By Aruna Kulatunga –
Lankans loose Rs. 10,000 per person due to looses incurred under Cabraal
It was in 1992 that I returned to Sri Lanka from Hong Kong to start Forbes Research, one of the first independent equity research houses in Sri Lanka. During my two year stint with Forbes Research, before leaving to Hong Kong again to take up an offer with one of Asia´s top stock broking firms, Credit Lyonnais Securities Asia (CLSA) as their institutional sales head for the Indian sub-continent based in HK, I was a member of the USAID-ISTI primary debt committee that made a series of recommendations which laid the foundation for the change of what was previously known as rupee loans to treasury bonds.
This background left me in some consternation when I read the report of the committee appointed by the government to look into the Bond issues of the Central Bank last week. Before I delve more, I have known Central Bank governor since his days as a young advisor to the then Minister of Industries Mr Ranil Wickremesinghe in the early 90´s, and have worked in parallel while he was head of research for Society Generale Cross Asset Research ( Soc-Gen Crosby) and I was at Credit Lyonnais. I have been in regular contact since 2012 with Charlie Mahendra, a contemporary of my father at the University of Peradeniya and his neighbour at the Ramachandra Hall and an advisor to the Prime Minister Mr Ranil Wickremesinghe. The senior Mr Mahendra tolerated my chatter during the time we both visited the office of the leader of the opposition since 2012. When the first indications of the Bond issue becoming an issue became apparent through a Facebook post, I was amongst the first to defend Arjuna Mahendra – not because I had knowledge of him, but also because it made no sense – and still does not.
The Public Debt Department (PDD) of the Central Bank in consultation with others estimates the debt requirement for the next month – in this case for month beginning 01 March 2015. No evidence has been presented as to what this amount was
DG of Treasury Operations sends a letter to PDD stating the borrowing requirement to be Rs. 13.55 billion. (The report erroneously states this amount to be Rs Thirteen point five hundred and fifty billion. It should read instead Rs. Thirteen billion and five Hundred Fifty Million. The report also states that “in terms of the document referred to the entirety of the funding has to be through treasury bonds.”
The monetary board, where the Central Bank governor is also a member decides to issue a 30 year treasury bond to re-profile the debt service profile of the country “as there is good interest shown by foreign investors”. The Board had already decided to do away with the method of direct placements followed before the change of government and to raise funds through direct bond auctions.
The board does not fix the amount that needs to be raised, as that is a function that is vested with the PDD. Two pertinent comments are in the Board paper (MB/ER/4/2/2015):1.) That the board disagreed with the cut in policy rates as recommended by the MPC as ” is NOT appropriate at this stage, given the rising trend of market interest rates and rising growth of private sector credit” while deciding to maintain rates at the current level and that it was of the view “that issuing 30 year treasury bonds would be favourable at this stage to extend the yield curve and re-profile the debt service”, clearly indicating that board considered the policy rates to be the short-term rates and the 30 year bond rate as a separate issue altogether that needs to be addressed differently.
PDD publishes the advertisement calling for bids for a 30-year bond for a total of Rs One Billion. PDD indicates (not in the advertisement, but in verbal communication with the primary dealers that the indicated yield will be around 9.25%, as is the normal practice followed prior to the change of government
The bidding for the Bond of the series number LKB03045C013 opens at 1000hrs.
The governor of the central bank, accompanied by two deputy governors is present near the PDD dealing room from 1030hrs until 1056hrs. This information is not in the report but has been gleaned from other reports publicly available and not denied by the Governor or the two deputy governors.
The governor and the two deputy governors leave the area at 1056hrs. By this time, nearly 24 bids had come in, including two from Perpetual Securities. The largest bids up to this time came from EPF, (Rs. 1,000,000,000 at Yield net of Tax (YNT) of 10.9998% and Seylan Bank (Rs. 1,250,000,000) at YNT of 11.754%. The two bids from Perpetual, at equal amounts of Rs 250,000,000 each were at an YNT slightly lower than Seylan at 11.55 and 11.75%. The initial funding requirement of Rs One billion had been satisfied by this time.
Immediately after the Governor left the dealing room with his two deputies, within the period of four minutes from 1056hrs till 1100hrs when the auction officially closed, Perpetual made four further bids, one at a YNT of 11.997, another at other at 12.24, the third at 12.75 and the fourth at 12.99. All of these bids, for 13 billion rupees were made by Bank of Ceylon on behalf of Perpetual.
Two further notable bids came in after 1056hrs. One was the bid made by Bank of Ceylon for Rs. Three billion at the highest YNT of 12.5009 and another that came in seconds after the bids closed, but accepted by the Tender board from HSBC bank for Rs. 100,000,000 at a YNT of 12.5
The treasury Bond Tender committee meets at 12:30 pm (the meeting continued till 13:10pm) and decides to accept Rs. 10,058 million at a weighted average yield (WAY) of 11.73%. The governor did not participate in this meeting according to the minute paper. Following the tender committee decision, the Public debt Department of the Central Bank released a press release giving details of the Auction, providing the coupon rate of 12.50%, the amount accepted and the weighted average yield.
36 bids were received of which only 26 bids were accepted and ten rejected. Amongst these ten rejected bids were two bids amounting to Rs 10 billion by Perpetual made through Bank of Ceylon at a WAY of 12.9% and curious bid by Sampath bank for Rs. 100,000,000 at a WAY of 18%. Acuity, whose name was mentioned by Perpetual CEO to the committee, saying he also wanted to bid through Acuity but was unable to do so as an Acuity director could not be located, also made a failed bid for Rs. 100,000,00 at a WAY of 13%.
Here are the bullet points from the timeline
The market was aware of the government´s borrowing requirement from the 20th of February, the date on which the Finance ministry director general of Treasury Operations sends a letter to Public Debt department indicating the amount to be raised as Rs 13 Billion and apparently indicating that the entirety of the funding has to be through the treasury bonds.
The market was aware that the monetary board decided to issue a 30-year Treasury bond to extend the yield curve and re-profile the debt service as of the 23rd of February.
The market is aware that the yield curves for the previous four 30 year bond issues are relatively similar and was issued at similar debt service profiles. (See illustration – “Previous 30 year bond issues and yield curves on the issue dates “).
They were all issued around a WAY of 11.75 with the differential between the short term rates to the 30 year bond was between 31% to 44%. In comparison, the differential of the 30-year US bond rate to the 3 month US T-bill rate on 27th February 2015 was over 130 times. (See illustration – “US yield curve on 27/02/2015”)
A short explanation of the yield curves may be necessary here. The yield curves of short to long term treasury bills and bonds simply reflect the confidence level of investors of the country’s growth prospects and the risk the investors are willing to take in giving their money for longer periods of time. The risk profile of a 30-year bond is obviously much higher than that of a 3 month Treasury bill and therefore investors do demand a higher premium or interest rate to give their money for a 30-year period. If a yield curve is flat or is trending downwards – meaning the longer-term rates are lower than the short rates, that indicates an economy that is entering into a deflationary period and there will be no demand for the longer-term instruments. The recent European economic crisis, especially in the economies of Greece and Spain, are good examples where the yield curve reversed and there were no buyers for the long-term instruments.
The end February US yield curve and the healthy appetite shown by investors for US 30 year bonds is one of the reasons why economists believe the US has turned strongly around and is today back in the saddle as the world´s strongest economy.
Any reasonable investor, having in hand the information that the government needed a considerable amount of money to pay off the debts incurred by the previous regime, that the monetary board intended to extend the yield curve using the 30 year bond and having access to market rates of previous issues and current bond prices can make a reasonable guess as to where the yield will be. It was not only Perpetual who made this reasonable guess – Wealth Trust Securities, HSBC, Pan Asia Banking Corp and Capital Alliance all bid at a weighted average higher than 11.73% with HSBC, Pan Asia and Capital alliance all coming in at 12.5%, slightly higher than the 12.311% WAY that Perpetual received for their accepted bids. There were unreasonable assumptions too – for example that curious 18% bid from Sampath Bank. Others whose bids failed to make the cut-off point, in addition to the Rs 10 billion that Perpetual made unsuccessfully, includes Acuity, Pan Asia, Commercial Bank and Union Bank, who all bid above 12.5%. (See illustrations “Total bids and weighted Average Yields” and “Rejected bids”).
There is a crucial assumption that I am making here – and that is what needs much more scrutiny. I am making the assumption – based on information gleaned from various sources – that the market players were fully aware of two pieces of confidential information before the bidding started on the 27th – that is that the government needed more money and that the monetary board had expressed a sentiment that the 30 year bond issue will be used to re-profile the debt profile and extend the yield-curve. It is no secret amongst the primary dealers and the top financiers of the country of the incestuous relationships between the dealer desks of the primary dealers and that of the Public Debt department. Jobs are offered to kith and kin of senior central bank employees by primary dealers to propagate these relationships and there has been a free-flow of information between dealer desks for decades. Perpetual is one of these primary dealers who had access to confidential information since its inception, long before Arjuna Mahendran, whose son-in-law created and launched Perpetual Treasuries, became the Governor. A large number of the somewhat “controversial” private placements or direct placements that the Pitipana Committee alludes to in the Bond issue report, have been placed through Perpetual by the previous regime.
As the committee itself observes, the very fact that a confidential internal document, the accepted bids list, prepared by Mr L.S. Fernando, employee Number 1888 of the Public Debt Department and verified by Mr M.S.M.P. Fernando, employee number 1678 of the same department, was available on the internet not even 24 hours after the auction, testifies to the sieve like nature of the PDD. (See illustration “bids acceptance sheet for 27/02 auction”)
As the timeline shows, what is curious is that the large bids from Perpetual and the other high yield bids came after the Governor and the two deputies left the tender committee room. As the committee observes, there is no digital footprint available either at the PDD or of the senior Central Bank officials. It would however be trivial to obtain the Governor´s phone records to clarify whether or not the governor did make any calls to his son-in-law or any other connected individual after he left the dealing room and before the bids came in.
On the other hand, one could also question as to why four other primary dealers, including the late bid from HSBC, bid at a higher yield after 10:56am. Did all of these get a phone call from the Governor? Or was there another “communicator” within the PDD that relayed the information that there still was a gap in the money needed – because while the PDD decided to accept bids up to Rs 10,058 million, only at 12:15pm, it would not be wrong to assume that by 10:56am, there was a general agreement on the final numbers, given the Treasury borrowing requirements of the 20th and the Monetary Board decisions of the 23rd, the same numbers that the market had too. However, the massively aggressive bidding by Perpetual, made through Bank of Ceylon for a total of Rs 13 billion, coming after the crucial time of 10:56am also tells a different story. Perpetual made four bids on their own, for a total of Rs two billion, for a WAY of less than 12% before the deluge came through Bank of Ceylon. These four bids are on par along with the other bids that had been received by that time. Others including the EPF and Seylan Bank made similar bids (though EPF bid low, receiving their allocation for a WAY of 10.99% – possibly fund managers at EPF were not able to make best use of market information.)
This brings us to another crucial part of the puzzle. Other than for EPF, and possibly Seylan Bank, none of the other primary dealers would have been bidding for their own account. Certainly, Perpetual will not have the capital of Rs 15 billion in total to invest in a bond. Primary dealers generally find a client, often an investment fund or insurance company, and then bids on the client´s behalf. Banks, like Bank of Ceylon, extends margin calls to primary dealers and their clients. Given the sovereign status of Central Bank bonds and Treasury bills, such margins are offered at minimum rates and minimum fuss. The Bank of Ceylon dealer is on record on the committee report that he was under the impression the end client for the Rs 13 billion order from Perpetual was an insurance company. Perpetual CEO has denied that he disclosed the end client.
A source from Bank of Ceylon indicated to me that Perpetual had been short-selling both equities (which is illegal and is not possible under the current CDS rules) and debt, which is possible under repurchase or REPO agreements, in the week before the 27th auction. There was a differential between the 30-year bond and the short-term instruments – but unless one is extremely aggressive, one would not take the risk of a price miss-match between the short and long-term instruments.
Along with this mismatch of information came the completely contradictory statements by former minister Bandula Gunawardane and the former governor Ajith Nivard Cabraal regarding the so called losses incurred due to the Bond being placed at a higher yield. While Mr Gunawardane is on record saying this is as high as Rs million 59,000, Mr Cabraal places the loss at Rs. Million 8,000.
A detailed calculation made by independent and respected research firm Verite has now proved beyond doubt the veracity of these claims, so much so that both Mr Gunawardane and Mr Nivard has stopped mentioning losses. Even the so called “interim draft report of the COPE investigation” refers only to an “opportunity cost” of Rs 526 million, less than one per cent of the Rs million 59,000 that former Minister Gunawardane claims to be the loss. (Page 11, section 17.B).
The Verite research calculation, that has now been analysed and accepted by a number of competent analysts states that Mr Gunawardane and Mr Cabraal simply did not know how to calculate a value of a bond. They pointed to three major errors:
- A computational error on the time-value of money,
- An inaccurate stipulation of the base-rate and
- A weak assumption with regard to market impact and ‘loss’.
According to Verite estimates, the only impact the decision to increase the amount from Rs million 1,000 to Rs million 10,000 was an increased interest burden of Rs. 896 million, over a 30 year period, or an interest burden of less than Rs 29 million every year, approximately the same amount former President Mahinda Rajapaksa spent per day for the upkeep of his personal fiefdom. Other analysts have pointed out that this is not a loss, as this increased interest burden actually gets paid back to captive central bank controlled state institutions such as the EPF, ETF and Bank of Ceylon, who were the end clients of the primary dealers, ensuring that money is captured in a loop between Central Bank and state institutions.
Both the COPE report and other reports allude to the apparent disregard of the former Central Bank governor to follow established patterns in placing bonds and treasury bills. The guidelines clearly printed in the PDD manual (COPE report, Page 6, section 5, paragraph 4) says that as much as possible, debt must be raised through auctions. This is the established practice in all-major economies in the world and ensures transparency and market rates for investors. On the contrary, the former governor decided to change the system in favour of direct or private placements to explicitly fix the interest rates as per the observations in the COPE report (page 06, section 05 and page 10, section 14). The COPE report also notes that there is simply no transparency in this method of raising debts. (Ibid. page 10, section 14).
Information now available through the Central Bank (made available to the COPE committee) tells of the enormity of this very opaque method that reeks of favouritism and possible corruption. Under this method, a few favoured primary dealers were given the opportunity of quoting on behalf of the captive institutions. The modus operandi adapted by the pre-09 Jan 2015 Central bank was to auction a pittance of bonds and treasury bills and then make a round of calls to captive institutions to force them to buy at 500 basis points or half a per cent lower than the price fixed through the auction. These transactions then were executed through just a couple of favoured dealers. (See Private placements vs. auctions).
The 500 basis point “discount” means that ETF, EPF and other captive institutions like the Insurance corporation and Bank of Ceylon gets less for the monies they invest and in turn beneficiaries of those institutions, i.e. ETF and EPF beneficiaries earn less on their deposits.
Central Bank calculates that the loss for the ETF and EPF alone because of this controlled interest rate regime was Rs. Million 13,000 in 2013 and Rs. Million 24,000 in 2014.
As the table below shows, each Sri Lankan citizen lost a staggering Rs 2,445 rupees during the past four years in total due to mismanagement and fraud at the Central Bank under the watch of the former governor. EPF and ETF holders alone, the working population of this country, lost Rs 2,516 per beneficiary in those four years or Rs 629 per beneficiary every year. If EPF had invested this Rs. 2,516 in the February 27, 30 year bond issue at an interest rate of 12.5%, using the erroneous method of calculation used by former minister Bandula Gunawardane, each member would earn Rs 9,435 in interest alone at the end of that 30 years, without compounding the interest.
Central Bank losses and frauds from 2011 to end 2014 in Rs. Millions
When one speaks with the primary dealer community in Colombo, one gets a strong impression that the incestuous relationships that the current opposition alleges against the current governor, Arjuna Mahendran, are not unique, but endemic in the community. For example, its now established that former governor´s sister served for over three years as a director of the holding company of Perpetual Treasuries.
Another director of the company, Ranjan Hulugalle is allegedly closely connected with Anura Fernando, a well known figure in the financial circles and a former partner of the former governor Cabraal when Cabraal family held equity in the multi-level marketing scheme connected with Malaysian high profile investor Vijay Eswaran.
Over the years, many allegations have been made against Mr Fernando regarding the proprieties of his deals, but not much has been proven. Allegedly Mr Fernando was closely linked to the controversial deal in 2012 when the National Savings Bank, under the watch of its former chairman Pradeep Kariyawasam, purchased the The Finance Company (TFC) in what appeared to be a classic pump and dump action. The previous government was forced to cancel and reverse the deal.
Primary dealers claim that Perpetual showed an extraordinary growth since its start in 2013. For example, their dealer license had been granted in just two months ‘time when most had to wait for over two years. While Perpetual did not show much wins in the auctions, dealers allege that they did have a steady flow of income as the lead dealer for ETF and EPF in the primary money markets where most deals (96% in 2014) were done in the opaque and paper-trail-less direct placement market.
The government of Mr Ranil Wickremesinghe has promised a through investigation in to whether or not Perpetual made use of inside information and if so, as to who are culpable. In a recent interview, Mr Wickremesinghe said that he would be appointing select committee if his government returns to power post- august 17 and that he will appoint an opposition member to head that committee.
The Aegean stables that Mr Wickremesinghe inherited on Jan 09th of this year are not just messy, smelly, intricate and hides not one but many monsters, it needs a herculean effort to clean.