Development Financing through
Bonds backed by foreign currency receivables can allow public and private sector entities in developing countries to raise financing from international capital markets. With proper planning, such transactions can sustain external financing even during a crisis.
This page is grossly outdated - was created in October 2001 based on Ketkar and Ratha 2001 – but still has some useful material.
Securitization is the process by which a borrowing entity—a company or a bank in the public or private sector, or a sovereign or sub-sovereign body—issues tradable securities backed by dedicated cash flows from selected assets.
The first securitized transactions
occurred in the
(See also ABS, CBOs, CLOs, CMOs)
See also Giddy (1994, pp 486-489)
Rated vs. unrated transactions. Securitization transactions can be classified according to whether these are rated or not rated by major credit rating agencies, and within each of these categories, according to whether they involve existing assets or future receivables. It is hard to obtain information on unrated securities issued by developing country entities which are typically underwritten by commercial banks that either keep them on their own books or distribute them through private placement. Nevertheless, it is believed that rated transactions may be more prevalent in emerging market economies with relatively more developed capital markets.
Existing asset vs. future asset securitization. Securitization of existing assets (such as lease financing) as well as future assets (such as workers’ remittances) are being used by developing country entities for raising finance. Existing asset securitization is increasing in importance and can be a big aid to the development of local capital markets. But since existing assets are denominated in local currency, their role in raising external finance may be limited.
The first important future flow securitized transaction in a
developing country occurred in 1987 with the securitization of telephone
receivables due to
In a typical future flow transaction, the borrowing entity in a developing country sells its future product to an offshore Special Purpose Entity (SPE), which issues the debt instrument (see box for an example). By a legal arrangement between the borrowing entity and major international customers, payments for the future product are directly deposited in an offshore collection account managed by a trustee. The debt is serviced from this account, and excess collections are forwarded to the borrowing entity in the developing country.
The transaction structure outlined above mitigates several elements of the default risk. The ability of the government to interfere with debt servicing is greatly reduced by the offshore payment arrangements. The market risk arising from price and volume volatility is mitigated using over-collateralization. The risk that a product may be sold to other than designated customers depends on the choice of collateral: such risks tend to be low for crude oil and for credit card receivables (because crude such as Maya from Mexico is sold to a limited number of buyers who have the refining capacity, and there are only a handful of major credit card companies); in contrast, diversion risks are high for agricultural staples.
Keeping in mind the performance, product and sovereign risks, the rating agencies have arrived at the following hierarchy of future flow receivable transactions in terms of deals that are most secure to those that are least secure. The securitization of heavy crude oil receivables is deemed to be most secure while the securitization of future tax receipts is thought to be least secure.
It is possible to securitize future flow receivable transactions even at the lowest end of the hierarchy shown in Table 1. An example of this is the securitization of co-participation tax revenues (via federal tax sharing) by several Argentine provinces (Standard & Poor’s 1999). Of course, it becomes more difficult to obtain investment grade transaction rating as one moves to the lower end of the hierarchy. Alternatively, it becomes necessary to build in more safeguards to improve credit rating as one moves down the hierarchy. (The ability to structure away sovereign risks is greatly reduced at the height of a liquidity crisis. The risk mitigation through future flows structure works best when sovereign risk perception are high and liquidity is low, but not during a full-blown crisis.)
Insurance companies are playing a rising role in the 1990s insuring the various elements of risk described above. A number of insurance companies – MBIA, Ambac, FGIC among them – have provided financial guarantee.
In the 1990s, many borrowing entities in developing countries that had a higher local currency rating than their government were able to pierce the sovereign foreign currency credit ceiling by using securitization of future receivables. The innovative structuring of these transactions allowed borrowers to obtain significantly lower interest rates and longer maturity than on their own unsecured bonds or government eurobonds.
To the investors,
the attractiveness of this asset class lies in its good credit rating and its
stellar performance in good as well as bad times. Their investment grade
rating allows future flow-backed securities to attract a wider class of
investors including, for example, insurance companies that face limitations
on buying sub-investment grade papers. Also, the price of future flow
securities tends to be less volatile than that of unsecured debt which is
another reason why investors like this asset class. Moreover, there have been no debt defaults
on rated future flow asset-backed securities issued by developing country entities,
despite repeated crises of liquidity and/or solvency. An interesting example
is the telephone receivable deal of
Does securitization increase the cost of unsecured debt? According to the efficient market hypothesis, pledging a part of receivables to back securitized notes should affect the ability of the borrower to service the remainder of its debt. However, market participants argue that this would be the case only when securitized debt rises significantly above certain critical levels. One reason behind this lack of effect of securitization on unsecuritized debt is that by achieving investment-grade ratings, asset-backed securities attract a wider range of investors including insurance companies and pension funds who are constrained to buy only investment grade assets (Giddy 1994, p 487). Another reason may be that the benefits of securitization may improve the ability of the entity to service its unsecured obligations. For example, a bank may profit from lower capital costs (for meeting capital adequacy requirements) if it offloads a part of its loans through securitization. Other explanations rest on the presence of market imperfections. For example, unsecured liabilities may be guaranteed by the government (e.g., by deposit insurance in the case of a bank).
Future flow securitization has significant
potential for growth because such transactions allow issuers to pledge
receivables over a number of years. The potential for future flow
securitization from developing countries appears far more than the level of
current issuance. The potential
outside Latin America, especially in Eastern Europe and
Constraints on future-flow securitization. A major constraint on the growth of future flow transactions arises from the paucity of good collateral in developing countries. (Oil is an example of good collateral for several reasons. The stock of oil in a country is more or less known. Well-developed global markets make oil a highly “liquid” asset. Given its importance to a nation’s economy, chances of government interference in oil exports are low. Finally, the risks that exports may be diverted to foreign importers not covered in a securitization structure is low in the case of oil exports, especially crude oil exports.)
Other constraints to securitization include the absence of high-quality issuers. Securitization deals tend to be complex and involve high preparation costs and long lead-times. The lack of legal clarity on bankruptcy procedures in many developing countries adds further impedimenets to these deals. In some cases, policy makers are simply not familiar with this mechanism. Many issuers cannot—or do not want to—assume the burden of full disclosure of information in a timely fashion. Others worry about whether pledging future receivables might taint their creditworthiness.
securitization, however, increases inflexible debt of the issuer as
well as the nation. Although the
current level of future flow debt is nowhere near
the danger level in any country, such debt combined with debt from other preferred
creditors can reduce the flexibility in debt servicing and jeopardize
issuer creditworthiness. However,
inflexibility in debt servicing may be (arguably) a good thing in many
developing countries, especially in those with a history of misallocation of
public debt. (Rating agencies have not downgraded sovereign credit ratings of
Nevertheless, if developing country entities do need to borrow to smooth consumption or investment over business cycles, they may find this asset class attractive. If planned and executed ahead of time, it can provide a way of accessing markets during times of liquidity crisis. Another attractive aspect of this structure is that the value of the underlying collateral—for example, worker remittances, credit card receivables, or oil exports—may rise during a crisis, thus, making this asset counter-cyclical in nature. (For example, Mexico’s real exports rose 30 percent and real imports declined 8 percent in 1995.) For many developing countries, future flow receivable-backed securitization may be the only way to begin accessing international capital markets. Considering the long lead times involved in future flow deals, however, even public sector entities would need to keep securitization deals in the pipeline and investors engaged in good times so that the asset class remains accessible during a crisis.
An equally important incentive for governments to promote this asset class lies in the externalities associated with future flow deals. Future flow deals involve a much closer scrutiny of the legal and institutional environment than unsecured transactions. Besides, the preparation of a future flow transaction often involves reforms of the legal and institutional environment. These reforms would facilitate domestic capital market development and encourage international placements as in the aftermath of the Brady deals in the early 1990s.
policy to facilitate future flow-backed securitization should focus on
relaxing the above constraints.
Transaction costs can be reduced through expansion of the scale of
these deals by planning a series of issues by the same issuer (the so-called
master trust arrangement). The size of the deals can also be raised via
receivable pooling. (Telephone companies in several
IBRD’s negative pledge. Future flow securitization can potentially conflict with the negative pledge provision included in IBRD loan and guarantee agreements. This provision does not prohibit the creation of security in favor of other creditors. Instead, it prohibits the establishment of a priority for other debts over the debt due to the IBRD. However, the IBRD may grant a waiver in respect of this clause in certain circumstances, in particular, when transactions involve small amounts (World Bank Operational Manual OP7.20).
A. United Mexican States (Pemex) and the
Amount $ 6 billion, closing date of transaction
August 5, 199, maturity 5 years (2001), interest
three-month LIBOR plus 2 percent, payable quarterly, Depositaries: Swiss Bank
Corporation, New York Branch and the Federal Reserve Bank of
In August 1996, the United Mexican States issued $6 billion in structured notes backed by exports of crude oil and oil derivatives by Pemex. This transaction used a modified version of the structure used in the ($20 billion) financing of the rescue package by the U.S. Treasury in February 1995. The proceeds were used for repaying the U.S. Treasury financing. In this structure, Pemex’s export sales subsidiaries, PMI Comercio Internacional (PMI) and PMI Trading, irrevocably instructed their customers to make all payments for exports into designated accounts at the Swiss Bank Branch in New York (depositary), which was in turn instructed to transfer 57.14 percent of all funds on deposit to a transaction account owned by Banco de Mexico at the FRBNY, and the remainder to a trustee account for servicing the structured notes. In the event of a payment default to the U.S. Treasury or the holders of the notes, FRBNY was authorized to debit the transaction account of Banco de Mexico for amounts then due under the notes, for making payments to debt holders.
According to Standard and Poor’s, the credit rating of the structured notes did not benefit from the involvement of the FRBNY which acted only as a depositary, nor from that of the U.S. Treasury, since the obligations due to the latter were scheduled to mature before the notes’ final maturity in 2001.
B. Pemex Finance Limited
Amount: Nine issuances during 1998 and 1999, each up to $500 million. Future US dollar receivables owed to Pemex Finance Ltd. by designated customers who will receive Mayan crude oil from Pemex Exploracion y Produccion (PEP), via Petroleos Mexicos Internacional (PMI). Rating BBB.
PMI arranges to sell Mayan crude oil, or some other crude oil type if Mayan becomes unavailable, to designated customers who agree to deposit their payments into an offshore collection account. PMI, a subsidiary of Pemex, is the distributor for Mayan crude oil, which is produced by PEP. Pemex Finance Ltd. is the offshore issuer of notes. It purchases the receivables from PMI via the offshore Pemex subsidiary, PMI Services.
The diagram shows that sales of the crude oil to designated customers and of receivables to PMI Services are out of the jurisdiction of the Mexican government. The first claim on the receivables is from the note holders, and the Mexican central bank is not involved in the process. Chase Manhattan Bank has agreed to administer the issuance of all debt and the payment of interest and principal on such debt in accordance with Pemex’s agreements. After paying note holders principal and interest, excess payments, based on fluctuation in crude oil prices, are paid to PMI Services and PMI, via the offshore collection account.
While this structure mitigates the usual convertibility and transfer risks, other risks still remain. Primarily, there is a risk that a fluctuation in crude oil prices will result in revenues insufficient to cover the interest and principal due to note holders. The overcollateralization of the notes minimizes this risk – PMI will provide a minimum coverage ratio of three times the amount needed for payment of interest and principal. Designated customers have also signed agreements acknowledging their commitment to purchase crude oil and to make any future payments into the offshore collection account. Further enhancing the strength of such issuance is Pemex’s track record of timely servicing of debt in the past. As a result of these enhancements, S&P rated the credit of 1998 and 1999 tranches A-2 and A-4 and 1999 tranche A-5 as BBB. Rated as AAA are 1998 and 1999 tranches A-1 and A-3, as they are insured by MBIA and AMBAC. These ratings are clearly favorable relative to the BB foreign currency rating of the United Mexican States.
No default on asset-backed papers even in the face of selective default on sovereign debt
In 1997, the Pakistan Telecommunications Company Limited (PTCL) issued $250 million in bonds backed by future telephone settlement receivables from AT&T, MCI, Sprint, British Telecom, Mercury Telecommunications and Deutsche Telekom. Even though the Government of Pakistan owns 88 percent of PTCL, this issue was rated BBB- by S&P, four notches higher than the B+ sovereign rating.
Following the detonation of nuclear devices in