Feature of the Month: Mexico's Thriving MBS Market

1. Introduction - Setting the stage for considerable growth in Mexico's mortgage-backed securities ("MBS") market

1.1. Macroeconomic juncture and recent trends

In 2001, we saw an impressive performance of the structured finance market in Mexico. Overall, between 2000 and 2001, the increase in volume in Mexico?s structured finance market amounted to 290%. This trend continued in 2002 and is expected to continue into 2003 due to favorable macroeconomic conditions.

First, record low interest rates allowed Mexican companies to access the local capital markets at low costs. Interest remained low and the Mexican Government issued, earlier in 2002, a long-term local currency bond with interest levels around 10%. This issuance was seen as a keystone for the development of Mexican capital markets to be followed by local issuers seeking financing.

Second, Mexico?s continued growth of private sector savings through the Afores (pension funds) has been fueling the structured finance domestic market. The amount of funds channeled through institutional investors is increasing and, as a result, new investment opportunities have developed in the Mexican capital markets in response to the demand from the Afores for new investments.

Third, investor confidence in Mexican capital markets has been strengthened with the improvement of the domestic financial system and very limited repercussions of recent crises in other few Latin American countries.

In the past year, two new products have become popular: low-income housing-related securitizations and municipal tax revenue securitizations. This article will discuss low-income housing-related securitizations, which are viewed as a first-step towards the development of a mortgage-backed securities (?MBS?) market. Some of these transactions have been rated by internationally recognized rating agencies and some have involved international guarantors. For instance, Moody's Investors Service has rated the Crédito y Casa S.A. (Aaa.mx), the Hipotecaria Su Casita (Aa2.mx), the Consorcio Hogar (Aa2.mx) and the Metrofinanciera (Aaa.mx) transactions, among others. A rating is fundamental since it provides access to a large amount of funds held by the Afores. Mexican issuers that have a lower rating than the one required by Afores, have resorted to structuring their transactions with a partial credit risk guarantee from a creditworthy guarantor. FMO (Nederlandse Financierings-Maatschappij Voor Ontwikkelingslanden N.V.), the Dutch Development Bank, for example, has been providing guarantees for several low-income housing related securitizations including the recent Crédito y Casa transaction in which it provided a liquidity facility. The involvement of foreign entities such as FMO in these transactions generally improves the rating. Additionally, Mexican issuers also have resorted to overcollateralization as a credit enhancement for their transactions, which also leads to a better credit rating. Both alternatives increase the likelihood that foreign investors will invest in these securities, although in cross-border deals the inconvertibility risk remains a concern for international investors.

1.2. Low-income housing deficit and the strategies to eliminate it

Today, Mexico has a six-million-unit housing deficit. This has led to increased housing demand caused by the growing purchasing power of its young population, a high rate of household formation and a strong expansion of urban areas. The Mexican government has committed to eliminate the deficit, and it expects to increase funding and to build at least 750,000 houses per year by 2006 (as opposed to the funding provided during 2001, which was only sufficient to build 300,000 homes). The remedial measures taken by the government are expected to eliminate the housing deficit through the construction of 750,000 houses per year during 20 years, in order to cover the housing demand triggered by the formation of new households. Hence, it is expected that to cover the deficit, the majority of the funding will be channeled through SHF, FOVI and Infonavit, which are the government entities that provide funds for low-income housing mortgages.

The Mexican government has also implemented the National Housing Program as a cornerstone of the National Development Plan and it created the Sociedad Hipotecaria Federal, which we will describe below. Both facts should improve the system for Mexican low-income households to access financing for the purchase of a home.

2. Mexico's low-income housing industry ? Sofoles, FOVI and Infonavit

The main funding sources in the Mexican low-income housing industry are FOVI, Infonavit and the Sofoles. The role that each of them plays in the low and middle-income housing sector is described below.

2.1 Sofoles - Sociedades Financieras de Objeto Limitado

Historically, Mexican banks have not been providers of mortgage lending for low and middle-income Mexicans. More recently Sofoles have provided such financing. They are special purpose financial companies that originate and service almost 90% of low-income mortgages and bridge loans for developers of low-income homes. Sofoles obtain their funding mainly from FOVI, Infonavit and a few private banks. No individual investor may own more than 25% of a Sofol. FOVI, Infonavit and such private banks act as take-out providers while the Sofoles handle the origination and servicing of the mortgages. Sofoles also provide bridge loans to developers (i.e., construction companies) of low-income housing projects so that they may undertake those projects.

Sofoles have grown from having 0% of the mortgage lending market in 1995 to approximately 90% of the market today. They are backed by private investors, which usually are real estate-developers, project developers, individuals or entities related to the construction business.

2.2 FOVI - Fondo de Operación y Financiamiento Bancario a la Vivienda

FOVI, is a government-sponsored program that provides affordable mortgages to households that earn less than US$30,000 a year. FOVI was created in 1963 by the Mexican Secretary of Finance and Public Credit as a public trust in the Bank of Mexico and is funded by governmental budgetary allocations and funds from the World Bank. FOVI's main purpose is to finance low-income housing purchasers by providing long-term affordable loans channeled through the Sofoles. FOVI also provides financing to Sofoles so that they, in turn, can provide bridge loans to housing developers for the construction of low-income housing projects.

Recently, Congress created the Sociedad Hipotecaria Federal ("SHF") for the purpose of replacing FOVI. In comparison with FOVI, SHF's objective will be to provide partial risk guarantees for any issuance of securities by Sofoles, rather than to provide direct financing for the purchase of low-income housing. In that sense, SHF is undergoing a transition between being a provider of funds towards being a guarantor of financing for low-income housing transactions. SHF is fully guaranteed by the Mexican Government and was created to increase the total amount of funds available for social housing.

2.3 Infonavit - Instituto del Fondo Nacional de la Vivienda para los Trabajadores

Infonavit is the administrator of a payroll deduction fund created in 1972 as a joint venture between the Mexican government and the labor industry. It operates as a low-income housing fund and a pension plan. Infonavit is funded by the Mexican government and by payroll deductions from Mexican employees and has the same objectives as FOVI and functions in a similar manner.

3. Examples of structured finance transactions undertaken by Sofoles and by low-income housing developers

Mexican low-income securitizations are generally undertaken using a Guaranty Trust, which is an SPV owner trust set up by the originator (either the Sofol or the Developer). The Guaranty Trust is similar to an SPV corporation and is created pursuant to a trust agreement between the Sofol, the common representative of the debenture holders (investors) and an independent trustee who holds a fiduciary responsibility to manage the assets, income and debt service obligations of the Guaranty Trust for the benefit of the investors and, if applicable, of the guarantors.

3.1 Securitizations by Sofoles

Sofoles have securitized pools of bridge loans granted to developers ("Developers") of low-income housing projects ("Projects"). Under this structure, the Sofol transfers at closing a pool of bridge loans to the Guaranty Trust together with the rights to repayment derived from such loans and transfers, from time to time, additional bridge loans (together with its repayment rights) for the purpose of maintaining the assets of the Guaranty Trust at a required level and a constant cash flow into the Guaranty Trust. The funds to repay these loans come from Infonavit, FOVI (through its successor SHF) and other housing funds (the "Take-Out Providers") who pay on behalf of the purchasers of the houses that are being built on the Projects, which in turn have been financed with the securitized bridge loans.

4. Risk Factors and Legal Considerations

4.1. Business practices risks: Construction risk, Take-out risk Future commitments from Take-Out Providers, and Demand and supply risk

4.2. Legal Considerations:

True sale

Under Mexican law, the transfer of the Proceeds and the assignment of the Projects to the Guaranty Trust on an ongoing basis should be considered "true-sales". Mexican counsel to these transactions have rendered reasoned opinions confirming that if the Developer files for bankruptcy, enters into insolvency proceedings or initiates a reorganization for the benefit of its creditors, the assets of the Guaranty Trust should be legally insulated from any claims by creditors of the Developer. However, there are no clear precedents under Mexican law supporting such proposition.

Non-recourse to assets of Developer

Under Mexican law, the investors have no recourse against the assets of the Developer in the event that the assets held in trust by the Guaranty Trust are insufficient to make the interest and principal payments under the Certificates. Hence, it is important for investors to conduct a thorough due diligence of the sufficiency and liquidity of the assets that will form part of the Guaranty Trust on the date of closing of the transactions and subsequently on an on-going basis. However, non-Mexican guarantors are not bound by such restrictions and may require having a right of recourse against the Developer under another law (for example New York law).

Acknowledgements by Take-Out Providers

It is paramount that investors verify that the Take-Out Providers have acknowledged that they will make payments directly to the Guaranty Trust, which in turn will use such collections to service principal and interest on the Certificates. Without the acknowledgements from the Take-Out Providers, there is no assurance that the funds required to service the Certificates will be directed to the Guaranty Trust for payment of principal and interest under said Certificates.

Waterfall of payments

Any monies received by the Guaranty Trust are generally applied in the following order: (i) to pay trustee's fees, (ii) to pay guarantors' fees, (iii) to pay principal and interest on the Certificates, (iv) to replenish the used portion, if any, of the credit support facility (reserve accounts) provided by the Guarantor, (v) to pay principal and interest on the guarantees, if any, and (iv) the excess, if any, to be returned to the Developer. Most recent deals have been structured with a combination of guarantees made available by a foreign guarantor, such as FMO, on a senior basis and a local guarantor, such as SHF, on a subordinate basis.

Conclusion

As long as favorable macroeconomic conditions and the growth of private sector savings through the Afores continues in Mexico, securitizations by Developers and Sofoles will likely remain an important source of funding for them. This will most likely lead to the creation of a strong MBS market in Mexico, provided that the regulatory framework is set for such development and a sufficient number of mortgages exist for such market to be feasible. In particular, a key regulatory change should allow mortgage foreclosure against defaulting debtors, which currently has its limitation under Mexican law. In addition, Mexico's domestic financial system, as well as its credit bureaus, have shown recent improvements that are bringing Mexico in line with more developed financial markets, giving confidence to investors.

On the other hand, the political support that low-income housing has been receiving from the current government may translate into large amounts of funds being channeled to SHF, FOVI and Infonavit. Hence, the securitization structures we have described will continue to develop as Sofoles and construction Developers access the market for additional financing. Mexican issuers will continue to resort to national and international guarantors in order to enhance the ratings given to their issues, and this will generate an increased appetite, both locally and abroad, for securities issued as a result of low income housing-related securitizations.

Finally, it is important to mention that the Mexican economy has become more connected with the US economy, not only from an industrial production level, but also in the development of its capital markets. More and more investors are seeing more transparent regulations implemented by Mexican authorities and a deepening of Mexican capital markets is slowly occurring. From a macroeconomic standpoint, the Mexican Peso has been less volatile and the macroeconomic indicators have remained more stable than in past macroeconomic cycles. These factors, we believe, will likely cause international investors to consider the possibility of investing in the local capital markets and hence, in local currency denominated mortgage-backed securities.

The authors would like to thank Lex Pfaeltzer (Senior Counsel) and Remco Polman (Investment Officer) of FMO, the Dutch Development Bank, and Jean Michel Enriquez, partner at Creel, Garcia-Cuellar y Muggenburg, S.C., in Mexico City, D.F., who provided valuable comments and insight for this article.