Securitizations of Tax Revenues in Mexico
By Boris Otto and José Antonio Chávez
State and municipal governments in Mexico have been securitizing, or borrowing against, future tax collections as a way of raising needed funds to pay for infrastructure projects and to refinance prior public debt.
In the largest such transaction done to date using state taxes, the state of Veracruz converted its future payroll tax collections in 2003 into 6.3 billion pesos. The peso traded at .097¢ to the US dollar in early June. The securitization covered 30 years of future tax collections.
At least 40 such state and municipal tax securitization transactions have been done to date after the first one in 2002. The securitized taxes are generally revenue sharing payments to states out of federal tax collections by the central government. However, securitizations of state taxes such as payroll taxes and vehicle ownership taxes are being securitized more often in the last couple of years. The typical transaction raises between one and three billion in pesos. The typical use of funds is state infrastructure projects. The counterparties in the transactions are Mexican institutional investors.
Under Mexican law, state and municipal governments are limited in their ability to raise tax revenue. States and municipalities do not have the option, as they do in the United States, of funding roads, schools and other infrastructure projects by borrowing at reduced rates in a tax-exempt bond market. Therefore, many turn to securitizations of the taxes they are allowed to collect.
Securitizations are only possible in states and municipalities that have the right legal framework. One of the first steps for the investment bankers and lawyers who are behind the transactions is to persuade the local Congress to put in place the right legal underpinning for a deal. The law must allow the state or municipality to assign the right to future tax revenue to a sole-purpose private trust that will receive the revenue and pay amounts due on securities. Any provision allowing administrative control by the state or local government must be avoided. The trustee is an authorized Mexican bank and is appointed by the bondholders.
In the typical transaction, the state or municipality first requests authorization from the local Congress to carry out the intended securitization.
A trust is formed. The government assigns the right to 20 to 30 years of tax revenue to the trust. The government commits to the trust to collect the revenues and not to change the tax rate. No commitment is made about the amount of tax collections.
The state or municipality issues debt securities, called certificados bursátiles, through the trust. The bondholders have no recourse against the state or municipality; the trust is the only obligor. The revenue collected is used by the trust to repay the securities. The securities are placed on the Mexican Stock Exchange, called the Bolsa Mexicana de Valores. Only Mexicans are allowed to acquire such securities directly from the Mexican Stock Exchange. However, there are legal structures that make it possible for foreigners to acquire the securities, for example, by using a special-purpose Mexican company to acquire the bonds and then issue the US bonds collateralized by the Mexican bonds. The US bonds used in such structures are not very liquid; there is no secondary market for them.
The typical security is a debt instrument with a term of 20 to 30 years and that bears floating interest at a market rate. The average rate for such securities is currently 9%. There is usually only one tranche of securities issued with a single maturity date.
The government assigns only a percentage of the expected tax collections. Securitizations are done typically at a 50% level of expected tax collections to address the risk that tax revenue might vary.
If tax collections fall short of what is required in any period to pay debt service, then the bonds become subject to cash sweeps until the bonds have been repaid in full.
The main risks for the holders of the securities are the risk that tax collections might fall short of what is expected due either to an economic downturn or inability of the government to collect fully from taxpayers and the risk that the government might decide to abolish the tax. There is nothing to prevent the state as a sovereign entity from abolishing the tax, but it would have to pay damages to the bondholders. The debt would be accelerated, and the bondholders would have recourse against the state. The indemnities in such deals have a wide scope; in general, the state must indemnify for all harm caused by its actions.
The securities are rated by Standard & Poors, Moody’s and Fitch Ratings. The key to getting an investment-grade rating is the legal strength of the structure and the level of collateral.
There are a number of recurring legal issues that come up in deals.
One of the biggest issues is isolation of the funds derived from securitized taxes from the control of the state or municipal government. This is done by requesting the taxpayers to pay the relevant taxes directly to a bank account owned by the trust. So far there have not been any legal challenges to isolation, nor have any states or municipalities ignored their obligations. Each state and or local government has its own mechanism for collecting taxes.
Another challenge is to persuade the local Congress to authorize the transaction. There is a strong prejudice in Mexico against public debt; there has been too much experience with local officials who overborrowed to finance political campaigns and pay for projects that did not perform as expected. Nevertheless, local Congresses continue to approve these transactions because most states have few other options for financing needed infrastructure. The holders of the securities bear the risk that tax collections will fall short.