A Useful Tool for Developing Countries
During financial crises, developing countries cannot obtain low-cost, long-term loans. Securitization of future flow receivables can help investment-grade public and private sector entities in these countries obtain credit ratings higher than those of their governments and raise funds in international capital markets.
Suhas Ketkar and Dilip Ratha
Suhas Ketkar is a principal of International Research and Strategy Associates LLC and a consultant to The Royal Bank of Scotland Financial Markets.
Dilip Ratha is a Senior Economist in the World Bank’s Economic Policy and Prospects Group.
Since Mexico’s devaluation of the peso in 1994, financial crises have occurred in a number of emerging markets, dealing severe blows to investor confidence. Three years after the Asian crisis, capital flows to emerging markets remain depressed, while borrowing costs remain high. The major international agencies’ ratings of the creditworthiness of major emerging market economies are lower than they were in 1997, and the short-term outlook for private portfolio capital flows to these countries is not bright.
Under these circumstances, and given the limitations of official emergency financing, developing countries need to find innovative ways of securing foreign finance. Market placements backed either by partial public guarantees or by hard-currency receivables can allow issuers to break through sovereign credit ceilings and gain access to cheaper financing; they can also prevent the large-scale panic that may result when a country’s foreign reserves suddenly dry up.
Securitization is a fairly recent financial innovation. The first securitized transactions occurred in the United States in the 1970s and involved the pooling and repackaging of home mortgages for resale as tradable securities by lenders. Since then, securitized markets have grown in sophistication to cover a wide range of assets. In developing countries, particularly in Latin America, some borrowers have raised financing by securitizing future flow receivables in hard currency.
In a typical future flow transaction, the borrowing entity (originator) in a developing country sells its future products (receivables) directly or indirectly to an offshore Special Purpose Vehicle (SPV), which issues the debt instrument. Designated international customers (obligors) are directed to pay for the goods they import from the originator directly into an offshore collection account managed by a trustee. The collection agent makes principal and interest payments to lenders. Any funds left over are forwarded to the originator (see diagram).
Sovereign transfer and convertibility risks are mitigated because the borrowing entity has obtained a legally binding consent from designated customers that they will make payments to the offshore trust; bankruptcy risk is also decreased in such transactions because SPVs typically have no other creditors and hence cannot go bankrupt. Of course, there is always a risk the originator will go bankrupt. Lenders can reduce this risk by favoring originators with high credit ratings for domestic-currency debt and a strong ability and willingness to produce and deliver the products that generate the receivables. Rating agencies have come to accept the argument that an entity may continue to generate receivables even when it is in financial default. Thus, based on such recently developed criteria as Fitch IBCA’s “going concern” and Standard and Poor’s “survival” assessment, certain entities such as banks may receive higher ratings for asset-backed transactions than for domestic-currency debt. While securitization may not be of much help to sub-investment-grade borrowers in developing countries, it can help investment-grade issuers (in local-currency terms) to pierce the sovereign credit ceiling on long-term external debt.
Some elements of sovereign (country) risk cannot be totally eliminated, however. For instance, the government may force an originator to sell its products in domestic rather than export markets. This risk is generally higher for commodities (such as agricultural staples) for which domestic demand is large than for products such as crude oil that can be sold only to a limited number of buyers. The risk of product diversion is also low for credit card receivables, because of the small number of credit card companies.
Although market risk arising from price and volume volatility, which may cause cash flow to fluctuate, cannot be totally eliminated, it can be mitigated through excess coverage or overcollateralization. Typically, product risk is easier to control for commodities like oil, gas, metals, and minerals, for which there is demand from many diverse sources, than for custom-made products unless long-term sales contracts are enforceable.
Based on their assessment of performance, product, and sovereign risks, the rating agencies have ranked future flow receivable transactions from most secure to least secure (Table 1). But it is possible to securitize even the least secure future flow receivables: several Argentine provinces, for example, securitized tax revenues to be received via federal tax sharing. Of course, the lower in the hierarchy they are, the more future flow receivable transactions require safeguards to improve their credit ratings. Insurance companies are playing a growing role in structured finance transactions by providing complete financial guarantees, as MBIA recently did for a securitization launched by Pemex, Mexico’s state-owned oil and gas company. The Multilateral Investment Guarantee Agency (MIGA) of the World Bank Group has provided insurance against political risks in several future flow deals.
The innovative structure of these transactions has allowed many investment-grade borrowers in developing countries to obtain financing at much lower interest rates than their governments. In late 1998, Pemex Finance Ltd. issued oil-export-backed securities rated BBB by Standard and Poor’s, three notches above Mexican sovereign and Pemex unsecured debt. Securitization saved Pemex anywhere from 50 to 337.5 basis points on what it would have had to pay on senior debt. In the aftermath of the Mexican crisis of 1994-95, Argentina’s oil company YPF (by then privatized) raised $400 million at a 200 basis-point spread advantage through the securitization of future export receivables.
Securitization also allows issuers from developing countries to lengthen the maturities of their debt, improve risk management and balance sheet performance, and tap a broader class of investors—for example, insurance companies facing limitations on buying sub-investment-grade debt. Moreover, by establishing credit histories for borrowers, these deals enhance borrowers’ future ability to access capital markets and reduce their borrowing costs.
Most of these incentives are common to public and private sector entities alike. During crises, however, the latter are usually reluctant to take on new debt, and the use of future flow transactions to raise financing is likely to be limited to public sector entities. Considering the long lead times involved in future flow deals, public sector entities will need to keep securitization deals in the pipeline and investors engaged during good times so that the asset class remains accessible during a crisis.
From investors’ point of view, the attractiveness of this asset class lies in its good credit rating and its stellar performance in both good and bad times. Although there is a lack of information on secondary market prices and spreads for securitized debt, because it is traded so infrequently, the information available (and the perception of market players) suggests that prices and spreads tend to be less volatile for future flow securities than for unsecured debt from developing countries. For example, as shown in Chart 1 and the accompanying table, the spread on Pemex’s 7-year secured debt was less volatile than the spread on United Mexican States bonds maturing in 2026 (UMS 2026).
Chart 1Spreads on Pemex 7-year bond and UMS 2026 bond
Sources: J.P. Morgan; Bloomberg.
|(basis points)||Pemex 7-year||UMS 2026|
There have been no debt defaults on rated future flow asset-backed securities issued by developing country entities despite repeated liquidity and solvency crises. The asset class withstood the test of the Mexican peso crisis in 1994-95, the Asian liquidity crisis in 1997-98, and the Russian and Ecuadoran debt defaults in 1998 and 1999 respectively. An interesting example is the receivable deal of PTCL, Pakistan’s phone company, which continued to perform even in the face of selective default on sovereign debt.
While this track record of no default is encouraging, future flow asset-backed debt has not yet been severely tested because it still represents a very small percentage of total debt. So far, given the low volume of future flow issues, the pledging of future assets has not affected the cost or rating of unsecured debt. But there are obviously limits to the amount of future exports that can be pledged.
Characteristics of securitized transactions
Securitization of future flow receivables has a relatively short history in developing countries. The first important future flow securitized transaction in a developing country occurred in 1987, when the Mexican telephone company, Telmex, which was then state owned, securitized telephone receivables. By the end of 1999, the three principal rating agencies—Fitch IBCA, Duff & Phelps; Moody’s; and Standard and Poor’s—had rated more than 150 future flow securitizations, with total principal exceeding $36 billion, in developing countries. The issuance of future flow receivable-backed securities has increased, especially since the Mexican crisis of 1994-95 (Chart 2).
Chart 2Volume of future flow securitization transactions, 1987–99
Source: Authors’ estimates.
Latin American issuers dominate the market for future flow securitization. Mexico alone accounts for over one-half of asset-backed transactions in nominal dollar terms; Argentina, Brazil, and Venezuela account for another 34 percent.
Although nearly one-half of future flow transactions, in dollar terms, are backed by oil and gas export receivables, non-oil deals account for a much larger number of transactions (Table 2). The asset class has demonstrated an enormous scope for creativity: recently, credit card and telephone receivables, workers’ remittances, tax receivables, and even export receivables to be generated by developing new investment projects have been securitized.
|Issuance (million dollars)||Percent of total issuance||Number of transactions||Percent of number of issues|
|Oil and gas export receivables||16,362||45||25||17|
|Non-oil export receivables||7,537||21||40||27|
|Credit card receivables||4,314||12||37||25|
Potential and constraints
Fuel and mineral exports of low- and middle-income countries totaled $196 billion and $63 billion, respectively, in 1998. Using a conservative 5:1 overcollateralization ratio—that is, only one dollar of debt is issued for five dollars of receivables—the volume of securitization supported by future fuel and mineral export receivables, based on 1998 data, could reach nearly $52 billion a year (Table 3). Adding securitization of remittances raises this amount to $56 billion annually. This calculation excludes credit card vouchers and telephone receivables, which could add another $8 billion a year (not shown in the table).
|Europe and Central Asia||9.8||4.6||0.7||15.1|
|Latin America and Caribbean||7.5||5.2||1.3||14.0|
|Middle East and North Africa||16.5||0.4||1.0||17.9|
|Total for low- and middle-income countries||39.2||12.6||4.8||56.4|
The estimated potential for future flow securitization from developing countries in Latin America and especially in Eastern Europe and Central Asia appears greater than current issuance might indicate. Countries in the Middle East have large oil receivables. In South Asia, the potential for securitization lies in remittances, credit card vouchers, and telephone receivables.
Several constraints, however, have prevented the realization of this potential. A major constraint on the growth of future flow transactions is the paucity of good collateral in developing countries. Oil is an example of good collateral for several reasons: (1) the stock of oil in a country is more or less well known; (2) well-developed global markets for oil make it a highly liquid asset; and (3) given its importance to a nation’s economy, exports of oil are less vulnerable to government interference. In addition, crude oil may work better as collateral than refined petroleum because the former cannot easily be diverted to foreign importers not covered in the securitization structure.
The paucity of good collateral is also reflected in the absence of high-quality public and private issuers in developing countries. 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 further complicates these deals. (Some countries’ bankruptcy codes—for example, that of the United States—do not give creditors access to future flow assets once a bankruptcy petition has been filed, reducing the potential for future flow securitization.) In some cases, policymakers are simply unfamiliar with this mechanism. Many issuers cannot—or do not want to—assume the burden of full and timely disclosure of information. Others worry, perhaps unduly, about whether the use of future flow secured bonds will taint their creditworthiness.
Public policy issues
Future flow securitization increases an issuer’s—and a country’s—inflexible debt, perhaps jeopardizing its creditworthiness. While this is a valid concern, the present issuance of securitized debt does not appear to have approached this critical level. For instance, rating agencies have not downgraded sovereign credit ratings of either Mexico or Venezuela on account of their rising securitized debt. Mexico’s securitized debt of $19.3 billion is about 16 percent of its total debt, and Venezuela’s securitized debt of $6.1 billion is 18 percent of its total debt. Thus, it appears that securitized debt can rise to around 15 percent of a developing country’s total debt without necessarily jeopardizing the sovereign’s overall creditworthiness. Nevertheless, when combined with debt owed to other preferred creditors, it could eventually reduce a borrower’s ability to service its debt.
Still, governments may find this asset class attractive because it can provide a way of accessing markets during liquidity crises. Because of their investment-grade rating, future flow deals attract a much wider class of investors than unsecured deals. Thus, future flow deals can improve market liquidity and reduce market volatility, making them even more attractive to international investors in other asset classes. For many developing countries, securitization of future flow receivables may be the only way to begin accessing international capital markets.
An equally important incentive for governments to promote this asset class lies in the externalities associated with it. Future flow deals involve a much closer scrutiny of the legal and institutional environment—the existence as well as the implementation of laws relating to property rights and bankruptcy procedures—than unsecured transactions. Thus, these deals can produce enormous benefits by making valuable information available to investors. In addition, the preparation of a future flow transaction often involves reforms of the legal and institutional environment that facilitate domestic capital market development and encourage international placements, as the Brady bond deals did in the early 1990s.
Public policy to facilitate future flow-backed securitizations should focus on removing constraints. Issuers may reduce transaction costs by planning a series of issues (a so-called master trust arrangement), which would allow them to reap economies of scale. Establishment and use of indigenous credit rating agencies to obtain domestic credit ratings can also reduce transaction costs, although care has to be taken in mapping local rating scales to international scales. Pooling receivables may work in some instances. Certain segments of this asset class—such as securitization of oil receivables—may be amenable to standardization. Clarification of bankruptcy laws would be helpful for all financial deals including securitization. Educating policymakers and potential issuers would also help promote this asset class.
This article is based on a research report by the authors, “Development Financing During a Crisis: Future-Flow Securitization” (unpublished; Washington: World Bank, 2000).