It's taken a while for the pull-back in bank lending across the globe to hit Mexico's states and municipalities.

Sub-sovereigns in the country have been fairly active in taking on asset-backed loans this year, with the state of Nayarit closing a Ps1 billion ($93 million) deal as recently as a month ago.

However, notwithstanding its popularity among lenders, the sector is hardly devoid of risk, as noted by recent reports from Fitch Ratings and Moody's Investors Service. And this comes apart from the fact that, in line with other bond and loan markets, activity is on hold until the U.S. financial and economic picture clears up.

Mexican states and munis have been cozy with banks for some time, to the detriment of bond issuance, which several years ago appeared to be packed with promise. The low perceived risk of asset-backed loans to these entities, coupled with a coterie of fairly liquid private and development banks, has left bond issuance from states and munis in the dust.

"States themselves prefer this kind of financing," said one analyst at a local brokerage. And it's not only because liquid banks mean better pricing than paper. "In a bond, they have to issue audited financing statements every quarter. For loans, they don't have to do that," the analyst said.

The most common collateralized assets among states and municipalities in Mexico are the participation revenue that is doled out by the federal government. Other assets include payroll taxes, vehicle ownership taxes and other vehicle fees, known as refrendo.

Apart from lowering costs, the more recent spate of loans has helped sub-sovereign entities push their debt profile further outward.

Early in the summer, the state of Sonora sealed a financing deal with a handful of banks to restructure old debt. The borrower took out eight asset-backed loans for a total Ps4.8 billion with BBVA Bancomer, Banco del Bajio, Scotiabank Inverlat, and Dexia Credito Local Mexico. The loan's collateral consists of federal participation revenue, about 34% of which will flow into the issuing trust. Each loan will in turn receive a corresponding portion of the flows. The loans have maturities ranging from 25 years (Bancomer and Dexia) to 20 years (Bajio, Scotiabank, and Banorte).

In April, the State of Mexico engineered a massive overhaul of its debt. The state took out ten loans for a total Ps25 billion as part of a restructuring. State development bank Banco Nacional de Obras (Banobras) provided a partial guarantee on the loans, helping to lift the ratings to 'AA+(mex)' on Fitch's national scale.

The most recent entrant to the banking market, the state of Nayarit, borrowed $1 billion with a remarkable 30-year life. Backing the loans are payroll taxes, vehicle ownership fees and the refrendo. Fitch rated that loan 'AA(mex)', a few notches higher than Nayarit's rating of 'A-(mex).'

But these sources of funding carry risks as well.

In a recent report, Moody's, which appears to take a tougher stance on payroll taxes and vehicle-related flows than the other agencies, noted that the rights to these payments can not be assigned to a third party. As such, "Moody's in all cases views these securitizations as highly linked to the credit quality of the state that is originating these flows," said the agency, which refers to this class of assets as "future flows from own-source revenue."

"What they can assign are the cash flows they've already collected," said Victoria Moreno, vice president of Moody's. "They still have control of the assets."

This sets these assets apart from federal participation revenues, which come directly from the federal government, and are therefore generally viewed as strongly linked to the federal government's credit rating, which is triple-A on the national scale of all three ratings agencies.

In order for a transaction backed by own-source revenue to surpass, and indeed even achieve the rating of the state in question, there have to be strong mechanisms in place that reduce the risk of the state's interference, Moreno said. One example she cited is a mechanism that generates direct or contingent obligations or indemnifications to investors.

Fitch also recently put out a report on the potential effects on outstanding state and muni deals of a government decree abolishing vehicle ownership taxes beginning in 2012. States can either set up their own analogous tax and replace the collateral behind existing deals with it, or come up with a substitute flow. So far, no state has addressed the issue.

As the elimination of the tax will take place in more than three years, Fitch hasn't made any ratings move on the potentially-affected transactions it rates. These include two deals from the state of Veracruz and one from Oaxaca. Since it was arranged after the decree came out, the loan for Nayarit was structured under the assumption that the vehicle ownership tax would be dropped in 2012, and the other underlying assets would pick up the slack.

Despite these issues, players still see strong long-term potential in the sector, particularly with regards to banking loans. And it's not as if there is much exposure to sub-sovereign risk at large. It's only historically recently that states and munis have taken on any debt, and most is concentrated in a few entities, said Eduardo Hernandez, associate director of Fitch. "There are still states that have no debt," he added.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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