Get the latest updates as we post them — right on your browser

. Last Updated: 07/27/2016

Betting on Security Services to Make a Killing

Russia is within striking distance of an investment grade rating that will open the doors to a new, and much larger, class of foreign institutional investor.

However, some of Russia's leading banks are attempting to take a short cut and tap this huge pool of cheap investment money before Russia is upgraded again, by wrapping up their best businesses in a legal package that removes the word "Russian" from "Russian risk."

Three leading banks -- Rosbank, MDM and Russky Standart -- are on the verge of launching the country's first securitizations.

Securitization means that any money that gets tied up in some sort of credit or investment is an asset that can be sold to investors and put back into circulation, vastly increasing a bank's flexibility and ability to expand booming businesses like consumer lending.

Securitization schemes have already proven popular in other emerging markets like Mexico and Turkey with similar problems. The scheme works this way: A Russian bank sets up a special purpose vehicle, or SPV, into which it puts the rights to own sources of money it generates entirely outside the country. Then, it sells a bond secured on this money to foreign investors.

The attraction for the Russian bank is that this bond can get ratings far above the country's sovereign rating allowing it to tap buyers like U.S. pension funds -- presently barred from investing in Russia by its "speculative" rating -- at cheaper prices and longer maturities. Foreign investors enjoy the advantage of buying a bond backed with super-safe collateral but get a much bigger discount than they would from a western bond.

So what can be securitized? In theory, any source of regular payment can be wrapped up in an SPV and sold. However, the weak state of Russia's legal system means, in practice, if the bond is to get the all-important investment grade rating, all the money must be generated outside Russia.

Banking on Visa

Take for example a foreign businessman who comes to Moscow for a meeting. He pays his hotel bill using a Visa card issued at home. The hotel then goes to the local Visa agent, a Russian bank, to get its money and that bank in turn goes to Visa International in the U.S. to get the money from the businessman's account.

Even if the Russian bank goes bust or the Russian economy goes into meltdown, Visa International will pay this bill to whomever has the right to collect it. The Russian bank can sell this obligation to foreign investors (at a discount) and, what is more, they can sell part of the money they expect to get in the future at very cheap rates.

Let's say the bank receives $10 per day from credit card settlements. It sets up an SPV that has the right to collect these payments. The SPV -- not the bank that organized the deal -- issues a one year bond backed by these payments. The bond is worth one year times the daily flow, or $3,650. The bank that has this business does not have to wait a year to get this money, it gets it now. The investors, however, have to wait a year to recoup their $3,650, so they get a discount, or are paid interest on the same amount, or both; they pay $3,000 now for a cash flow of $3,650 over the year.

If, during the course of that year, the bank goes belly-up, the investors are unaffected, because the rights to collect their $3,650 is signed over to the SPV, which will continue to pay out $10 a day regardless. Since the money is coming from Visa, and both it and the SPV are outside Russia, the risk of buying these notes is greatly reduced, so the note can get a better rating than a Russian bond backed by a bank physically located in Russia. So, for the bank, the cost of borrowing is driven down dramatically.

Of course, if there is civil war and businessmen stop visiting Russia altogether, investors would be in trouble. Barring this, though, enough foreigners should continue to visit and spend money to cover the repayments if the economy slows down.

Rosbank and MDM

This month, both Rosbank and MDM are expected to announce they have hired international investment banks to securitize their foreign future flows. The two hope to issue notes abroad worth between $100 million and $200 million, passing their right to collect their future flows to foreign investors in the event the banks go bust.

"The lead manager has been chosen and the mandates agreed. How long it will be before we can raise funds will depend on the market conditions," said Alexander Kotcherguine, the head of international business development at MDM. "The terms will depend on the credit rating we can get and the how the SPV is structured."

Rosbank has a very similar deal in mind. It owns United Card Service, which settles the payments for about three-quarters of Russia's credit cards. Rosbank hopes to securitize the foreign tourist part of these payments.

"We are looking to securitize the Visa card tourist receipts. We will assign Rosbank's claims on Visa to an offshore SPV and securitize the claim," said German Aliyev, the deputy chairman of Rosbank.

Russia's leading exporters have been borrowing money against the promise of future exports of oil and metals for years and command interest rates of 1 percent to 2 percent over LIBOR, a standard benchmark for international interest rates based on the cost of borrowing in London. Even in the worst of the 1998 crisis, Russia continued to export oil and get paid for it -- generating money outside Russia.

Russia's banks are much less trustworthy. A few of the leading banks have issued eurobonds and syndicated loans are growing rapidly at the moment, but because these banks are inside the country, they pay more -- between 3 percent and 4 percent over LIBOR.

If MDM and Rosbank can securitize their future flows, they can look forward to interest rates on a par with those paid by companies in the West. For the investor, the risk of not being paid is the risk that Visa International, a company bearing the top-grade AAA rating, will not pay them. This risk has nothing to do with what happens to MDM, to Rosbank or to Russia. If the bonds win a AAA rating, then the two Russian banks can look forward to borrowing money at 0.5 percent to 0.7 percent over LIBOR, a whole order of magnitude better. But the whole idea turns on what kind of rating the bonds will be awarded by the ratings agencies.


Rosbank is expected this month to announce it has hired an international investment bank to securitize its foreign future flows.

Over Sovereign Ceiling

Securitizations are only possible because the international agencies have upgraded Russia half a dozen times over the last four years -- Russia is just one step away from investment-grade on the Fitch scale, and two steps away according to Moody's and Standard & Poor's -- but the bonds cannot jump too far ahead of sovereign ratings, which measure the government's creditworthiness, and are weighed down by the country's turbulent banking history.

"People are talking about securitization now as Russia's sovereign rating is in spitting distance of investment grade," said Ian Bell, the senior legal council at Standard and Poor's. "It is possible to swing a deal, but it will not be easy.

"There are a number of legal issues to solve," he said, "not to mention the perception of risk in doing business in Russia."

Analysts in Russia are excited by these prospects and believe the sovereign rating will reach investment grade sometime next year after the presidential elections in March. The ratings agencies are more skeptical, saying that despite the government's impressive macroeconomic performance they want to see President Vladimir Putin commit to real progress with structural reforms, and banking reform in particular, before they bestow a higher rating again.

The securitized bonds can jump up a few notches, and if they get into investment grade territory, they can buy special insurance -- called an insurance wrap -- which improves their rating even further.

In theory, it is possible to advance all the way to the AAA rating Visa International enjoys, but in reality, the upgrade will be limited. At this point, it remains unclear whether the bonds will get into investment grade territory at all.

Natasha Page, head of Fitch's Russia office, said most of Russia's banks are five notches below sovereign rating. "In principle it is possible [for an SPV] to get an investment grade rating, but in practice, it will be very difficult," she said.

Crisis-Era Baggage

Page said that improved compliance with banking standards cannot mask bank's past behavior, which Fitch considers as part of its ratings decisions.

For example, Rosbank's main shareholder is the Interros group, headed by Vladimir Potanin, who owned the Uneximbank that defaulted on more than $1 billion in debt during the 1998 crisis. Local analysts say that Interros is now on solid financial footing and the bank is functioning as a proper bank, rather than the vehicle for whisking money offshore that Uneximbank once was.

Nonetheless Rosbank, like all Russian banks, has a long way to go to escape the legacy of the wild days of the 1990s. "Despite all the credit enhancement [banks can build into a securitization deal], we will still be looking at the future flows and what might happen if there is a financial distress situation," Page said. "We need to look at the force behind the banks, if it can keep paying under these conditions," she said.

Bell said that if securitization is going to work in Russia, investors need to be convinced of two things.

"First is that the company is going to generate those receivables at least for the duration of the deal. This is the survivability criteria," Bell said. "If an issuing bank goes bust, will the doors stay open and will people continue to use it?

"Second is what local law says about international insolvencies. After the bank goes bust, do the receivables still belong to the SPV or can the Russian authorities claim them?"

On the first count, Bell said, Russia's image is poor, while on second, the situation looks promising. "We are still doing our initial investigations, but so far, Russian law looks good," he said.

However, the mounting enthusiasm for all things Russian and the sheer pace of change might carry the deals through.

David McCaig, who has been dealing with securitizations in emerging markets for the last decade at WestLB, noted that there are only two big banks in Russia, and both are state-owned: Sberbank and Vneshtorgbank. "Both could do a securitization [but] both are not particularly interested in it at the moment, as they are busy with other things," he said.

"However, these [MDM and Rosbank] deals could go through simply on the momentum of the current enthusiasm for Russia."

The ratings gap between Russia's sovereign rating and those of the banks may prove too wide to jump for now, but with the successful first reading of the deposit insurance bill in September, bank reform seems to be moving again, so this gap is likely to narrow.

Another Bank Jumps In

Both Rosbank and MDM are building up retail banking businesses, which increases the chances of a bail-out in troubled times, and this supports their case with the ratings agencies.

Even if these deals are delayed while Rosbank and MDM wait for their ratings to improve, a local securitization could happen much sooner. In September, Russky Standart, a local consumer lending pioneer, announced its desire to issue a ruble-denominated bond by securitizing its portfolio of consumer debts.

Russky Standart chairman Dmitry Levin said his bank plans to raise $100 million on the back of a loan portfolio that has been growing by $50 million a month. He said he expected the deal to close between April and June next year.

"Everything will depend on the structure [of the SPV] and whether you can remove the risk of the bank from the receipts from customers with loans," said Pavel Mami, corporate debt analyst at Renaissance Capital. "They have been talking about it for more than a year now, and it seems to be proving difficult."

While Rosbank and MDM are hoping to raise long-term cheaper financing that they can use for corporate lending, Russky Standart's motives are tied to consumer lending.

Its consumer lending business eats up capital, draining the bank of money to make more loans while it waits for individuals to pay back their credit. By securitizing these loans, Russky Standart can get back all the money it has lent as well as the profits it expects to make immediately (minus the discount paid to investors) and use the cash for more loans.

The Ripple Effect

If Russky Standart is successful, its experience will have significant consequences for a range of financial services.

Another classic candidate for securitization is mortgages. A new law on mortgages that has already passed its first reading in the State Duma would create the legal infrastructure for mortgage-backed bonds. Successful mortgage banks could thus immediately recoup the money they lend individuals to buy an apartment, rather than waiting for 20-years of mortgage payments. This money can then be reinvested in more mortgage lending.

Securitization also will be good for the legal system. Today, the idea of "collateral" is poorly defined in the law and largely limited to property. Meanwhile, items like trust funds and derivatives -- another type of complex, structured asset transaction -- do not exist at all.

Domestic securitizations are much easier to organize because they are sold to domestic investors and do not need a rating. The only hurdle involves the difficulty of creating a watertight SPV under Russian law.

Securitization would be good for the banking sector as a whole by creating access to longer-term cheaper credits and introducing a wider range of risk-graded investment instruments. These instruments are likely to be snapped up by fledgling insurance and private pension funds, which seek investments like mortgage-backed bonds.

"No one has done a deal like this in Russia before," Kotcherguine said. "It will take six to 12 months to work out, but it is not a question of if securitization will happen in Russia, but when."