46263 noTE no. 39 ­ Aug. 2008GRIDLINES Sharing knowledge, experiences, and innovations in public-private partnerships in infrastructure Enhancing the creditworthiness of municipal bonds Innovations from Mexico James Leigland and Cledan Mandri-Perrott I n 2001­03 the municipal bond market in Looking for a better way Mexico was among the most active in the developing world. Government officials had The 1994­95 financial crisis in Mexico led the found a way to dramatically enhance the cred- federal government to take stock of its public itworthiness of local government debt without financial health. Among many other things, federal using sovereign guarantees. The technique, officials began to look for better ways of financing adapted in part from private sector "future investment by state and local governments. flow" financing deals, enabled a state or local government to earn significantly higher credit The most popular existing method involved loans ratings for bond issues than for its normal by development and commercial banks backed balance sheet debt. Many other developing by intercepts of the intergovernmental tax- countries have turned to Mexico as a source sharing grants managed by Banobras, the largest of innovation that may have application in their state development bank. Loan agreements typi- own markets. cally allowed creditors, in case of default, to ask the federal government to deduct debt service Many central governments in the developing world payments from the borrower's monthly tax-sharing are looking for alternatives to sovereign guarantees grants. The deduction amounted to an intercept to help municipalities and local utilities access of payments, executed through Banobras, before capital markets. One well-known enhancement the funds reached the state or local government. involves intercepting intergovernmental transfers to pay subnational debt service if the borrower The intercept arrangement created an implicit proves to be unwilling or unable to make normal federal guarantee of state and local borrowing-- payments. and a massive contingent liability for the federal government. Lenders, viewing such loans as The Mexican government introduced a varia- backed by the federal government's creditworthi- tion of this technique at the end of the 1990s, ness, paid little attention to the purpose of the which allowed states and municipalities to use borrowing or the credit standing of the borrower. sophisticated revenue intercept mechanisms to create credit enhancements of a type pioneered As part of decentralization reforms in the late by private financial institutions. The added confi- 1990s, Mexico's federal government sought to dence these enhancements provided to investors increase the financial autonomy and accountabil- and rating agencies led to a sudden blossoming of ity of state and local entities by clearly separating the municipal bond market in Mexico. Starting in the finances of different levels of government. December 2001, with no previous experience in municipal bond issuance, the market registered 10 subsovereign bond issues in less than two years. James Leigland is program leader for subnational technical PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY assistance at PPIAF. Cledan Mandri-Perrott is senior infrastructure specialist in the World Bank's Finance, Economics, and Urban Development Department. Helping to eliminate poverty and achieve sustainable development through public-private partnerships in infrastructure PUBLIC-PRIVATE INFRASTRUCTURE ADVISORY FACILITY Beginning in March 2000, no state or municipal flow transactions usually involve borrowings debt could be backed by federal intercepts of tax- backed by future revenues (such as expected future sharing grants. The grants would continue to flow sales) rather than existing assets. These revenues to states and municipalities and could be pledged typically come from sources that investors regard for debt repayments, but new loan agreements as highly reliable. could no longer involve direct federal participation or any implied federal guarantees. In addition, The first major future flow securitization in a changes in bank capitalization requirements developing country was structured in Mexico encouraged banks to scrutinize the credit stand- by Citibank in 1987. The transaction involved ing of local government borrowers by seeking two securitizing telephone service receivables owed to ratings from nationally recognized credit rating Telmex, Mexico's monopoly phone company. The agencies before making loans. receivables arose when Telmex completed more calls for AT&T customers calling into Mexico The need to provide adequate assurances without than AT&T completed for Telmex customers the federal government's implicit guarantee chal- calling into the United States. These net interna- lenged subsovereign borrowers to find innovative tional settlement receivables were relatively easy solutions. U.S.-style general obligation borrowing, to estimate because of the market histories of the backed by the full faith and credit of local govern- two companies. Moreover, they originated from a ments, was not attractive to investors because of highly reputable U.S. company. the short term limits for state and local elected officials (usually three or six years). The rapid turn- Telmex was therefore able to issue investment-grade over of officials created concerns that promises to bonds at a time that Mexico was restructur- pay debt service could be amended or retracted for ing its sovereign debt and Mexican companies, political reasons. particularly state-owned ones, were unable to access international capital markets. Telmex sold Revenue bonds, backed by cash flows from proj- its AT&T receivables to a U.S.-based trust and ects financed by bond proceeds, were even less instructed AT&T to pay its Telmex invoices to attractive, because of a perceived lack of sound that trust. This arrangement isolated debt service local administration. Years of relying on tax- payments to bondholders from any possibility of sharing grants to back borrowings had allowed misdirection by company or government officials New rules state and local officials to ignore problems in local and guaranteed the bondholders first access to revenue management. State and municipal services reliable cash flows. That allowed Telmex securi- on implicit were often run inefficiently, leading to volatile or ties to earn a higher credit rating than Mexico's guarantees led otherwise unreliable cash flows. sovereign debt. to a need for Tax-sharing grants remained a large and predictable new solutions source of local government revenue. In the late The idea catches on 1990s they accounted for more than 90 percent of revenue for states and more than 70 percent Mexican officials realized that the future flow for municipalities. The challenge was to find a mechanism offered a way to simulate the federal way to convince investors that state and local offi- intercept arrangements that had made borrowing cials would be willing to use those revenues to possible for states and municipalities before 2000. make future debt repayments even during financial Rather than the federal government intercept- downturns or after new elections. ing grant flows on behalf of lenders or investors, administrative trusts run by professional finan- cial managers could receive tax-sharing grants and A solution in future flows make debt service payments to bondholders before any of the grant funds flowed to local officials A solution was found by looking at how future (figure 1). This mechanism could allow munici- flow securitizations allowed public and private pal bond issues to receive higher ratings than the companies in below-investment-grade countries to parent municipality's general obligation debt. access affordable international finance. Traditional asset-backed securitizations involve repackaging Federal officials proposed that states and munici- diversified pools of home mortgages or car loans palities create such trusts. They envisioned for resale as tradable securities. In contrast, future two possibilities: The local government entity Enhancing the creditworthiness of municipal bonds could issue debt securities and use the trust to make debt service payments. Or the trust itself could sell securities and pay them off with tax- FIGure 1 sharing revenues assigned to it by the state or local How funds flow in master trust borrowing government. Either way, trusts could isolate debt service payments from general government expen- diture accounts. As legal, tax-neutral entities under Federal government Mexican law, trusts could be created relatively Features of easily by local officials. And master trusts could Tax-sharing allow management of several debt obligations at the future flow grant payments the same time, with funds going into designated mechanism subaccounts. Master create a trust Debt service Investors payments Such trusts quickly caught on beginning in late web of 2000, with many Mexican states and municipali- Excess Rights Bond proceeds ties using master trusts as payment mechanisms grant to future enhancements payments grant flows Bonds for local-currency-denominated infrastructure bonds. The bonds had relatively high ratings, low Local interest rates, and terms ranging from five to seven government borrower years. These Mexican deals stopped short of actual secu- ritization. Most of the trusts were debt repayment vehicles only, and not structured as full guarantee and expenditure processes. Because the money trusts. Importantly, debts managed by the trusts used to pay debt service does not pass through remained direct obligations of the state or munici- the hands of municipal officials, it cannot be pal borrowers. Their revenues were simply used diverted or withheld. That sharply reduces the by the trusts to make debt service payments. The basic risk that future municipal governments revenues were not packaged and sold to investors, might be unwilling or unable to pay creditors. as they would be in a genuine future flow securi- tization. · Irrevocable instructions to the federal government to direct tax-sharing grants to the trust rather than the municipality provide additional credit A web of internal enhancements strength. The state or local legislature often issues these instructions, adding to their effect. Perhaps the most important aspect of Mexico's version of the future flow mechanism is that it · Trusts always involve overcollateralization of debt: enables rating agencies to give higher ratings to the tax-sharing grant revenues pledged to support state or municipal projects than they normally the outstanding debt are typically several times would to state or municipal governments. Fitch's the face value of the debt. This surplus assures credit ratings for the five master trust financings investors that if tax revenues fall, or federal allo- completed by April 2003 averaged nearly five cation policies change, a trust will still be able to rating grades higher than its ratings for general repay bondholders. obligations of the parent state or municipal entity (table 1). · Covenants with bondholders require that unfavorable "credit events"--such as rating The future flow mechanism achieves such rating downgrades or reductions in debt service reserve improvements because of features that function accounts--trigger specific remedial actions by as a web of sometimes overlapping internal credit the trust. Remedial actions can include larger enhancements--mitigating precisely the kinds of contributions to reserve accounts, the creation borrowing risks that concern Fitch and the other of additional reserve accounts to serve as a credit rating agencies. first line of defense against revenue problems, acceleration of debt repayment, or immediate · The administrative trust structure isolates debt repayment of all debt using all pledged revenues service payment from normal municipal budgets as they become available. A recent decline in bond sales TAbLe 1 The number of future flow municipal bond sales ratings of local-currency general obligations in Mexico has declined in recent years, for several and master trust financings, April 29, 2003 reasons. Mexico's economic growth has led to Master higher subnational credit ratings, reducing the General trust need for the added assurances that future flow Government entity obligations financings mechanisms provide. Favorable investor senti- State of Morelos A AA+ ment toward emerging market debt has reduced San Pedro Garza Garcia, AA AAA the perceived risk of default for more traditional securities and standard loans. And because of Nuevo León added complexity, future flow bond issuances often State of Mexico BB+ AA involve higher transaction costs for municipalities. Guadalajara, Jalisco AA- AAA These costs, along with the overcollateralization State of Guerrero A- AA+ of the debt, make the future flow deals expensive, even with the lower interest rates made possible by Source: Fitch Ratings, Duff & Phelps 2003. the enhancements. The high costs of bond issuance have encour- particularly interested in assessing the overall cred- aged local commercial banks and local, privately itworthiness of the borrower or the reasonableness managed pension funds to move into the sector of the projects that will use the bond proceeds. by taking advantage of the same credit-enhancing administrative trust structures developed for use with bonds. Banks have been particularly effective Conclusion in competing for the business of medium-size and small municipalities, whose issue sizes are typically Whatever the future mix of bond issuance and too small to warrant the relatively high issuance bank lending--and the federal government's and collateral costs of future flow deals. Issuance evolving role in overseeing subnational finance costs for these deals have stabilized at roughly practices--the municipal future flow mechanism Mex$10­15 million--as much as 10 percent of is clearly a powerful financing tool. It has helped the average loan size for these smaller municipali- Mexican states and municipalities access badly ties. Larger municipalities and states, with much needed capital at affordable interest rates. And it larger borrowing needs, can more readily afford the may have application in other countries, particu- all-in costs of these bond sales. But these too are larly those considering the use of revenue intercepts increasingly attracted to cheaper bank or pension to facilitate municipal debt issuance. fund borrowing. Note In addition, the Mexican government has become The authors are grateful for comments from Enrique Villatella, concerned about imprudent lending and borrowing former governor of Bancomext, and Sabino Escobedo, TAG practices. The future flow mechanism succeeded Financial Advisors. in part because it re-creates some of the moral hazard that plagued municipal borrowing Reference backed by federal government intercepts Fitch Ratings, Duff & Phelps. 2003. 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