In their quest for new funding options, Mexican originators are looking to Europe. Covered bonds, which are old hat in the old world, have never been done in Mexico, but players anticipate their arrival. Bankers, particularly those at European banks, have been pitching the idea for months, yet some hurdles need to be cleared for the instrument to achieve long-term growth, players said.

Over the past few years, Mexico has turned out securitizations collateralizing mortgages and construction loans at an ever-increasing clip. While originators have also begun tapping foreign appetite for these products by drawing buy-siders into the domestic market and going cross-border, they are constantly on the make for new investors. Here's where covered bonds come in. "We're looking at covered bonds as an option for this year," said Mark Zaltzman, deputy head of corporate office at Hipotecaria Su Casita, a sofol, or nonbank, originator.

Sofols' drive to latch onto new funding sources stems from a brisk demand for mortgages that has yet to slow down. The latest figures show that sofols specializing in the housing market had assets of Ps120 billion ($10.8 billion) as of June, up from Ps106 billion a year earlier. This growth came despite an aggressive push to shed assets in RMBS by several originators. Banks in Mexico, which only recently began to securitize, are growing their portfolios as well.

Covered bonds generally differ from securitization in a few key ways. The main one is that the assets securing a covered bond remain on the issuer's balance sheet, sustaining the link between the issuer and the collateralized pool that is eliminated in a true securitization.

On the other hand, depending on the jurisdiction, a cover pool is typically segregated from other assets on the balance sheet by law, giving covered bondholders rights to those assets in the event of an insolvency by the issuer.

Mexico doesn't have specific legislation dealing with covered bonds, unlike Germany and Spain, the countries that account for a fair share of covered bond activity in Europe. Spain's growing muscle in the market has been a function of its strong mortgage market, according to a Lehman Brothers research report. This might prove to be the same driver in Mexico.

But Mexico might differ in one crucial way from Spain, at least at the onset of the market. As in the U.K. and the Netherlands, players are likely to borrow well-worn techniques from the realm of securitization instead of waiting for specific legislation. "The idea for now is to do it U.K. style," said a source at a European bank with operations in Mexico.

There could be changes down the road, however. Authorities in the U.K. and the Netherlands are both looking into creating legislation particularly for covered bonds, according to the Lehman report. Mexico might follow a similar path, with a go-it-alone approach eventually giving way to regulations.

Even without legislation specific to covered bonds, Mexican law might need some tweaking, or at least clarification, if banks are to get in on the act. While there is a consensus that sofols don't face any regulatory obstacles to issuing covered bonds, their banking counterparts may not have it as easy.

Under Mexican law, banks aren't allowed to segregate assets that remain on their balance sheets, according to several sources. But at least one I-banker who had studied the matter, and a source at Mexico's banking and securities regulator, said that ring-fencing assets isn't necessarily a problem under current law. At press time, the regulatory commission forwarded, by e-mail, an excerpt of a current regulation stating that banks needed to demonstrate to the regulator that any bonds it issued were managed as "a structural part of the balance sheet."

Among sofols, not all issuers are ready to move as fast as Su Casita. One of the defining features of a covered bond is that the pool and the collateralized bond can differ markedly in duration. The asset-liability management risk is something that sofol Patrimonio, for instance, would like to be able to manage better before placing a covered bond.

"As a sustainable model, covered bonds entail very robust risk management," said Othon Paez, head of financial planning at Patrimonio. "In Spain, you have variable rates, so you don't have a duration mismatch." While Paez said that Patrimonio wasn't ruling out covered bonds, he added that access to better risk mitigation tools in Mexico would be an impetus.

As with many European issuers, covered bonds would enable Mexican originators to raise funds at a 10-year term, as the instrument often mimics the corporate bullet of that maturity, sources said. But local investors may not be the ideal target for that particular point along the curve.

"Mexico has an illiquid corporate debt market," Zaltzman said. European investors would be the preferred audience, he added. But with the recent volatility in global markets, a spike in spreads and worries about anything redolent of real estate, the air will certainly have to clear somewhat for a Mexican mortgage originator to attract European investors into a covered bond, sources said.

For those ready to go covered, sources said the fideicomiso de garantia, the vehicle typically used in securitizations in Mexico, could be applied to a covered pool. "You'd use the fideicomiso as a drawer, [and] if something goes wrong with the assets, these can be replaced," said Jose Razguzman, a partner at law firm Mijares, Angoitia, Cortes, & Fuentes. "The fideicomiso wouldn't buy the collateral, but rather hold it for the investor."

It goes without saying that the views of rating agencies will also be a key ingredient in the development of Mexican covered bonds. All three major agencies are active in the sector in Europe, and, as with other products, their approaches vary.

Fitch analysts examining the potential for covered bonds in Mexico see the depth of a secondary market in Mexican mortgages as a big issue.

"If the idea is to get the rating higher than the originator, you have to rely on the collateral," said Sam Fox, senior director at Fitch Ratings. He added that if the issuer were to turn insolvent, the batch of covered bond assets would have to be sold into the market to retrieve value for the covered bondholders. Thus, being able to place an accurate secondary market value on the pool is instrumental to the rating and plays a paramount role in how much enhancement would be needed to achieve the desired rating.

Ratings on covered bonds are often triple-A in Europe, and players said they would likely be the same in Mexico. Su Casita, for one, will be trying to achieve a top rating, on the national scale, for its covered bonds.

As for putting asset classes apart from mortgages in covered bonds, about half of Europe's volume is backed by loans to the public sector. This probably won't be the case in Mexico, where mortgages are set to dominate, if not monopolize, the product, sources said.

To some extent, this reflects the ABS makeup in the country, where mortgages are by far the fastest-growing asset class, and the lack of compelling candidates among other asset classes.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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