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  • Writer's pictureGerard Kavanagh

Bad moon on the rise

As Credence Clearwater Revival foretold - "I see a bad moon rising" Jim Chanos hit the nail on the head when he made these comments in the FT, following his declaration that "we are in the golden era of fraud": "a 10-year bull market driven by central bank intervention; a level of retail participation in the markets reminiscent of the end of the dotcom boom; Trumpian “post-truth in politics, where my facts are your fake news”; and Silicon Valley’s “fake it until you make it” culture, which is compounded by Fomo — the fear of missing out. All of this is exacerbated by lax oversight. Financial regulators and law enforcement, he says, “are the financial archaeologists — they will tell you after the company has collapsed what the problem was.” We'll swerve away from the finger-pointing, that cheap money leads to grotesque malinvestment and we will also avoid mention of Asia (esp China) as a poster child of this, especially as we did that in the previous blog commentary! In the West, we are no better we have hollowed out those that were meant to police excess and protect us. The auditors are now no longer partnerships and instead are all LLC's !!!) and have no fear of destitution when signing off on any delinquent company accounting (fraud). If that reality feels familiar it should do - it's what was allowed to happen with Investment banks, and that led to the crisis of 2008! Lawyers have also moved rapidly from partnerships to LLC's, but given they were rapacious anyway who notices standards have slipped, and money is all that matters. The SEC has long been a toothless pussycat and the less said about the bought and paid-for bond rating agencies the better. Everything is slipshod, and that is most certainly true of debt covenants, and this is at a time when we have the highest level of debt-to-GDP ever recorded in the history of the world. Here is the FT Alphaville team on: Putin’s booby-trapped bonds ( "Well, that’s that. Russia did not make its April 4, 2022 dollar bond payments. It tried, but the accounts from which it tried to make the payments have been frozen by the US Treasury Department on account of the matter of Russia having invaded Ukraine. Whoops. In a week, the 30-day grace period for Russia to cure the default will be over. Ordinarily, one would predict a certain default to be in the offing. Vladimir Putin’s bond, however, might have a few landmines buried in them. Focusing on the dollar bond that came due on April 4, 2022, here are four of them. 1. Unilateral Modification Bond contracts are generally loaded with contract provisions that protect bondholders against dastardly things that a distressed debtor might be inclined to do. So, a provision that one would decidedly NOT expect to see is one that gives the debtor and its flunkies the right to unilaterally modify provisions that would otherwise protect creditors. Under the title “Modifications and Waiver”, it says: The parties to the Fiscal Agency Agreement may agree, without the consent of the Bondholders, to any modification of any provision of the Fiscal Agency Agreement, which is of a formal, minor or technical nature or is made to correct a manifest error. This is worth a slow read. The first bit says, “The parties to the Fiscal Agency Agreement, without the consent of the Bondholders”. Who is that? That’s Russia and the Fiscal Agent. And the Fiscal Agent is Russia’s agent; an agent who, it tells us elsewhere in the document, Russia “reserves the right to . . . vary or terminate”. And what can Russia and its agent do? The clause says that they can “agree to any modification that is of a formal, minor or technical nature”. Putting aside “minor” (who wants to modify minor stuff), it sounds anything in the contract that is formal or technical can be modified unilaterally. But what counts as formal or technical? Potentially lots of important and crucial stuff, like what accounts payments are supposed to made into, what time of day, what location, maybe even what currency. Isn’t pretty much everything in a contract formal and technical? One might ask at this point whether there is some definition in the contract of what counts as “formal” or “technical”. There is not. It may be that what the drafters intended to say was that unilateral changes could only be made where the changes were to provisions that were “formal, minor and technical and made to correct a manifest error”. But replace “and” with “or” in those two places and we have a different ballgame. 2. Re-opening Almost every international sovereign bond issued these days contains what are called “Collective Action Clauses”. These are clauses that typically allow a supermajority of creditors (in principal amount) to modify the bonds to reduce the amounts the issuer owes. That supermajority requirement in the April 4 bonds is 75 per cent. Pretty standard stuff so far. Let us say for now that the majority of western creditors have zero interest in voting to let Russia off the hook for the bonds and they constitute more than 50 per cent of the creditors in principal amount. No modification possible, one might think. But what if there was a provision that allowed a debtor to, at any point in the game, to issue as many additional bonds as it wished to friends and family (call them Oligarch Inc.) who could be depended on to vote in favour of whatever the debtor wanted? Under the heading, “Further Issues”, we have the following delight: The Russian Federation shall be at liberty from time to time, without the consent of the holders of the Bonds, to create and issue further bonds ranking equally in all respects (or in all respects save for payments made prior to the issuance of such further bonds and, if applicable, the date and amount of the first payment on such further bonds) so that the same shall be consolidated and form a single series with the Bonds . Seems pretty clear that Russia can issue as many new bonds as it wishes, place them with sympathetic holders (Oligarch Inc.) and ensure the direction of the vote. Now, there are typically disenfranchisement provisions in these bonds that say that bonds controlled by the issuer cannot vote. But if this ever gets to a legal forum, Oligarch Inc. is presumably going to claim that it is sympathetic and loyal to mother Russia, not “controlled”. There is nothing anywhere, it could add, that requires it to vote consistent with the interests of western bondholders. The cherry on top is that there are bonds out there, such as Uruguay’s 2003 restructured bonds, that make clear that the issuer may not use this “re-opening” of a series feature with the intention of placing the bonds in the hands of investors expected to vote in favour of an amendment. That then leads to the question: Why didn’t investors in Russia’s bonds ask for this protection? 3. Fiscal Laws The Fiscal Laws clause is generally supposed to address payment that might need to be made under the laws of the place of payment (usually someplace like Luxembourg or London that is unconnected to either the issuer or creditor). It usually says something like: All payments are subject in all cases to any applicable fiscal or other laws regulations and directives in the place of payment . In the Russian bond, the crucial “place of payment words” are missing. It reads: All payments of principal and interest in respect of the Bonds are subject in all cases to the applicable fiscal or other laws of the place of payment”. But what is “applicable fiscal or other laws”? Read literally, does this makes “all payments . . . subject in all cases” to Russian fiscal laws? One might wonder whether bondholders are protected by another clause, the tax gross up clause, which provides that: If at any time any Taxes are withheld or deducted from such a payment [of principal and interest] by the Russian Federation, the Russian Federation shall increase the payment of principal or interest, as the case may be, to such amount as will result in the receipt by the Bondholders of such amounts as would have been received by them had no such withholding or deduction been required . On its face, this provision seems to negate any attempt to tax away payments to bondholders by requiring the issuer to gross up the payment to account for the tax. However, not all fiscal laws are tax laws. “Fiscal” just means relating to government revenue. That includes taxes, but could also be a law passed during time of conflict that is intended to conserve scarce foreign currency — such as one that says that all foreign creditors must be paid in roubles. 4. Currency Indemnity It is widely assumed that Russia is not allowed to pay the dollar bonds that came due on April 4 in roubles. Yes, there are some Russian bonds that have a sneaky “Alternative Payment Currency” clause, that allow rouble payments under certain conditions. But those are the Russian bonds issued after its Crimean invasion. The bonds at hand were issued in 2012. But, as one of my sharp-eyed students pointed out in class, there is a clause that begs to differ — the “Currency Indemnity” clause. The first sentence of the clause says: The US dollar is the sole currency of account and payment for all sums payable by the Russian Federation . . . in connection with the Bonds, including damages. So far so good. But then the clause goes on to say: Any amount received . . . in a currency other than the US dollar . . . by any Bondholder in respect of any sum . . . due to it from the Russian Federation shall only constitute a discharge to the Russian Federation to the extent of the US dollar amount which the recipient is able to purchase with the amount so received or recovered in that other currency on the date of that receipt or recovery . . . If that US dollar amount is less than the US dollar amount expressed to be due to the recipient under any Bond, the Russian Federation shall indemnify such recipient against any loss sustained by it as a result. In any event, the Russian Federation shall indemnify the recipient against the cost of making any such purchase. Boiled down, the clause seems to say that payment in a different currency (eg, roubles) can constitute a “discharge”, so long as the recipient can use those roubles to buy a sufficient number of dollars. OK, so maybe this is not such a big deal — there is a discharge only to the extent the investors is able to convert its roubles to dollars. But the sneaky thing for Mr. Putin to do would be to make the payments in roubles into an account in Russia, immediately convert the roubles to dollars and then say that the dollars are frozen in place under capital controls. Pay enough roubles and, according to the strict terms of the contract, that would be a discharge. And Russia could say that those dollars would be frozen until its foreign assets in the west were unfrozen. One might ask here: Doesn’t the bond require payments to be made in New York? Yes, but Section 15 — the Currency Indemnity clause — describes what happens if the holder “recovers OR RECEIVES” a payment in another currency, presumably in another place. And it says that the US dollar payment is “discharged” if the holder receives a sufficient amount of that other currency to buy dollars in the amount originally due on the date the other currency is received or recovered. All of that will have happened. Would a court buy any of this? It probably depends on where the court is located. London, New York or Moscow (another one of the doozies in these bonds is that Russia explicitly says that it has neither waived its sovereign immunity nor submitted to any court’s jurisdiction).

The problem could have been obviated had the Currency Indemnity clause specified that the dollars acquired with the other currency (roubles, in our hypothetical) be “freely transferable dollars”. But it doesn’t say that. Game, set and match, Mr. Putin?" Trying to clear up this god awful, not to mention material, financial mess is not going to be fun - its not just Putin's debts, its Chinese USD debts, its other country debts (esp in the West), its corp debts, its individual debts etc. That level of debt-to-GDP will determine our entire future, and as we have argued, again and again, inflation and financial repression will be a strong dose of the medicine forced upon us. As Russell Napier explained: " is hard for people who have been brought up in the current system to imagine that we can go back to that system and what it looks like but, ultimately, that is why politicians are important. And I associate the word ‘politician’ with the word ‘control’ – and we are going to see a lot more controls coming in. So you have to understand the nature of what drives politicians. Now, it is not ideology, it is pragmatism – debts have to be inflated away and the market system has, let’s just say, not been very good at that, because the debt-to-GDP ratio was soaring up, so there will be active means to do this. You raise the subject of globalisation – and that is important in terms of this wealth-inequality issue – but I think it is much, much bigger than that. It is where we are in the continuum – if one extreme is a laissez-faire market economy and the other extreme is a command economy, we are moving from the market economy towards the command economy. Not ‘to’ it, but ‘towards’ it. And that is 100% about politics. And if all your economics is based on market economics, and you want to invest money based on that, then I will be choosing a different fund manager." So in short we have too much debt, coupled with a monumental macro mean reversion from globalisation and free markets to deglobalisation/cold war and a move to more command-oriented economics .... the politicians, not the central banker, controlling the capital allocation spigots. Back to Russell Napier yet again: "Governments got involved in the commercial banking system, by guaranteeing private sector loans. When I look at the latest data, I see bank balance sheets growing at about 10%, which translates into broad money growth of around 10% per annum. People have to understand that it’s not central banks that create most of the money, but commercial banks. So now governments, through their loan guarantees to commercial banks, can create as much money as they like. Out of thin air." ***** And central banks will have no say in the management of broad money growth? No, they won’t. This is exactly what happened after World War II. Central banks were impotent during that time. The supply of money was dictated by governments controlling the commercial banking system. I strongly believe that we’re going back to that system. The government can never tell you that, because the whole point of financial repression is to steal money from savers slowly. But this is a fantastic thing for politicians: It isn’t fiscal spending, it isn’t higher taxation, it’s a contingent liability on the government's balance sheet but not an actual liability. It creates politically directed growth, and it creates inflation. For politicians, it’s the magic money tree." So inflation, repression, the shifting sands of excess debt upon which everything is built, and the manifold likelihood of crisis increases exponentially during such a macroeconomic volte farce. This won't be a blink of an eye, and everything is back to normal - BTFD - situation but a trend for 15 years or so. As William Butler Yeats That's why you NEED portable stores of value. That's why our digitalising of gems (F-NFTs), with ownership and benefits, is so important as it will allow ordinary people, for the first time ever, to gain exposure and defense from such assets that have until now only been available to the very wealthy. Power to the people!

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