THE OUTLOOK FOR THE BRAZILIAN ECONOMY AND LOCAL CREDIT MARKETS!November 4, 2015

Vernon H. Budinger!

Latin America Structured Finance Advisors, LLC | 710 S. Myrtle #519, Monrovia, CA USA vbudinger@latamsfc.com

The Outlook for the Brazilian Economy

and Local Credit Markets November 4, 2015

Overview •! The economic drivers that have brought Brazil to its knees are now pointing to a more

favorable climate, even though economists continue to lower their GDP forecasts. The market is now looking for GDP to fall 1.7% in 2016. The forecast for 2016 sounds bad until compared to 2015’s forecast of a decline in GDP of -3.1%. Even the most negative economists are calling for zero growth in 2017. Similarly, our indicators are showing more favorable conditions for Brazil’s economy and eventual economic recovery.

•! Furthermore, Brazil’s economy is no longer “Brazil Inc.” composed mainly of the big government-owned conglomerates. An important entrepreneurial class has emerged over the past 15 years and this sector of the economy shows signs of turning around before the corruption-plagued semi-public mega-businesses with most of the financial problems.

•! The “black hole” in Brazil’s economy comes from the Brazilian government’s poor stewardship of government finances and the fiscal policies that affect the economy.

•! This indicates that there is an end in sight for the Brazilian economic crisis and this should provide the environment for Brazil’s entrepreneurs and small businesses to begin the recovery process.

•! While credit performance has deteriorated, the performance is not as bad as many investors envision and nowhere close to the carnage seen in the United States and Europe in 2008 and 2009. Returns on equity quotas (tranches) of Brazilian asset-backed securities are lower than last year, but they are still positive and are on track for average returns of 25% (BRL) in 2015.

Introduction We are receiving many requests for our insight regarding Brazil’s economic tailspin. Investors ask, “When does Brazil turn around and how bad is the performance of the Brazilian credit market?” Many investors have taken Brazil out of their allocation plans because the economy is plumbing the depths of economic uncertainty and they believe that investing now would be an attempt to catch a falling knife. I just returned from Brazil and the situation was indeed grim. The flight down on Korean Air was only half full and it is one of the most popular non-stops from Los Angeles. Last year the same flight was consistently full. It was a harbinger of the economic problems that I would find once I landed in Brazil.

The headline in the Brazilian newspaper Estado de São Paulo on Saturday, October 31, 2015 was “Factory Stands Ready, but Honda Does Not Inaugurate the Facility Because of the Crisis.” Another Brazilian paper Folha de São Paulo blared a second telling headline, “To Raise Cash, the Government Will Sell Bad Debt.” The unannounced or unpublished sale of BRL$3.3 billion in bad debt from Empresa Gestora de Ativos (Asset Management Company – a government agency designed to assume the bad debt of the public banks) is a first for the government. It is estimated that the best bid will be BRL165 million or 5% of the face value of the debt. Brazilians, as is their nature, deal with the adversity by telling jokes. Two of the best jokes:

•! “Which price reaches five first, the price of the USD/BRL or the price of Petrobras (PBR)?” Most investors know that Petrobras won that race.

•! “Eike Batista had great vision; he said that one day the value of his enterprise would be equal to the value of Petrobras – he was right they both are now worth almost zero.”

Many economists and investment analysts have provided excellent reviews of the factors that brought Brazil to this point. Rather than hashing through old news, we put together this paper to provide a forward-looking analysis of the variables that Latin America Structured Finance uses to develop our economic outlook for Brazil and Brazilian credit. We refer our readers to David Stockman’s “Contra Corner” for a particularly detailed review of all of the developments that took Brazil down this devastating path. Fracturing Bubble Down South The Outlook With respect to credit, Brazil is truly an Emerging Market; it offers some of the highest interest rates in the world. Many analysts were dismayed that Petrobras was shopping BRL debt with a coupon of 17% or higher on the package that was recently postponed. This just shows that many foreign investment analysts do not understand Brazil: 17% was a favorable rate in Brazil where most companies have been paying on average 30% to 40% annually for financing in local markets. The first step in understanding the Brazilian economy is to realize that it is really two economies in one: first the economy for big multinationals and state-owned enterprises (like Petrobras) that have access to foreign capital markets and second the local economy made of smaller companies with no such access. Furthermore, the current economic nosedive was not driven by the Lava Jato (Car Wash in Portuguese) corruption probe. The reader should completely disregard any article that asserts that the Lava Jato investigation is driving Brazil’s economic woes, because its author clearly does not understand Brazil and its economic landscape. Brazil and Petrobras were suffering long before this scandal surfaced. The local journals and the Financial Times have documented President Dilma’s efforts to hide Brazil’s problems with accounting legerdemain. LASFA wrote several articles in 2011 and 2012 that warned that Brazilian banks were increasing their reserves more than expected in anticipation of losses and that the Debt to Service Ratio was climbing to unsustainable levels. This indicated that the Brazilian banks had a very negative long-term view for the Brazilian economy and Brazilian credit.

The Figures 1 and 2 show why the banks were so cautious. The data from Serasa/Experian, a credit bureau in Brazil, reveals that business delinquencies at finance companies are now over four times higher than at the end of December 2007. Figure 1

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Serasa/Experian Delinquency IndexConsumer Delinquencies

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However, the bulk of the change came between 2010 and 2013 as credit jumped to over three times the level seen at the end of 2007. While the uptrend seen this year is in line with that of 2009, it does not yet equal the strong uptrend that started in 2010. Furthermore, delinquencies in bank portfolios have been meandering sideways for much of 2014 and 2015; this indicates that the banks have succeeded in pushing the poor credit out of their portfolios and to the finance companies. Figure 3

The point is that while delinquencies are currently at historic levels, they have been climbing steadily for years and the current trends have been seen before. The one worrisome indicator is judicial recoveries – requested and deferred. After so many years of delinquencies and defaults, many of the bad credits have been identified and the cleansing process has begun. (Figure 3 and Page 12) We see a moderately positive scenario for future credit performance in Brazil. Based on Banco Central do Brasil (BCB) studies, we use four economic variables to forecast delinquencies and defaults: Industrial Production, the Risk-free rate for Brazil, Inflation, and the Debt to Service Ratio (DSR - the ratio of monthly debt payments to monthly income). These variables indicate that credit problems should level off in the near future. Unlike equities, where investors need to see the economy improve, LASFA believes that credit can perform well if we see the end to the economic deterioration.

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Serasa/Experian Brazil Bankruptcy DataBusiness Bankruptcies

Bankruptcies Requested Bankruptcies Decreed Judicial Recoveries Requested

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Industrial Production The decline in Industrial Production for 2015 has come in far below the direst economic forecasts made at the end of 2014, as can be seen in Figure 4 with the year-over-year change. We believe that the severity of forecast error stems from the government’s rosy economic scenario at the end of 2014. Few private economists wanted to run the risk of contradicting the government since Brasilia has dealt harshly with such contradictions in the past. However, LAFSA feels that there is more to the story. Looking at Figure 5, month-over-month Industrial Production in Brazil has actually been trending higher since February 2015. The graph clearly shows that the economy had begun its downward spiral in 2013 but the government pumped up the economy in 2014 to reelect the Worker’s Party candidates. The year-over-year numbers look horrible, but the most recent monthly trend looks promising. In addition, the downturn is concentrated in fuel, vehicles, construction goods and capital materials. These sectors are dominated by government-owned entities or government-associated companies (Figure 6). Figure 4

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Most Pessimistic Forecast (Dec 2014) Actual Industrial Production

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Inflation Next, we monitor inflation as a key indicator for credit quality. A complete breakdown of the statistics provides a promising story. Once again even the most pessimistic economists did not forecast the inflation’s torrid pace for 2015. Even more puzzling, inflation usually declines during economic contractions, but it continues to rise during this downturn. A portion of the unexpected inflation is due to the extraordinary collapse of the Brazilian Real and the resulting higher prices for imports (Figure 7). However, we feel that biggest error in the inflation forecasts stems from economists who underestimated the amount of government intervention – that is the degree to which the government suppressed prices and subsidized the economy to support President Dilma’s candidacy the Presidential 2014 elections. Figure 7

The government used the government pensions and public banks to support the economy and the government’s misguided programs. One of the main tools was price controls for electrical energy and petroleum products. For example, a record drought closed many hydro-electrical plants and electric utilities were forced to incur higher costs to fire up coal and diesel-fueled plants. The increased cost would have added tremendous pressure to inflation and significantly reduced household spending before the election (as it has after the election). The Worker’s Party forced the electrical utilities to hold prices steady and the government subsidized the utilities for their losses.

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Source: Banco Central do Brasil The y-axis scale has been intentionally increased in Figure 9 to provide a more visually compelling story about the government-determined prices as opposed to the market-driven prices. Most of the market-driven price components are below 10% over the last year, clothing and domestic goods prices are fairly stable. Figure 10 demonstrates price inflation for products monitored by the government. All but two of the components are above 10% and only bottled gas is below 5%. In addition, it is plain to see the cost pressures from increases in the cost of electricity. Most of the increase in prices for electrical energy came in March 2015 when utilities (with the permission of the federal government) increased prices 22% (Banco Central data). Brazilians that I talked to complain that their bills for electricity have doubled over the past year even though they were using the same amount of electricity as the year before. As a result of their ill-advised programs, the government has to adjust the prices higher because Brazil can no longer afford to pay the subsidies; this is part of the government’s “fiscal adjustment.” LAFSA believes that when the government stops raising prices for controlled items it will be a signal that the government’s fiscal “black hole” has closed and the “fiscal adjustment” has finished.

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Interest Rates Our position on interest rates is founded in our analysis that the inflation problem is actually coming from government prices as opposed to market-driven prices. If the prices with biggest increases are not being driven by supply and demand, how will reducing demand through a punishing monetary policy help control prices? The Copom, the FOMC for the BCB, has increased SELIC, the equivalent of the Fed Funds Rate, by 325 basis points over the last year and six of the increases were 50 basis points. Only the most pessimistic economic forecasts at the end of 2014 came close being right and even they were a little low. Figure 11 depicts the worst-case predictions (maximum rate forecast) for interest rates (SELIC) versus the actual path the rates have taken. LASFA believes that the government has erred by continuing to increase rates with the well-intentioned desire to control inflation. As we stated above, LASFA believes that this policy is ill-conceived; continued monetary tightening will not affect the government’s pricing policy. In a positive development for the Brazilian economy, the most recent announcements from the Copom indicate that it is in a holding pattern and most economists believe that the BCB is finished with aggressive tightening. LASFA believes that the Copom should lower rates. Figure 11

Consumer Indebtedness The DSR is a much better indicator of the debt load and stress for the Brazilian borrower than Debt to GDP. As an example, the monthly payment is $308.77 for 36-month loan at 7% interest for $10,000 principal, for the same payment the average Brazilian consumer could only borrow BRL5,394.64 because the interest rate would be about 55%. The DSR for the average Brazilian

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consumer in 2014 was above that of the average American in 2008 while the Debt to GDP is lower. This large debt load is due in part to President Dilma’s 2013/2014 plan that incentivized Brazilians to keep spending in an attempt to push the economy higher. The Worker’s Party promoted many one-time incentive packages to promote debt-based consumer spending. There were special tax breaks to purchase cars and good deals on loans for consumers from government sponsored banks. These programs left the consumer with a heavy debt load. Figure 12

Government policies also reduced credit availability when the government trashed the banking sector by forcing the government-owned banks to give out loans at very low rates. This forced many private banks out of the small business and consumer finance credit markets. However, as we stated above, years of high delinquencies and defaults have begun to clean out the bad debt in Brazil’s financial system. Figure 13, the Boa Vista Credit Services Index for Credit Risk of New Applicants, reports a significant drop in the credit risk of new borrowers. This indicator leads us to believe that much of the credit risk has been worked out of the market over the last few years and that new credit is a reasonable investment. Year to Date Credit Performance All the bad economic news bodes ill for year-to-date performance of Brazilian credit, right? Given the severity of the Brazilian economic decline, many US credit investors assume that Brazilian asset-backed securities must be suffering the same plight as the US and European asset-backs did during that 2008/2009 crisis. However, that is not the case. Brazilian credit, has performed reasonably well as measured by returns on leveraged subordinate ABS tranches.

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US DSR Brazil DSR Principal Brazil DSR Interest Brazil DSR

While the returns are lower than 2014 at this point, Brazilian asset-backed securities are reporting positive returns for 2015 as of the end of September. Figure 13

The following table shows that the year-to-date average return for 2015 is almost 21% and that 42% of the securities are earning returns of more than 30%. This is important because 30% return is the benchmark measure that we use to determine profitability for equity tranches after taxes and hedging. With Brazilian taxes and hedging costs reducing returns by 4% and 14% respectively, 30% return provides the minimum 10% to 12% USD return demanded by investors in risky, illiquid investments. The 2015 YTD average of 21% in BRL would be almost a break-even scenario in USD terms.

Summary Return Statistics for 31 FIDCs Tracked by LASFA Statistic 2015 YTD 2014 YTD

Average Return 20.71% 28.43%Biggest Gain 83.83% 191.79%Greatest Loss * -100.00% -100.00%* In 2014 FIDC Orion failed; in 2015 the junior quota for FIDC Lego II lost all of its value.

Breakdown of 2015 Year NumberPercent of

FundsAverage Return

for GroupEarned more than 30% 13 41.94% 48.63%Earned More than Risk Free Rate** 21 67.74% 20.61%Earned Less than Risk Free Rate 10 32.26% 9.46%Loss YTD 1 3.23% -100.00%Better than last year 14 45.16% 45.16%** Risk-free Rate = 14.00%

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Brazilian ABS have performed relatively well because interest rates for local credit are so high, some of the highest interest rates in the world. While delinquency and default rates are running high, five to fifteen percent of the face value of the loans, the average rates of 30% on business credit and in excess of 60% per annum on consumer credit more than compensates for the losses. Figure 14

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Interest Rates for Brazilian CreditSource: Banco Central do Brasil

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Outlook LASFA sees signs that Brazil’s economy is bottoming out and credit will perform better as delinquencies begin to decline.

•! Economic sectors such as industrial production are starting to edge higher when we look at month-over-month trends.

•! Much of the current slow down is coming from government budget cuts that affect large state-owned or state-sponsored enterprises. Smaller businesses outside of vehicle manufacturing and natural resources have not suffered as much in the economic downturn.

•! The stabilizing economy will allow businesses to begin the recovery process. •! The Copom is finished or almost finished with the tightening – much of the slowdown

that we are seeing now is a result of the monetary tightening over the past year.

•! LASFA’s view is that the Copom should begin to lower the SELIC rate now. Unfortunately, it might increase SELIC again by 25 basis points in 2016 before beginning to ease monetary policy.

•! Boa Vista’s Credit Risk Index has fallen and is stabilizing, indicating much lower credit risk for new lenders.

•! Brazilian government is selling bad debt and cleaning its fiscal house. Summary In summary, the government’s fiscal stimulus and market intervention kept the economic symptoms hidden for a while, like a pyramid scheme. The economy has fallen dramatically now that the government’s debt rating has been reduced by two rating agencies and the Brazilian government can no longer provide economic support to large companies. However, we see a glimmer of hope in the economic carnage. Smaller companies and businesses outside of large-scale manufacturing have been able to partially insulate their operations. The Copom has finished with the bulk of the monetary tightening and could start to lower rates next year. Returns on credit investments should start to improve as the economy bottoms out. Equity tranche returns of Brazilian ABS could equal or beat the 34% average return seen in 2014. The economy does not need to start improving in order for returns on credit investments to improve, it just needs to stop deteriorating. The main challenge is to figure out just how much the government intervention sidetracked the economy - because that is what has to be undone to get Brazil back on the road to economic growth. Two indicators provide key insights into this morass. First, the DSR will indicate when consumers have worked through their binge spending. Lower interest rates will help dramatically because the current high interest rate environment is driving up the interest rate component of this measure. However, the main challenge is to figure out just how much the government intervention sidetracked the economy - because that is what has to be undone to get Brazil back on track for economic growth. LASFA believes that inflation is the key; when it starts to decline significantly we will know the government has brought supervised prices in line with the real world and that the government’s fiscal adjustment has ended. Then the Central Bank of Brazil certainly will start lowering interest rates to stimulate the economy. With the economy moving ahead, the free-market component of Brazil’s economy can engage and charge forward.