The following will highlight important stipulations of different commercial documents mentioned. These stipulations will give the reader an overview on how financing institutions (such as banks) shape our developing economy by providing loan accommodation to applicants in need of financial assistance.
I. Promissory Note:
1. Principal amount of the loan. However, except as the Monetary Board may otherwise prescribe for reasons of national interest, the total amount of loans, credit accommodations and guarantees as may be defined by the Monetary Board that may be extended by a bank to a corporation shall at no time exceed twenty percent (20%) of the net worth of such bank.
2. Amount of interest. The amount of the interest that will be charged will be based on the transfer pool rate after considering the cost of money and interest expenses, giving both the lender and the borrower a win-win situation. Based on the current banking practice, the amount of interest would range from 9% to 13% depending on the inflation rates, transfer pool rates and cost of money as determined by the Treasury Department.
3. Authority given to the bank (lender) to set-off from the borrower’s account any existing deposits which he may have in the bank (lender), in order to pay the principal loan in case of default.
4. Amount of attorney’s fees and penalty charges in case the borrower defaults in payment of the principal obligation. This stipulation is intended to protect the interest of the bank (lender) against defaulting corporations.
II. Credit Line Agreement:
1. A voluntary undertaking that the borrower is desirous to obtain credit accommodation from the lender, freely accepting the terms and conditions set forth in the agreement; and that the lender is willing to extend such credit accommodation.
2. Principal amount of the credit line agreement;
3. The kind of credit line that would fit the needs of the borrower. Under the LC/TR Line (Letter of Credit/Trust Receipt) Line, a bank extends to a borrower a loan covered by the letter of credit, with the trust receipt as security of the loan. A trust receipt is a “security transaction intended to aid in financing importers and retail dealers who do not have sufficient funds or resources to finance the importation or purchase of merchandise, and who may not be able to acquire credit except through utilization, as collateral, of the merchandise imported or purchased. This is a requirement in case the need of the borrower involves importation of goods. However, this credit line may also be utilized in the export of goods. Of course, the bank gets minimal commission for opening a credit line from the bank and additional commission on the remittances (in case the credit line involves importation of goods). A trust receipt is a requirement in the importation of goods. In the export of goods, the bank may agree on a simple loan agreement with a letter of credit.
4. Collaterals, which may involve bank deposits, chattels or real property;
5. An authority given by the borrower/client to the bank to debit all notes unpaid at maturity from the client’s current account with the bank;
6. The term of the credit line and the interest to be charged for opening a credit line;
7. An authority in favor of the bank to sell properties which were utilized as collaterals, to apply the proceeds thereof to the due and demandable principal loan amount, interest and charges;
8. List of subsidiaries and affiliates of the client which will benefit from the credit line, with an additional stipulation that all the subsidiaries and affiliates will also be solidarily liable with the client;
9. Effectivity of service of correspondences to the client/borrower;
10. A stipulation that the books of the bank concerning the principal amount and computation of the interest shall be conclusive;
11. Attorney’s fees, penalty charges and costs of the suit, in case the bank is compelled to hire the services of counsel to litigate the collection of the principal amount; and
12. Venue in case of litigation.
III. Real Estate Mortgage:
1. The parties in the real estate mortgage;
2. Principal amount of the credit accommodation;
3. Description and list of the real properties subject of the mortgage;
4. A stipulation that the mortgage will also bind the successors in interest of the mortgagor/borrower;
5. A voluntary undertaking that the real property would stand as a security to pay the principal amount of the loan;
6. Payment of expenses in connection with the mortgage, such as the documentary stamp tax, cancellation of the mortgage, notarial fee and taxes assessed on the real property;
7. While the property is in the possession of the mortgagor, an undertaking that all expenses in the repair of the improvements shall be borne by the mortgagor;
8. In case of insolvency by the mortgagor/borrower, an automatic appointment of the bank as receiver to take charge of the property subject of the mortgage;
9. In case of breach of any of the conditions of the mortgage, an automatic appointment of the bank as Attorney-in-Fact to do acts of administration and acts of strict dominion over the mortgaged property;
10. An authority given by the borrower/client to the bank to debit all notes unpaid at maturity from the client’s current account with the bank;
11. Penalty interests, attorney’s fees, and other expenses relative to the foreclosure of the real property;
12. A prohibition that the mortgaged property will not be encumbered, leased and mortgaged without the written consent of the mortgagor;
13. Possibility of changes in the interest rates and bank charges with advance notice to the mortgagor/borrower;
14. A stipulation of the mortgagor’s waiver under Article 13 of Rule 39 of the Rules of Court;
15. A stipulation that the mortgaged property is clean from all prior liens and encumbrances;
16. Signature of the parties and their respective witnesses to the mortgaged contract;
17. The mortgage must be notarized and annotated in the Registry where the real property is located.
III. Chattel Mortgage:
1. Same Stipulations as in the real estate mortgage
2. Affidavit of Good faith - It is an oath wherein the parties “severally swear that the mortgage is made for the purpose of securing the obligations specified in the conditions thereof and for no other purposes and that the same is just and valid obligation and one not entered into for the purpose of fraud.”
IV. Surety Agreement:
It is customary in the banking institution that at least 51% of the stockholders acquiring a controlling interest in the corporation must sign the surety agreement. In the surety agreement, the signatories will be solidarily liable with the corporation with respect to the credit line granted in favor of the corporation. It is a common banking practice to require the JSS (“Joint and Solidary Signature”) of a major stockholder or corporate officer, as an additional security for loans granted to corporations. There are at least two reasons for this: (1) In case of default, the creditor’s recourse, which is normally limited to the corporate properties under the veil of separate corporate personality, would extend to the personal assets of the surety; (2) Such surety would be compelled to ensure that the loan would be used for the purpose agreed upon, and that it would be paid by the corporation.
Some banks will grant a continuing suretyship agreement with Corporations whom the bank considers as a valued client. The criteria for the grant of the continuing suretyship agreement will be based on the following:
1. Number of years in the business
2. Status in the industry
3. Satisfactory credit.
The continuing surety agreement credit line program will allow corporations to avail of the credit line even before the 6-month waiting period.
V. Trust Receipt:
1. The description of the merchandise with reference to the bill of lading
2. The term of the trust receipt
3. An undertaking of the entrustee that he merely holds the merchandise subject of the trust receipt in trust from the entrustor (bank) and that the entrustee is authorized to sell the goods and apply the proceeds for the full payment of his liability with the bank.
VI. Letter of Credit:
1. A notice that the bank has granted a credit line in favor of the corporation/borrower.
2. Percentage commission for opening a credit line plus commission for the remittances, if any. In the banking sector, this is called the compensating business with the client.
Friday, November 5, 2010
Commercial documents necessary for loan availment by companies
First, let us define some of the terms in line with the commercial documents which are necessary in the processing of loan availments:
Loan – it is a transaction wherein the owner of the property, called the LENDER, allows another party, the BORROWER, to use the property. The borrower customarily promises to return the property after a specified period with payment for its use, called INTEREST. The documentation of the promise is called a PROMISSORY NOTE when the property is cash.
Collateral -- ASSET pledged to a lender until the loan is repaid. If the borrower defaults, the lender has the legal right to seize the collateral and sell it to pay off the loan.
Letter of credit – (L/C) An instrument or document issued by a bank guaranteeing the payment of a customer’s draft up to a stated amount for a specified period. It substitutes the bank’s credit for the buyer and eliminates the seller’s risk. A “confirmed letter of credit” is provided by a correspondent bank and guaranteed by the issuing bank. A “commercial letter of credit” is normally drawn in favor of a third party, called the beneficiary.
Trust Receipt – A commercial document whereby the bank releases the goods in the possession of the entrustee but retains ownership thereof while the entrustee shall sell the goods and apply the proceeds for the full payment of his liability with the bank. It is a security arrangement to which a bank acquired ownership of the imported personal property . It is a security transaction intended to aid in financing importers and retail dealers who do not have sufficient funds or resources to finance the importation or purchase of merchandise, and who may not be able to acquire credit except through utilization, as collateral, of the merchandise imported or purchased.
The failure of the entrustee to return the goods covered by the trust receipt or of the proceeds from the sale thereof shall constitute the crime of estafa.
Promissory note – It is a written promise committing the maker to pay the payee a specified sum of money either on demand or at a fixed or determinable future date, with or without interest.
Mortgage – A debt instrument by which the borrower (mortgagor) gives the lender (mortgagee) a lien on the property as security for the repayment of a loan. The borrower has use of the property, and the lien is removed when the obligation is fully paid. A mortgage normally involves real estate which is called Real Estate Mortgage. For personal property, such as machines, equipment, or tools, the lien is called a chattel mortgage.
Credit – that which is extended to a buyer or borrower on the seller or lender’s belief that that which is given will be repaid. The document evidencing the credit line given to a borrower is called Credit line agreement.
Surety – one who undertakes to pay money or perform other acts in the event the principal fails to do so; A surety is directly and immediately liable for the debt. The document evidencing such is called a surety agreement.
Deposits- Cash, checks or drafts placed with a financial institution for credit to a customer’s account.
The following are the commercial documents which are usually necessary and required in the processing of loan availment in favor of the borrower (corporation):
1. Promissory Note --
2. Credit Line Agreement
3. Real Estate Mortgage
4. Chattel Mortgage
5. Surety Agreement
6. Letter of Credit
7. Trust Receipt
As part of the regulation of the government, the bank (a person extending “credit” must give the debtor (borrower) in writing, a recital of the following upon extending a loan:
1. Cash price;
2. Amount credited if on installment price;
3. Difference between cash and installment price; and
4. Recital of finance charges and what these charges bear to the amount to be financed in percentage.
There are additional charges imposed for the application of loan such as notarial fees, insurance fees, documentary stamp tax, and handling fees. Non-compliance would authorize the debtor to recover any interest payment made.
Loan – it is a transaction wherein the owner of the property, called the LENDER, allows another party, the BORROWER, to use the property. The borrower customarily promises to return the property after a specified period with payment for its use, called INTEREST. The documentation of the promise is called a PROMISSORY NOTE when the property is cash.
Collateral -- ASSET pledged to a lender until the loan is repaid. If the borrower defaults, the lender has the legal right to seize the collateral and sell it to pay off the loan.
Letter of credit – (L/C) An instrument or document issued by a bank guaranteeing the payment of a customer’s draft up to a stated amount for a specified period. It substitutes the bank’s credit for the buyer and eliminates the seller’s risk. A “confirmed letter of credit” is provided by a correspondent bank and guaranteed by the issuing bank. A “commercial letter of credit” is normally drawn in favor of a third party, called the beneficiary.
Trust Receipt – A commercial document whereby the bank releases the goods in the possession of the entrustee but retains ownership thereof while the entrustee shall sell the goods and apply the proceeds for the full payment of his liability with the bank. It is a security arrangement to which a bank acquired ownership of the imported personal property . It is a security transaction intended to aid in financing importers and retail dealers who do not have sufficient funds or resources to finance the importation or purchase of merchandise, and who may not be able to acquire credit except through utilization, as collateral, of the merchandise imported or purchased.
The failure of the entrustee to return the goods covered by the trust receipt or of the proceeds from the sale thereof shall constitute the crime of estafa.
Promissory note – It is a written promise committing the maker to pay the payee a specified sum of money either on demand or at a fixed or determinable future date, with or without interest.
Mortgage – A debt instrument by which the borrower (mortgagor) gives the lender (mortgagee) a lien on the property as security for the repayment of a loan. The borrower has use of the property, and the lien is removed when the obligation is fully paid. A mortgage normally involves real estate which is called Real Estate Mortgage. For personal property, such as machines, equipment, or tools, the lien is called a chattel mortgage.
Credit – that which is extended to a buyer or borrower on the seller or lender’s belief that that which is given will be repaid. The document evidencing the credit line given to a borrower is called Credit line agreement.
Surety – one who undertakes to pay money or perform other acts in the event the principal fails to do so; A surety is directly and immediately liable for the debt. The document evidencing such is called a surety agreement.
Deposits- Cash, checks or drafts placed with a financial institution for credit to a customer’s account.
The following are the commercial documents which are usually necessary and required in the processing of loan availment in favor of the borrower (corporation):
1. Promissory Note --
2. Credit Line Agreement
3. Real Estate Mortgage
4. Chattel Mortgage
5. Surety Agreement
6. Letter of Credit
7. Trust Receipt
As part of the regulation of the government, the bank (a person extending “credit” must give the debtor (borrower) in writing, a recital of the following upon extending a loan:
1. Cash price;
2. Amount credited if on installment price;
3. Difference between cash and installment price; and
4. Recital of finance charges and what these charges bear to the amount to be financed in percentage.
There are additional charges imposed for the application of loan such as notarial fees, insurance fees, documentary stamp tax, and handling fees. Non-compliance would authorize the debtor to recover any interest payment made.
Requirements of banks for loan accommodation
Generally, the loan accommodation given to entities are based on the latter’s needs in business. In this regard, the needs will be based on the nature of the business as assessed by the bank. In the usual banking practice, the following are the pre-qualifying documents which are required by the bank before a loan will be extended:
I. Collateral – Accepted collaterals may be in the form of real property, chattels (machineries or fixtures), placements and deposits of the bank.
a) Real property – this is the most secured interest which is regularly accepted by banks as collateral. In case the loan will be approved on the basis of the real property as collateral, the bank will usually grant loan which is equivalent to 60% of the value of the property as assessed by an internal appraiser of the bank. In case the property has improvements, such as building, the real property must be insured against fire.
Except as the Monetary Board may otherwise prescribe, loans and other credit accommodations against real estate shall not exceed 75% of the appraised value of the respective real estate security, plus 60% of the appraised value of the insured improvements, and such loans may be made to the owner of the real estate or to his assignees.
b) Chattels – this is also considered as an accepted secured interest. However, corporations are discouraged to offer chattels as collaterals as these do not have long-term value, unlike real property which increases in value every year. In case the loan will be approved on the basis of the chattel as collateral, the bank will usually grant loan which is equivalent to 50% of the value of the property as assessed by an internal appraiser of the bank.
Except as the Monetary Board may otherwise prescribe, loans and other credit accommodations on security of chattels and intangible properties such as, but not limited to, patents, trademarks, trade names, and copyrights shall not exceed 75% of the appraised value of the security, and such loans and other credit accommodations may be made to the title-holder of the chattels and intangible properties or his assignees.
c) Deposits – this is the most convenient collateral which can be offered by the borrower to the lender. In case the loan will be approved on the basis of the existing deposits as collateral, the bank will grant the loan which is equivalent to 90%-100% of the deposit.
II. Articles of the Incorporation, By-laws, SEC Certificate of Incorporation - This will inform the bank of the borrower’s background, including the company history, nature of its business, products being offered, and the company’s ownership/management.
III. Financial statements for the past two (2) to three (3) years – These documents determine the financial standing of the entity. Cash flows will be reviewed to determine whether the entity is able to cover short term and long term debts. This is based on Section 40 of the General Banking Law of 2000 wherein the bank may demand from its credit applicants a statement of their assets and liabilities and of their income and expenditures and such information as may be prescribed by law or by rules and regulations of the Monetary Board to enable the bank to properly evaluate the credit application which includes the corresponding financial statements submitted for taxation purposes to the Bureau of Internal Revenue. The bank will usually request the applicant to wait for six (6) months to determine whether the applicant is qualified for the loan accommodation or not. The six-month period will provide time for the bank to make an appraisal of the property being offered as collateral and provide a credit investigation of the company through plant visits and research.
It is customary in all banking institutions to execute a credit investigation report wherein it will provide the bank with facts to determine whether the applicant is financially qualified to be given a loan accommodation. The credit investigation report is considered an internal confidential document which must not be furnished to the client.
Nevertheless, the loan accommodation will be based on the value of the collaterals as appraised by the bank (lender).
I. Collateral – Accepted collaterals may be in the form of real property, chattels (machineries or fixtures), placements and deposits of the bank.
a) Real property – this is the most secured interest which is regularly accepted by banks as collateral. In case the loan will be approved on the basis of the real property as collateral, the bank will usually grant loan which is equivalent to 60% of the value of the property as assessed by an internal appraiser of the bank. In case the property has improvements, such as building, the real property must be insured against fire.
Except as the Monetary Board may otherwise prescribe, loans and other credit accommodations against real estate shall not exceed 75% of the appraised value of the respective real estate security, plus 60% of the appraised value of the insured improvements, and such loans may be made to the owner of the real estate or to his assignees.
b) Chattels – this is also considered as an accepted secured interest. However, corporations are discouraged to offer chattels as collaterals as these do not have long-term value, unlike real property which increases in value every year. In case the loan will be approved on the basis of the chattel as collateral, the bank will usually grant loan which is equivalent to 50% of the value of the property as assessed by an internal appraiser of the bank.
Except as the Monetary Board may otherwise prescribe, loans and other credit accommodations on security of chattels and intangible properties such as, but not limited to, patents, trademarks, trade names, and copyrights shall not exceed 75% of the appraised value of the security, and such loans and other credit accommodations may be made to the title-holder of the chattels and intangible properties or his assignees.
c) Deposits – this is the most convenient collateral which can be offered by the borrower to the lender. In case the loan will be approved on the basis of the existing deposits as collateral, the bank will grant the loan which is equivalent to 90%-100% of the deposit.
II. Articles of the Incorporation, By-laws, SEC Certificate of Incorporation - This will inform the bank of the borrower’s background, including the company history, nature of its business, products being offered, and the company’s ownership/management.
III. Financial statements for the past two (2) to three (3) years – These documents determine the financial standing of the entity. Cash flows will be reviewed to determine whether the entity is able to cover short term and long term debts. This is based on Section 40 of the General Banking Law of 2000 wherein the bank may demand from its credit applicants a statement of their assets and liabilities and of their income and expenditures and such information as may be prescribed by law or by rules and regulations of the Monetary Board to enable the bank to properly evaluate the credit application which includes the corresponding financial statements submitted for taxation purposes to the Bureau of Internal Revenue. The bank will usually request the applicant to wait for six (6) months to determine whether the applicant is qualified for the loan accommodation or not. The six-month period will provide time for the bank to make an appraisal of the property being offered as collateral and provide a credit investigation of the company through plant visits and research.
It is customary in all banking institutions to execute a credit investigation report wherein it will provide the bank with facts to determine whether the applicant is financially qualified to be given a loan accommodation. The credit investigation report is considered an internal confidential document which must not be furnished to the client.
Nevertheless, the loan accommodation will be based on the value of the collaterals as appraised by the bank (lender).
Role of Banks in Financing
The General Banking Law of 2000 (Republic Act 8791) was enacted based on the following State Policy:
“The State recognizes:
"1. The vital role of banks in providing an environment conducive to the sustained development of the national economy; and
"2. The fiduciary nature of banks that requires high standards of integrity and performance;
“In furtherance thereof, the State shall promote and maintain a stable and efficient banking and financial system that is globally competitive, dynamic and responsive to the demands of a developing economy.
The term “bank” generally is a corporation formed for the purposes of maintaining savings account and checking accounts, issuing loans and credit, and dealing in negotiable securities issued by governmental entities and corporations. Banks earn money by investing their customers’ deposits. In order to protect the customers against loss, banks are strictly regulated by the Bangko Sentral ng Pilipinas.
Loan stipulations between entities and banks are regulated by the General Banking Law of 2000. However, the parties are free to stipulate additional clauses, terms and provisions as they may seem convenient, provided these stipulations are not contrary to law (i.e. General Banking Law of 2000), morals, good customs, public order and public policy.
The diligence required in banks before granting loans to prospective applicants has been enunciated by the Supreme Court in the following cases:
a) Citibank N.A. vs. Spouses Cabamongan, et al, G.R. 146918, May 2, 2006. “x x x since the banking business is impressed with public interest, of paramount importance thereto is the trust and confidence of the public in general. Consequently, the highest degree of diligence, [Bank of the Philippine Islands vs. Court of Appeals, 383 Phil. 538, 554 (2000); Philippine Bank of Commerce v. Court of Appeals, 336 Phil. 667, 681 (1997)] is expected, and high standards of integrity and performance are even required of it. [Sec. 2 of Republic Act 8791, otherwise known as “The General Banking Law of 2000”] By the nature of its functions, a bank is ‘under obligation to treat the accounts of its depositors with meticulous care, [Westmont Bank vs. Ong, G.R. No. 132560, January 30, 2002, 375 SCRA 212,221; Citytrust Banking Corp. v. Intermediate Appellate Court, May 27, 1994, 232 SCRA 559, 564.] always having in mind the fiduciary nature of their relationship. [Simex International (Manila), Inc. Court of Appeals, March 19, 1990, 183 SCRA 360, 367].
b) Development Bank vs. Court of Appeals, 331 SCRA 267 (2000). “While an innocent mortgagee is not expected to conduct an exhaustive investigation on the history of the mortgagor’s title, in the case of a banking institution, it must exercise due diligence before entering into said contract, and cannot rely upon what is or is not annotated on the title. Judicial notice is taken of the standards practiced for banks, before approving a loan, to send representatives to the premises of the land offered as collateral and to investigate who are the real owners thereof.
c) Ibaan Rural Bank vs. Court of Appeals, 321 SCRA 88 (2000). “Banks, being greatly affected with public interest, are expected to exercise a degree of diligence in the handling of its affairs higher than expected of an ordinary business firm.”
Before granting a loan or other credit accommodation, a bank must ascertain that the debtor is capable of fulfilling his commitments to the bank.
More of these on my next blog where I will give you insights on the different loan stipulations and agreements being done by banks in the Philippines.
“The State recognizes:
"1. The vital role of banks in providing an environment conducive to the sustained development of the national economy; and
"2. The fiduciary nature of banks that requires high standards of integrity and performance;
“In furtherance thereof, the State shall promote and maintain a stable and efficient banking and financial system that is globally competitive, dynamic and responsive to the demands of a developing economy.
The term “bank” generally is a corporation formed for the purposes of maintaining savings account and checking accounts, issuing loans and credit, and dealing in negotiable securities issued by governmental entities and corporations. Banks earn money by investing their customers’ deposits. In order to protect the customers against loss, banks are strictly regulated by the Bangko Sentral ng Pilipinas.
Loan stipulations between entities and banks are regulated by the General Banking Law of 2000. However, the parties are free to stipulate additional clauses, terms and provisions as they may seem convenient, provided these stipulations are not contrary to law (i.e. General Banking Law of 2000), morals, good customs, public order and public policy.
The diligence required in banks before granting loans to prospective applicants has been enunciated by the Supreme Court in the following cases:
a) Citibank N.A. vs. Spouses Cabamongan, et al, G.R. 146918, May 2, 2006. “x x x since the banking business is impressed with public interest, of paramount importance thereto is the trust and confidence of the public in general. Consequently, the highest degree of diligence, [Bank of the Philippine Islands vs. Court of Appeals, 383 Phil. 538, 554 (2000); Philippine Bank of Commerce v. Court of Appeals, 336 Phil. 667, 681 (1997)] is expected, and high standards of integrity and performance are even required of it. [Sec. 2 of Republic Act 8791, otherwise known as “The General Banking Law of 2000”] By the nature of its functions, a bank is ‘under obligation to treat the accounts of its depositors with meticulous care, [Westmont Bank vs. Ong, G.R. No. 132560, January 30, 2002, 375 SCRA 212,221; Citytrust Banking Corp. v. Intermediate Appellate Court, May 27, 1994, 232 SCRA 559, 564.] always having in mind the fiduciary nature of their relationship. [Simex International (Manila), Inc. Court of Appeals, March 19, 1990, 183 SCRA 360, 367].
b) Development Bank vs. Court of Appeals, 331 SCRA 267 (2000). “While an innocent mortgagee is not expected to conduct an exhaustive investigation on the history of the mortgagor’s title, in the case of a banking institution, it must exercise due diligence before entering into said contract, and cannot rely upon what is or is not annotated on the title. Judicial notice is taken of the standards practiced for banks, before approving a loan, to send representatives to the premises of the land offered as collateral and to investigate who are the real owners thereof.
c) Ibaan Rural Bank vs. Court of Appeals, 321 SCRA 88 (2000). “Banks, being greatly affected with public interest, are expected to exercise a degree of diligence in the handling of its affairs higher than expected of an ordinary business firm.”
Before granting a loan or other credit accommodation, a bank must ascertain that the debtor is capable of fulfilling his commitments to the bank.
More of these on my next blog where I will give you insights on the different loan stipulations and agreements being done by banks in the Philippines.
Sunday, October 10, 2010
Credit Default Swaps (Part 2)
In a CDS transaction, the borrower seeks to obtain a loan from the protection buyer in a CDS. For protection, the protection buyer avails of the CDS by paying a default protection fee from a protection seller based on tradable CDS Index. The borrower can be a private entity or a government (for sovereign debts). The borrower pays interest to the protection buyer for his loan using the LIBOR (London Interbank Offered Rate). The borrower should repay the loan to the protection buyer upon maturity date. In case of default of the borrower, the protection buyer will seek recovery from the protection seller. There are two kinds of settlement to be done by the protection seller depending on the agreement: Physical settlement and Cash Settlement. If a physically-settled CDS is triggered, the protection seller pays the face value of the debt (or another pre-specified amount) to the protection buyer in exchange for the debt itself, which would be worth less than face value given the recent credit event. Triggering a cash-settled CDS would require the protection seller to make a payment to the protection buyer of the difference between the original value of the debt (typically the face value) and the current value of the debt based on a specified valuation method.
Innovation and Current Trends of the CDS
There is a need to place clear and unambiguous terms of “credit event” and “reference entity” in the contract. The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.
In the case of in Ursa Minor Ltd. v. Aon Fin. Prods., Inc., 2000 WL 1010278 (S.D.N.Y. 2000) , Escobel Land Inc. (a company in the Philippines), obtained a $10M loan from Bear Stearns for the construction of condominiums in the Philippines. Escobel also secured a surety bond from Government Service Insurance System ("GSIS"), a Philippines government entity, which guaranteed Escobel's payment to Bear Stearns (BS). BS in turn obtained 1) a CDS from Aon Financial Products Limited ("Aon") as well as 2) an unconditional guarantee ("Guarantee") from Aon Corporation ("Aon") “for whatever reason or cause,” together promising to pay BSIL $10 million plus expenses if GSIS failed to satisfy its obligations under the surety bond. To reduce its own exposure, Aon entered into its own CDS agreement with Société Générale ("SG"), wherein SG agreed to pay Aon upon the occurrence of a defined "credit event," which is default of the Republic of the Philippines or any of its successors.” When Escobel's payment under its BS loan came due, Escobel failed to pay, triggering a demand on GSIS. GSIS refused, arguing that the surety bond might not be enforceable against GSIS because the GSIS representative who supposedly assigned the bond to BS did not have the authority, and because GSIS already had canceled the bond after discovering the collateral that Escobel had offered to secure the bond was not genuine. Due to GSIS' refusal to pay, BS was able to recover from its CDS with Aon agreeing to cover GSIS' default "'for whatever reason or cause," even if the underlying obligation was illegal or invalid.
By this reason, Aon sought to recover from SG based on the same credit event and by its reference entity, which is default of GSIS which is a successor or agency of the Republic of the Philippines. Unfortunately, Aon was not able to recover from SG because the basis or reference entity, the default of GSIS was held not to be a default of the Republic of the Philippines. The GSIS was held not to be a government of the Republic of the Philippines, being a separate entity altogether.
In the case of Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 2003 WL 21305355 (S.D.N.Y.), Argentina obtained a loan from Eternity Global in turn obtained a CDS from JP Morgan for a guarantee and promise to pay Eternity Global in case of Argentina’s bankruptcy or default in payment. Subsequently, Argentina sought a “voluntary debt exchange” by exchanging its debts to other foreign bonds in order to minimize payment of interests. By this reason, Eternity Global sought to recover from JP Morgan by reason of such “voluntary debt exchange”. It was held that Eternity Global cannot recover from the CDS because a “voluntary debt exchange program” does not constitute a term for bankruptcy or default in payment.
Another innovation in the over the counter CDS market is the reduction of the notional amount of CDS through a series a portfolio compression cycles, also known as tear-ups (according to ISDA) and has reduced operational, legal and capital costs and improved efficiency of the CDS market. Portfolio compression reduces the number of line items in CDS portfolios without changing the risk parameters of the portfolio. It is done by terminating existing trades and replacing them with smaller number of trades with the same risk profile and cash flows as initial portfolio.
CDS contracts are subject to clearing house rules and regulations. In the US, the Depository Trust and Clearing Corporation (DTCC), considering one of the world’s largest clearing houses.
REFERENCES:
Mike Jakola, Kellog School of Management, Northwestern University, Credit Default Swaps Index Options, June 2, 2006.
“Central Clearinghouse Planned to reduce Counterparty Risk in Credit Default Swaps Market,” Global Finance, July-August 2008.
“Credit Default Swaps Market Outstandings Shrinks as Dealers Tear-up Offsetting Agreements,” Global Finance, December 2008.
“Credit Default Swaps 101: A Primer on Legal Remedies,” Robins, Kaplan, Miller & Ciresi, February 16, 2009 (i.e. visit www.google.com)
“Credit Default Swaps: The Next Crisis?” by Janet Morrissey, March 17, 2008, (i.e. Search time.com)
Innovation and Current Trends of the CDS
There is a need to place clear and unambiguous terms of “credit event” and “reference entity” in the contract. The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.
In the case of in Ursa Minor Ltd. v. Aon Fin. Prods., Inc., 2000 WL 1010278 (S.D.N.Y. 2000) , Escobel Land Inc. (a company in the Philippines), obtained a $10M loan from Bear Stearns for the construction of condominiums in the Philippines. Escobel also secured a surety bond from Government Service Insurance System ("GSIS"), a Philippines government entity, which guaranteed Escobel's payment to Bear Stearns (BS). BS in turn obtained 1) a CDS from Aon Financial Products Limited ("Aon") as well as 2) an unconditional guarantee ("Guarantee") from Aon Corporation ("Aon") “for whatever reason or cause,” together promising to pay BSIL $10 million plus expenses if GSIS failed to satisfy its obligations under the surety bond. To reduce its own exposure, Aon entered into its own CDS agreement with Société Générale ("SG"), wherein SG agreed to pay Aon upon the occurrence of a defined "credit event," which is default of the Republic of the Philippines or any of its successors.” When Escobel's payment under its BS loan came due, Escobel failed to pay, triggering a demand on GSIS. GSIS refused, arguing that the surety bond might not be enforceable against GSIS because the GSIS representative who supposedly assigned the bond to BS did not have the authority, and because GSIS already had canceled the bond after discovering the collateral that Escobel had offered to secure the bond was not genuine. Due to GSIS' refusal to pay, BS was able to recover from its CDS with Aon agreeing to cover GSIS' default "'for whatever reason or cause," even if the underlying obligation was illegal or invalid.
By this reason, Aon sought to recover from SG based on the same credit event and by its reference entity, which is default of GSIS which is a successor or agency of the Republic of the Philippines. Unfortunately, Aon was not able to recover from SG because the basis or reference entity, the default of GSIS was held not to be a default of the Republic of the Philippines. The GSIS was held not to be a government of the Republic of the Philippines, being a separate entity altogether.
In the case of Eternity Global Master Fund Ltd. v. Morgan Guar. Trust Co., 2003 WL 21305355 (S.D.N.Y.), Argentina obtained a loan from Eternity Global in turn obtained a CDS from JP Morgan for a guarantee and promise to pay Eternity Global in case of Argentina’s bankruptcy or default in payment. Subsequently, Argentina sought a “voluntary debt exchange” by exchanging its debts to other foreign bonds in order to minimize payment of interests. By this reason, Eternity Global sought to recover from JP Morgan by reason of such “voluntary debt exchange”. It was held that Eternity Global cannot recover from the CDS because a “voluntary debt exchange program” does not constitute a term for bankruptcy or default in payment.
Another innovation in the over the counter CDS market is the reduction of the notional amount of CDS through a series a portfolio compression cycles, also known as tear-ups (according to ISDA) and has reduced operational, legal and capital costs and improved efficiency of the CDS market. Portfolio compression reduces the number of line items in CDS portfolios without changing the risk parameters of the portfolio. It is done by terminating existing trades and replacing them with smaller number of trades with the same risk profile and cash flows as initial portfolio.
CDS contracts are subject to clearing house rules and regulations. In the US, the Depository Trust and Clearing Corporation (DTCC), considering one of the world’s largest clearing houses.
REFERENCES:
Mike Jakola, Kellog School of Management, Northwestern University, Credit Default Swaps Index Options, June 2, 2006.
“Central Clearinghouse Planned to reduce Counterparty Risk in Credit Default Swaps Market,” Global Finance, July-August 2008.
“Credit Default Swaps Market Outstandings Shrinks as Dealers Tear-up Offsetting Agreements,” Global Finance, December 2008.
“Credit Default Swaps 101: A Primer on Legal Remedies,” Robins, Kaplan, Miller & Ciresi, February 16, 2009 (i.e. visit www.google.com)
“Credit Default Swaps: The Next Crisis?” by Janet Morrissey, March 17, 2008, (i.e. Search time.com)
Credit Default Swaps (Part 1)
Credit default swaps are a financial instrument used to transfer and mitigate the risk of credit exposure. They are a bilateral contract between the buyer, who purchases protection of the credit risk, and the seller, who provides protection.
A credit default swap (CDS) is a contract between two parties where a protection buyer pays a premium to the protection seller in exchange for a payment if a credit event occurs to a reference entity. CDS are customizable, over-the-counter products and can be written to trigger in the event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the reference entity. "Credit event" will usually determine whether the protection buyer has reason to demand payment from the protection seller. "Reference entity," which is the entity whose obligation is the subject of the swap.
Credit default swaps are a type of credit derivative that can be used to function as a sort of insurance or hedge against an existing investment. Credit default swaps are the largest type of credit derivative in terms of trading volume.
The CDS market has grown $180 billion in 1997; By 2004 it has grown to $5 trillion; In the 2006, $17 trillion; In 2010, it has an annual business of $70 trillion (notional amount).
As the CDS market increased in importance, tradable CDS indexes arose to allow players to trade a broader spectrum of credits at a lower cost and in a more liquid market (i.e. Dow Jones CDX and International Index Company Itraxx). The composition of each index is determined by member banks and a particular name remains in the index until the CDS is triggered due to a credit event. A new index is formed periodically but each incarnation of the index shares the majority of its names with the previous index. The member banks that help compose and price the index include sixteen major international banks. Each of the member banks makes a market in the CDS index and it is freely tradable with low bid-ask spreads of ½ to ¼ of a basis point. It pays the seller a premium relative to the amount of the debt obligation being covered—typically calculated by multiplying the principal amount by a number of basis points—called the spread—whose value is determined by the credit-worthiness of the third party.
Unlike hedging with less risky bonds which requires a cash outlay upfront, CDS do not subject the buyer to interest rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded position solely on credit risk. The market originally started as an inter-bank market to exchange credit risk without selling the underlying loans but now involves financial institutions from insurance companies to hedge funds.
The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.
A credit default swap (CDS) is a contract between two parties where a protection buyer pays a premium to the protection seller in exchange for a payment if a credit event occurs to a reference entity. CDS are customizable, over-the-counter products and can be written to trigger in the event of bankruptcy, default, failure to pay, restructuring, or any other credit event of the reference entity. "Credit event" will usually determine whether the protection buyer has reason to demand payment from the protection seller. "Reference entity," which is the entity whose obligation is the subject of the swap.
Credit default swaps are a type of credit derivative that can be used to function as a sort of insurance or hedge against an existing investment. Credit default swaps are the largest type of credit derivative in terms of trading volume.
The CDS market has grown $180 billion in 1997; By 2004 it has grown to $5 trillion; In the 2006, $17 trillion; In 2010, it has an annual business of $70 trillion (notional amount).
As the CDS market increased in importance, tradable CDS indexes arose to allow players to trade a broader spectrum of credits at a lower cost and in a more liquid market (i.e. Dow Jones CDX and International Index Company Itraxx). The composition of each index is determined by member banks and a particular name remains in the index until the CDS is triggered due to a credit event. A new index is formed periodically but each incarnation of the index shares the majority of its names with the previous index. The member banks that help compose and price the index include sixteen major international banks. Each of the member banks makes a market in the CDS index and it is freely tradable with low bid-ask spreads of ½ to ¼ of a basis point. It pays the seller a premium relative to the amount of the debt obligation being covered—typically calculated by multiplying the principal amount by a number of basis points—called the spread—whose value is determined by the credit-worthiness of the third party.
Unlike hedging with less risky bonds which requires a cash outlay upfront, CDS do not subject the buyer to interest rate risk or funding risk. CDS allow hedgers or speculators to take an unfunded position solely on credit risk. The market originally started as an inter-bank market to exchange credit risk without selling the underlying loans but now involves financial institutions from insurance companies to hedge funds.
The ISDA, International Swaps and Derivatives Association, sets standards for all derivative contracts.
Balance of Payment (Part 2)
IV. Methodology
The BOP Methodology Uses a double-entry accounting system. This means that every recorded item should have a debit and a credit, and there should be a net balance of zero.
Balance of Payments credits (act of making an entry) denote increases in liabilities, owners’ equity, revenue and gains; and decreases assets and expenses; debits denote decreases in liabilities, owners’ equity, revenue and gains; and increases in assets and expenses.
The ideal balance of payment should be:
Current Account = Capital Account+ Financial Account
In practice, however, the accounts frequently do not balance. Data for balance of payments estimates often are derived independently from different sources. As a result, there may be a summary net credit or net debit (i.e., net errors and omissions in the accounts). A separate balancing item is used to offset the credit or debit. In our country we call it NET UNCLASSIFIED ITEMS.
Hence:
Current Account= Capital Account+Financial Account (+ - Net Unclassified Items or Balancing Items)
NET UNCLASSIFIED ITEMS (or errors and ommissions) is an offsetting account to bring above-the-line and below-the-line into balance. A positive discrepancy denotes an understatement of receipts and/or overstatement of payments. Conversely, a negative entry denotes an overstatement of receipts and/or understatement of payment.
This separate entry, equal to that amount with the sign reversed, is then made to balance the accounts. Because inaccurate or missing estimates may be offsetting, the size of the net residual cannot be taken as an indicator of the relative accuracy of the balance of payments statement. Nonetheless, a large, persistent residual that is not reversed should cause concern. Such a residual impedes analysis or interpretation of estimates and diminishes the credibility of both. A large net residual may also have implications for interpretation of the investment position statement.
V. Standard Components of the Balance of Payment (BOP)
The following are the Standard components of the BOP:
Current Account which includes goods and services; income; and current transfer
Capital Account and Financial Account (Capital transfer is included in this component which includes debt forgiveness of nonresidents and donations of fixed assets by one econony to another economy. This also includes taxes on capital transfers like gift tax, estate tax)
Current Account
It covers import and export of goods and services. Goods which involves:
General merchandise
Goods for processing
Goods procured in ports by carriers
Non monetary gold
Services involves:
Transportation
Travel
Communication services
Construction services
Insurance services
Financial services
Computer and information Services
Royalties and license fees
Other business services
Personal, cultural and recreational services
Government services
Another classification under Current Account is Income which includes compensation for employees and investment income. Investment income consists of direct investment income, portfolio investment income and other investment income.
Another classification under Current Account is Current Transfer – transfers where no quid pro quo (economic value) is placed. It is classified as a current transfer when it directly affect the level of disposable income and should influence the consumption of goods or services. That is, current transfers reduce the income and consumption possibilities of the donor and increase the income and consumption possibilities of the recipient.
Included in the Current Transfer are:
cash transfers effected between governments for the purpose of financing current expenditures by the recipient government
gifts of food, clothing, other consumer goods associated with relief efforts
Gifts of certain military equipment
Annual contributions made by member governments to international organizations
Payments made by government or international organizations to governments for salaries for technical assistance.
Workers’ remittances (migrants who stay in an economy for a year or more)
Capital Account and Financial Account
Capital account covers all transactions that involve the receipt or payment of capital transfers and acquisition or disposal of nonproduced, nonfinancial assets.
The financial account covers all transactions associated with changes of ownership in the foreign financial assets and liabilities of an economy. Such changes include the creation and liquidation of claims on, or by, the rest of the world.
The foreign financial assets of an economy consist of holdings of monetary gold, SDRs (Special Drawing Rights), and claims on nonresidents. The foreign liabilities of an economy consist of indebtedness to nonresidents.
Components of the Financial Account as a Functional Type
The following are the components of the Financial Account as a Functional Type:
Direct Investment
Portfolio Investment
Reserve Assets
Other Investment
Direct Investment means a significant voice in the management of an enterprise operating outside his or her resident economy, often having substantial equity capital in the enterprise. Combined ownership of 10% or more. Ownership of less than 10% of total equity in an enterprise is already classified as Portfolio Investment.
Portfolio Investment – includes equity securities and debt securities which are traded and tradable in organized and other financial markets. Debt securities include bonds and notes, money market instruments, and financial derivatives that include a variety of new financial instruments. Equity securities covers all instruments and records acknowledging, after the claims of all creditors have been met, claims to the residual values of incorporated enterprises; holders of preferred shares are also included.
Reserve Assets - consist of those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.
The category of reserve assets, comprises monetary gold, SDRs, reserve position in the Fund, foreign exchange assets (consisting of currency and deposits and securities), and other claims.
Other Investment – these are neither classified as direct investment, portfolio investment and reserve assets. This includes short-term (contractual maturity of one year or less) and long-term investments (contractual maturity of more than one year or with no stated contractual maturity)
VI. Functions of the BOP Data
The following are the functions of the BOP data:
• Important for national and international policy formulation (i.e. for external aspects which are necessary for an interdependent world economy);
• Used for analytical studies (causes of payment imbalances and necessity of implementing adjustment measures)
• Indispensable link in the compilation of data for various components of national accounts (those related to the measurement of national wealth)
• The need to account for flows of foreign currency across national boundaries.
• Helps a country evaluate its competitive strengths and weaknesses, and forecast the strength of its currency.
REFERENCES:
John Downes and Jordan Elliot Goodman, Barrons Financial Guides: Dictionary of Finance and Investment Terms, Seventh Edition, 2006.
Bangko Sentral ng Pilipinas, Selected Philippine Economic Indicators, August 2009.
www.bsp.gov.ph
International Monetary Fund, Balance of Payments Manual 5th Edition.
The BOP Methodology Uses a double-entry accounting system. This means that every recorded item should have a debit and a credit, and there should be a net balance of zero.
Balance of Payments credits (act of making an entry) denote increases in liabilities, owners’ equity, revenue and gains; and decreases assets and expenses; debits denote decreases in liabilities, owners’ equity, revenue and gains; and increases in assets and expenses.
The ideal balance of payment should be:
Current Account = Capital Account+ Financial Account
In practice, however, the accounts frequently do not balance. Data for balance of payments estimates often are derived independently from different sources. As a result, there may be a summary net credit or net debit (i.e., net errors and omissions in the accounts). A separate balancing item is used to offset the credit or debit. In our country we call it NET UNCLASSIFIED ITEMS.
Hence:
Current Account= Capital Account+Financial Account (+ - Net Unclassified Items or Balancing Items)
NET UNCLASSIFIED ITEMS (or errors and ommissions) is an offsetting account to bring above-the-line and below-the-line into balance. A positive discrepancy denotes an understatement of receipts and/or overstatement of payments. Conversely, a negative entry denotes an overstatement of receipts and/or understatement of payment.
This separate entry, equal to that amount with the sign reversed, is then made to balance the accounts. Because inaccurate or missing estimates may be offsetting, the size of the net residual cannot be taken as an indicator of the relative accuracy of the balance of payments statement. Nonetheless, a large, persistent residual that is not reversed should cause concern. Such a residual impedes analysis or interpretation of estimates and diminishes the credibility of both. A large net residual may also have implications for interpretation of the investment position statement.
V. Standard Components of the Balance of Payment (BOP)
The following are the Standard components of the BOP:
Current Account which includes goods and services; income; and current transfer
Capital Account and Financial Account (Capital transfer is included in this component which includes debt forgiveness of nonresidents and donations of fixed assets by one econony to another economy. This also includes taxes on capital transfers like gift tax, estate tax)
Current Account
It covers import and export of goods and services. Goods which involves:
General merchandise
Goods for processing
Goods procured in ports by carriers
Non monetary gold
Services involves:
Transportation
Travel
Communication services
Construction services
Insurance services
Financial services
Computer and information Services
Royalties and license fees
Other business services
Personal, cultural and recreational services
Government services
Another classification under Current Account is Income which includes compensation for employees and investment income. Investment income consists of direct investment income, portfolio investment income and other investment income.
Another classification under Current Account is Current Transfer – transfers where no quid pro quo (economic value) is placed. It is classified as a current transfer when it directly affect the level of disposable income and should influence the consumption of goods or services. That is, current transfers reduce the income and consumption possibilities of the donor and increase the income and consumption possibilities of the recipient.
Included in the Current Transfer are:
cash transfers effected between governments for the purpose of financing current expenditures by the recipient government
gifts of food, clothing, other consumer goods associated with relief efforts
Gifts of certain military equipment
Annual contributions made by member governments to international organizations
Payments made by government or international organizations to governments for salaries for technical assistance.
Workers’ remittances (migrants who stay in an economy for a year or more)
Capital Account and Financial Account
Capital account covers all transactions that involve the receipt or payment of capital transfers and acquisition or disposal of nonproduced, nonfinancial assets.
The financial account covers all transactions associated with changes of ownership in the foreign financial assets and liabilities of an economy. Such changes include the creation and liquidation of claims on, or by, the rest of the world.
The foreign financial assets of an economy consist of holdings of monetary gold, SDRs (Special Drawing Rights), and claims on nonresidents. The foreign liabilities of an economy consist of indebtedness to nonresidents.
Components of the Financial Account as a Functional Type
The following are the components of the Financial Account as a Functional Type:
Direct Investment
Portfolio Investment
Reserve Assets
Other Investment
Direct Investment means a significant voice in the management of an enterprise operating outside his or her resident economy, often having substantial equity capital in the enterprise. Combined ownership of 10% or more. Ownership of less than 10% of total equity in an enterprise is already classified as Portfolio Investment.
Portfolio Investment – includes equity securities and debt securities which are traded and tradable in organized and other financial markets. Debt securities include bonds and notes, money market instruments, and financial derivatives that include a variety of new financial instruments. Equity securities covers all instruments and records acknowledging, after the claims of all creditors have been met, claims to the residual values of incorporated enterprises; holders of preferred shares are also included.
Reserve Assets - consist of those external assets that are readily available to and controlled by monetary authorities for direct financing of payments imbalances, for indirectly regulating the magnitude of such imbalances through intervention in exchange markets to affect the currency exchange rate, and/or for other purposes.
The category of reserve assets, comprises monetary gold, SDRs, reserve position in the Fund, foreign exchange assets (consisting of currency and deposits and securities), and other claims.
Other Investment – these are neither classified as direct investment, portfolio investment and reserve assets. This includes short-term (contractual maturity of one year or less) and long-term investments (contractual maturity of more than one year or with no stated contractual maturity)
VI. Functions of the BOP Data
The following are the functions of the BOP data:
• Important for national and international policy formulation (i.e. for external aspects which are necessary for an interdependent world economy);
• Used for analytical studies (causes of payment imbalances and necessity of implementing adjustment measures)
• Indispensable link in the compilation of data for various components of national accounts (those related to the measurement of national wealth)
• The need to account for flows of foreign currency across national boundaries.
• Helps a country evaluate its competitive strengths and weaknesses, and forecast the strength of its currency.
REFERENCES:
John Downes and Jordan Elliot Goodman, Barrons Financial Guides: Dictionary of Finance and Investment Terms, Seventh Edition, 2006.
Bangko Sentral ng Pilipinas, Selected Philippine Economic Indicators, August 2009.
www.bsp.gov.ph
International Monetary Fund, Balance of Payments Manual 5th Edition.
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