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Professor Catherine Mann Suggests Paths to Transform Debt

Lessons from Latin America

How Brady-like Bonds could end the sub-prime mortgage crisis
November 10, 2009

At a time when one in every 136 U.S. homes is in foreclosure and home values are down from their peak by about 30 percent, government officials and bankers continue to wrangle over the best way to end the sub-prime mortgage crisis. Catherine L. Mann, a professor at the Brandeis International Business School and Acting Director of the Rosenberg Institute of Global Finance, suggests they take a lesson from Latin America.
“The Latin American debt crisis of the 80s and 90s is the most notable case in history where we had toxic assets transformed into marketable debt through the use of another financial instrument: the Brady Bonds,” she says. “Before the Brady Bonds, Latin American debt was toxic on the balance sheets of US banks, and toxic to the performance of Latin American countries in almost exactly the same way that mortgage-backed securities are today.”

The Brady Plan’s principal achievement was to restore the market for sovereign debt. The plan, articulated by former U.S. Treasury Secretary Nicholas Brady, involved newly created bonds issued by Latin American countries, many of which had defaulted on their debt in the 1980s. Brady Bonds enabled commercial banks to swap illiquid, opaque syndicated loans for standardized new bonds for the principal sum. The key innovation was that the principal of the new bond was collateralized with specially issued zero-coupon 30-year U.S. Treasury bonds that the debtor country purchased and kept in reserve.  

“Brady recognized that the problem with Latin American debt was that it was not marketable,” says Mann. “By issuing these marketable bonds, the price of the debt became evident, and the banks had the opportunity to either correctly value or to clear the debt from their balance sheets.”

But Brady Bonds were not the first attempt at solving the crisis. The Baker Plan - created by former U.S. Treasury Secretary, James Baker, and launched in 1985 - encouraged U.S. banks to resume lending abroad by channeling money into the system. That plan, however, failed because it did nothing to make the value of the debt transparent.

Mann draws similarities between the Baker Plan and the Troubled Asset Relief Program, a government measure that involved equity injections into financial institutions in an effort to strengthen the financial sector. “Frankly I think the same thing happened,” she says. “TARP pumped money into the system but failed to improve the valuation problem and did nothing to remove the essential problem of bad assets on the balance sheets of banks.”

Mann’s research uses a rigorous duration analysis that illustrates how a program similar to the Brady Plan might work in practice today. In simple terms: the key time to provide insurance for a bond is where the bond has its biggest cash flow. In the case of a 30-year bond with a bullet payment at 30 years, that is at the 30-year mark. But in the case of mortgage-backed securities, the period where the bonds have the biggest cash flow is between seven and 12 years because along the way, people often pay off their mortgages. 

“We’re proposing that we - this could be anyone from the US government to a private sector entity - buy US Treasury instruments that pay off at the peak distribution as a form of insurance,” she says. “If those mortgages go into foreclosure and don’t pay, then the US Treasury instrument kicks in and pays it off instead. This insurance provides the underpinning for a resumption of trade in these assets, which would reveal their true price. Thus, the market improves today, but also this strategy reduces the probability you’re going to need the insurance in the future because you’ve improved market functioning.”

This approach is cheaper, less risky, and less interventionist, she adds. “This is an alternative strategy that does not require the Federal Reserve to buy up these assets themselves.”

* Reviving Mortgage Securitization: Lessons from the Brady Plan and Duration Analysis" By Catherine Mann and Fabia Gumbau-Brisa at the Federal Reserve Bank of Boston.