Asian Crisis
500
856 bps
350
200
Jul-97
Jul-98
Jul-99
Jul-00
Jul-01
Jul-02
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
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Capital Flows, LAC-7 (annualized, millions of
dollars and of GDP)
120.000
6
Drought
Recovery
Stalling
Drought
100.000
5
of GDP
80.000
4
Millions of dollars
60.000
3
40.000
2
20.000
1
0
0
1997-I
1998-I
1999-I
2000-I
2001-I
2002-I
1997-III
1998-III
1999-III
2000-III
2001-III
Includes Argentina, Brazil, Chile, Colombia,
Mexico, Peru and Venezuela.
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Capital Flows Latin America
Latin American External Financing
Source Institute of International Finance, IV
Quarter 2000
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Use of Capital Markets for Infrastructure
Sources

• Development of Local Capital Markets
• Need a local demand for long term financing
  products (long tenor assets).
• Need to develop Savings. Need to develop a
  Pension System (preferably under private sector
  governance).
• Need to attain a minimum level of macroeconomics
  stability
• Need to create the adequate regulatory framework
  to oversee and develop the long term capital
  markets access
• Pension Funds and Insurance Companies Regulations
• Bankruptcy Laws and clear enforcement rules
• Corporate Governance
• Arbitration and Court Procedures
• Rule of Law

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Size Structure of the Bond Markets (LATAM)

• Capital Markets still represent a very small
  of GDP (except Chile) average 11 (est. 2001).
• Average holdings of sovereign risk by investor
  is relatively high (70 to 85)

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Infrastructure Financing Risk Assessment
More complex and expensive To administer. Need
to deal with More than one regulatory Agency.
Cross-Border or Transnational Projects

• Project Related Risks
• (relatively manageable by sponsors and lenders)
• Completion Risk (engineering construction cost
  / time cost control)
• Operational Performance Risk (technical
  operational know-how)
• Market Risk (Price and Volume)
• Financial Risk (Exchange Rate and Interest Rate
  Fluctuations)
• Environmental Risk (past and future liabilities,
  project delays, costs overruns)

• Non-Project Related Risks
• (non-manageable by sponsors and lenders)
• Political Risk (expropriation, political
  violence, currency convertibility transfer)
• Contractual Risk Regulatory Risks.
  (Governments default on contractual obligations,
  i.e., pricing formulas )
• Macroeconomics Environment -- Volatility Risk
  (changes in macro balance in relatively short
  periods, i.e., exchange rate, inflation, etc...)
• Legal Environment (rule of law, i.e., judicial
  system, regulatory procedures and arbitration)

Complex Adm. More than One Environmental Agency
Most LATAM currencies are directly correlated
with US. Small hedging possibilities.
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Risk Mitigation Products LATAM
Transfer Converti. Provisioning issues for
Banks (Europe)
Mitigates Concession Contract default by Authority
Provides depth (tenor) to debt instruments.
Increases Underwriting capacities
Depth and Liquidity for Capital
Market Instruments
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Local Capital Markets Utilities (energy sector)

• Transmission Lines (corporates)
• toll-based transmission lines resemble an
  annuity from a financial perspective (i.e.,
  volume of KW per period at a predetermined toll
  rate). Structured bonds based on the future cash
  flow generation of transmission lines are typical
  fixed income instruments generally accepted in
  developed markets. The risks are mostly
  associated with the payment risk of the system
  and the regulatory risk
• Distribution
• Cash flows derived from energy sales are
  typically easy to predict. They fluctuate in
  accordance to economic growth, efficiency gains
  (i.e., technical and commercial loss) and tariff
  adjustment compensation mechanism The payment
  risk is a function of the type of client (I.e.,
  industrial, residential, public, private,etc.).
• Payment Risk / Performance Risk / Regulatory
  Risk
• Generation.
• Due to the risks associated with the initial
  construction phase, generation power projects
  present more structural challenges when financing
  them via capital markets from day one (these
  projects are normally finance via short-term
  construction finance during the first two to
  three years with a folow-up take-out capital
  market facility -- long term)

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Financial Guarantees IDB Exposure Placement

• IDB Exposure Limits
• Up to US75 million per project (local currency
  equiv.) or 25 of project size (in small
  countries can go as high as 40), whichever is
  lower.
• IDB can provide certain types of guarantees alone
  or participate alongside co-insurance from
  private guarantors, acting as guarantor of
  record.
• Market Placement of Debt
• Debt will be guaranteed in local currency and
  will be targeted primarily for placement in the
  local domestic market
• Local/foreign mixed currency debt issues placed
  in both domestic and foreign markets will also be
  eligible
• Subject to market circumstances for
  infrastructure and ABS projects, foreign currency
  bonds placed in the international markets will
  also be considered.

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Financial Guarantee Options
Application of Partial Credit Risk Enhancements
Design the optimal partial credit enhancement
for a given project in order to improve its
credit risk profile enough to capture private
capital on adequate terms conditions

• Mezzanine Guarantee
• Pool Guarantee
• Rolling Guarantee
• Maturity Guarantee
• Co-Wrap Guarantee with Co-insurance

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Financial Guarantees Options

• Mezzanine Guarantee
• A credit loss protection enhancement with IDB
  providing a guarantee for a specified mezzanine
  layer of credit risk, thereby elevating the
  overall transaction to investment grade on the
  local currency scale. It is anticipated that
  subsequent to the provision of the mezzanine
  guarantee by the IDB, the issuer could seek, if
  warranted, a full wrap guarantee on the
  transaction from a private financial guarantor.
• Illustration For a project bond, the IDB could
  provide a partial guarantee for an external
  liquidity reserve, which would pay out after the
  transactions internal credit enhancement (such
  as cash reserves or sponsor recourse) has been
  exhausted, but prior to the local investors
  capital being at risk for the remaining exposure.

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Mezzanine Guarantee (energy distribution co.)
Transaction (Receivables Securitization )
Mitigation of the lower credit risk quality and
improving the transaction rating attracts
participation of Monoline Insurers to provide a
wrap on the whole transaction, improving
further the transaction credit rating.
Project Revenues (High Credit Risk Quality
Layers)

• Transaction Reserves
• Over-collateralization
• Project Debt Service Reserve Acount
• Liquidity Reserve (sponsors recourse)

Partial Guarantee (a portion of the credit loss
on the transaction, -- debt service)
Layer of Lower Credit Risk Quality
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Financial Guarantees Options

• Pool Guarantee for Asset-Backed or
  Mortgage-Backed Bonds
• A partial credit enhancement product with IDB
  providing a guarantee for a portion of principal
  and interest sufficient to offset potential
  losses resulting from non-performing assets
  within the underlying collateral pool. The Pool
  Guarantees amount will be calibrated for each
  transaction to improve the projects credit
  rating in a manner sufficient to attract targeted
  local investors.
• Illustration A bank with a mortgage portfolio
  may pledge mortgage receivables as collateral to
  repay a bond issue. Although the mortgage
  collateral enhances the bonds credit quality,
  the information on the collateral in emerging
  markets may not be adequate (e.g. incomplete
  records of past performance) and as such, the
  collateral may not be sufficient to attract local
  investors to purchase the bond. The IDB could
  further enhance the bond with a partial credit
  guarantee in order for the bond to achieve a
  credit quality sufficient to interest targeted
  local investors.

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Pool Guarantee CBO, for Illustrative purposes
Source Rating Agencies Methodology (Case Example)
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Financial Guarantees Options

• Rolling Guarantee
• A partial credit enhancement product with IDB
  providing a guarantee of a specified number of
  interest and/or principal payments, on a rolling
  forward basis i.e. the guarantee rolls forward
  to the next installment date upon payment by the
  issuer of the current installment -- so that the
  IDB guarantee covers a rising share of remaining
  debt service.
• Illustration For a project or corporate bond
  issue where investors perceive a potential risk
  associated with a variation in the debt service
  coverage at some point within the overall bond
  tenor, or are uneasy about a period of heavy
  corporate expenditures, the IDB could provide a
  rolling guarantee to smooth out the repayment
  profile and allay investor concerns about
  potential timing/cash flow issues.

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Rolling Guarantee (transmission and
distribution companies)
Outstanding Principal
Debt / Service Coverage Ratio
DSCR
1.5
1.0
Rolling Guarantee
Years
N
N I
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Financial Guarantees Options

• Maturity Guarantee
• A partial credit enhancement product with IDB
  offering a put option to investors to refinance
  an issue at maturity with the IDB -for the
  purpose of persuading investors to accept longer
  maturities.
• Illustration In certain emerging markets the
  interest rate environments are such that even for
  private issuers with very strong credit quality,
  tenors longer than three years, for example, are
  just not available. In these markets, the IDB
  could offer issuers a maturity guarantee, to
  attract local investors with an appetite for
  3-year paper into longer maturities, by providing
  them an exit if desired.

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Maturity Guarantee (generation projects)
Outstanding Principal
Capital Repayment
Bullet
Maturity Guarantee
Bullet
Years
N
N I
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Financial Guarantee Options

• Co-Wrap Guarantee with Co-insurance
• A wrap credit enhancement product with IDB
  providing a guarantee for a portion of principal
  and interest and the remaining portion guaranteed
  by one or more private financial guarantors on a
  pari passu basis under a co-guarantee
  arrangement. IDB acts as guarantor of record for
  the transaction.

IDB Guarantor
Co-guarantor
Bond-holders
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Case Santiago-Valparaíso, Financial Guarantee

• Concession awarded to a consortium led by ACS and
  SACYR Group (Spain) in 1998 in Santiago de Chile,
  Chile.
• The toll-road concession consists in the
  expansion and refurbishing of 110 km linking
  Santiago-Valparaíso and Viña del Mar
• Investment program of US 450 million to be
  partly financed through a local currency bond
  issue for the equivalent of US 300 million.
• IDB provided a credit guarantee to enhance the
  bonds rating to a level acceptable to local
  institutional investors. The IDB is Guarantor of
  Record for up to US75 million with the remaining
  amount provided by private insurers. FSA (USA
  based private insurer) acted as co-guarantor of
  the transaction.
• The issue before the IDB/FSA credit enhancement
  has been rated Baa2 by Moodys, which is the
  highest investment grade rating ever given to a
  toll road project in Chile. This is also the
  largest infrastructure bond sold primarily to
  Chilean pension funds and insurance companies,
  paying a coupon of 6.02 percent (Unidad de
  Fomento), with a maturity of 23 years.
• The issue was rated AAA by local rating agencies
  after the IDB/FSA enhancement. It was
  successfully placed in April 9, 2002

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Financial Guarantee Pricing Approach

• Pricing F expected losses capital allocation
  cost market factors no-loss underwriting
  strategy
• Expected losses F default rates, recovery
  rates, ratings
• Capital allocation cost F capital accounting
  methodology structuring (i.e., how partial is
  the partial)
• Market factors valued added (improvement in
  credit rating) and market benchmarks (pricing of
  monoline and other private insurers)

Pricing Benchmarks Rating
BP
Credit Rating b/ guarantee
Guarantee Structure (capital allocation)
X1 BP
Market Pricing
Credit Rating a/ guarantee
X2 BP
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Capital Markets in the Region