For years a market outcast, the State of Mexico is undergoing intensive treatment to win over investors. Since Arturo Montiel became governor in late 1999, his PRI administration has pushed out debt maturities, tamed a beastly budget, and floated a novel program of securitized payroll taxes that has other Mexican states taking note. But the debt load is still unwieldy at nearly Ps30 billion (US$2.7 billion) - over 1.2x of revenue - and the assessment from ratings agencies is far from glittering. To be fair, both Fitch Ratings and Standard & Poor's have rewarded the state's austerity. The former upped its rating on the national scale to BB+(mex) from BB(mex), while the latter attached a positive outlook to its mxBB- rating.

The securitization of payroll taxes launched in December marks a milestone in the state's reform drive. Though its size must remain below 7% of combined debt, the program has bridged what was once a chasm between the State of Mexico and financial markets. No less important, it has catapulted this former laggard to the forefront of structured finance, as the first Mexican state to use payroll taxes as collateral. The total float is earmarked at Ps2bn (US$182 million). So far, the state has placed Ps1.7bn (US$156 million) in five separate issues, which have included both fixed-rate and floating-rate paper (see table).

Local investment bank Protego Asesores structured the deal and Santander Investment is issuer. Thacher Proffitt & Wood is legal counsel. The World Bank has advised the state on the wider financial reform initiated in 2000.

Designed to trap all revenue from the asset, the payroll tax deal is heavily overcollateralized. Payroll taxes jumped to over Ps2 billion (US$182 million) in 2002, from Ps1.6 billion (US$146 million) in 2001, piggybacking an increase in the tax rate to 2.5% from 2%. A reserve account equal to 10% of issuance adds further coverage.

Although the structure drove a fat wedge between the deal and originator risk, S&P's opinion was apparently not good enough for the issuer. The deal garnered a AA(mex) from Fitch, but it had also been rated A(mex) from S&P, until the agency withdrew its non-public rating on the transaction at the request of the state, according to sources. Marketing the deal with only the Fitch rating, Santander had narrowed the field of buyers. Pension funds - the state's monsters of liquidity - are not allowed to buy into single-rated paper, sources said. Also, the S&P rating may have gone out of sight, but it was not out of mind. As a result, Santander sold the transaction to banks, investment funds and retail.

The state is laboring to attract the nuts-and-bolts kind of investor as well. Under the umbrella of a concessions scheme, it has identified 43 projects in housing, hospitals, prisons, toll roads, and public transportation. The price tag: US$3.2 billion.

Last week, the Governor Montiel took these goodies straight to New York investors, with entourage in tow. At a luncheon for the dignitary thrown by Thacher Proffit, ASR spoke to one of the architects of the state's reworked financial structure, Luis Videgaray, CEO of Protego Asesores. He held forth on the state's progress and how its deal has opened the door for the subnational sector to explore unconventional assets.

Following is a Q&A with Videgaray.

ASR: Apart from the securitization, what other important liability management is the state engaging in?

Videgaray: The state's main creditor is Banobras (a federal development bank). Since mid-year, they've been restructuring that debt, which is around Ps11.5 billion (US$1 billion), or slightly more than a third of total debt. We're still working on the terms.

ASR: While it has improved, the state's rating remains dismally low at BB+'/'BB-'. And that's on the national scale, where the Mexican government is triple-A. What are the efforts in this arena?

Videgaray: Lifting the state's rating is a permanent effort, but it requires enormous work. You have to remember that we're talking about a state, one that faces an enormous demand for public services and infrastructure. And there are still constraints on its financial flexibility. This is what the reform program aims to resolve.

ASR: In regards to ratings, why exactly was the S&P rating dropped on the securitization program?

Videgaray: We have agreed with the agency to not discuss the matter.

ASR: I understand that while you're in N.Y. under U.S. securities regulations you can't discuss the payroll-tax program until it has closed. Could you tell me more or less when it will wrap up?

Videgaray: We're looking to close this within the next few months.

ASR: Any other visits to the capital markets from the state this year?

Videgaray: It will probably access the markets again for working capital.

ASR: Federal participation flows account for over 90% of revenue into Mexican states, and, as such, this asset has virtually monopolized securitization in the sector. After leading the State of Mexico into the unmarked territory of payroll taxes, is Protego nudging its peers to do the same?

Videgaray: We are trying to be innovators, using assets that aren't necessarily federal participation revenues, or crafting deals that at least include some element apart from those revenues. We've begun to work with other states, but the transactions are still preliminary. They include infrastructure, water, and communication projects. We're also working with some municipalities and moving towards project finance.

ASR: Are there other assets generated by subnationals you'd like to securitize?

Videgaray: We shouldn't lose sight that federal participation revenues still account for the bulk of state revenues, in the form of earmarked or discretionary transfers. The tax that generates the most income in states is levied on the payroll. But there are other taxes, like those on hotels, which are particularly important in those states where tourism is important. There are also, of course, tollroads. At the municipal level, there is a significant flow from property taxes and water use fees. All these assets are of good quality from the point of view of securitization.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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