States and municipalities in Mexico tripled their volume of securitization issuance in 2003 from 2002, to Ps8.1 billion (US$739 million) (see table, p. 21). Activity will creep higher this year, though its pace is unlikely to hold, sources said. More interestingly, sub-sovereign issuers are expected to link up in multi-originator deals and spread out into new assets.

"We might see [issuers] come together in pools," said Boris Otto, a partner at the Mexico office of Thacher Proffitt & Wood. "It will be a very interesting year."

That approach has succeeded in other countries and would be a boon for most municipalities, which, to date, have found the economies of scale of securitization inaccessible. So far, muni bonds have accounted for only 13% of the Ps11.8 billion (US$1.1 billion) placed since the sub-sovereign sector debuted three years ago, according to a report by Fitch Ratings.

Luis Videgaray of investment bank Protego Asesores pointed out that of the roughly 2,400 municipalities in Mexico, only 30 to 40 wield the kind of scale needed to go to market alone. "And there's a good chunk of [the others] that are financially viable," he said. Pooled issues might work particularly well for funding infrastructure that spans several municipalities.

Size in the sector most definitely matters. A trio that accounts for a disproportionately large chunk of the national economy - the state of Nuevo Leon, the Federal District and the State of Mexico - is behind 53% of all sub-sovereign structured deals.

The asset classes are similarly skewed. The majority of issuers have tapped federal co-participation revenues, which are flows allocated by the central government. Known as copas, the asset class backs 64% of the total issued, according to Fitch. Payroll taxes, which the State of Mexico introduced in late 2002, back another 35%. The remainder, a smidge under 1%, belongs entirely to the municipality of Tlalnepantla, which issued a tiny Ps96 million (US$8.8 million) securitization of water fees in June 2003.

Players expect to see more locally generated assets, although the volume is unlikely to match the copas, which in many cases make up around 90% of a government's flows. Among the assets being bandied around are property taxes, car taxes and water fees. Property taxes in particular have exceptional potential for municipalities, according to Videgaray. "Within five to ten years, this will be a fundamental source of revenue," he said.

Issuers this year are expected to push tenors further out as well. "Because of the macroeconomic stability, longer maturities are coming to market," said Charles Nottebohm, deputy director at Protego. Last year, the states of Guerrero and Nuevo Leon broke through the 10-year barrier to issue 12-year paper. Guerrero used the funds to stretch out its debt profile, refinancing loans from Banobras and Citigroup unit Banamex. Leon also channeled proceeds into refinancing shorter-term debt.

State and municipalities looking to strengthen their debt profiles in other ways are bound to tap the securitization market as well. The once-marginalized State of Mexico blazed that trail when it initiated its Ps2 billion (US$183 million) payroll tax program in late 2002. With a national scale rating of AA(mex)' by Fitch, the program far exceeded the state's ratings, which are now at BB(mex)' at Fitch and mxBB-' at Standard & Poor's. Structured finance was basically the only way for the entity to secure market funding.

But while the issue helped extend the average debt maturity, it was not a panacea for the issuer. Both S&P and Fitch put the entity's stand-alone rating on negative watch last year, months after the program was launched. Spending has yet to be sufficiently reined in, S&P noted in a recent report.

That is not to say that the door is closed for poorly rated entities. While the State of Mexico's performance has been less than encouraging, the rating on its payroll tax program has not budged. "This is a very heavy structure," Videgaray said. He added that the transaction has brought the state's finances under tighter scrutiny, thanks to the required disclosure of financial information.

At any rate, the State of Mexico is an unusual case. At Fitch, for example, it is the lowest rated sub-sovereign out of the 72 listed on the agency's Web site. Other states in the single-A category on the national scale visited the market last year and used the funds to strengthen their finances.

Apart from the intense challenges facing the State of Mexico, the credit quality of the sector in general appears to be stabilizing. "We see few changes this year," S&P said in a report. Spending pressures from pensions, education, health and infrastructure will continue to rise, but the economy should pick up as well, stimulated by growth from the U.S. The year will be one where those entities that have gotten their houses in order will further differentiate themselves from the laggards. "We'll see distinctions between those that have worked to improve their economic structure and those that have depended on inertial growth from the first stages of [NAFTA]," S&P said.

In general, the sector compares favorably to its peers in other countries. Sub-sovereign debt is equal to about 1.8% of Mexico's GDP. In the U.S. the figure is 16%; in Canada, 24%; and Germany, 23%. On the other hand, states and local governments in the latter three countries capture a much larger percentage of total public revenue than those in Mexico.

Lastly, guarantors will continue to court sub-sovereigns. The International Finance Corp. is expected to come back after partially enhancing Tlalanepantla. Local development entities are said to be eyeing the field as well.

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