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SECURITIZATION OF SOVEREIGN’S TAX REVENUE – A FUND RAISING SOLUTION IN ADVERSE MARKET SITUATIONS?

Vaidas Augustinavičius, Republic of Lithuania

Abstract. The main goal of this paper is to determine whether securitization of a sovereign’s tax

revenue could be a more effective fund-raising tool for the sovereign facing adverse financial

market situations by providing cheaper funding. During the crisis of 2008 borrowing costs for some

middle- rated European Union sovereigns increased substantially, as they faced a variety of globally

and domestically driven economic challenges and the urgent need to deal with destabilising public

finance trends. Therefore, securitization of the sovereign’s tax revenue could appear to fit well

among borrowing tools for sovereigns in order to reduce long-term and short-term borrowing costs.

The analysis of securitization of the sovereign’s tax revenue is based on historical cases, empirical

calculations of potential cost-benefits, and the focus on legal challenges.

Key words: sovereign, fund raising tool, securitization, true sale, stream of tax revenue flows.

Introduction

The financial economic crisis which began in 2008 demonstrated how swiftly and substantially

sovereigns’ access to capital market funding could deteriorate. During the crisis borrowing costs for

some middle - rated European Union sovereigns increased substantially, as they faced a variety of

globally and domestically driven economic challenges and the urgent need to deal with destabilising

public finance trends. Many debt-distressed sovereigns required practical decisions on whether to

proceed with raising funds in increasingly expensive capital markets via issuance of bonds or to turn

to multilateral lenders of last resort – the International Monetary Fund, European Union institutions

and others – for financial assistance (mostly known as bail-out programmes). There is no uniform

decision-making protocol on whether to apply for multilateral financial assistance, which in most

cases is followed by strict conditions, or yet to proceed with funding in capital markets by issuing

higher yield bonds. This is because every sovereign is an exceptional case and therefore every

decision is driven by exceptional factors. Both approaches were seen to have advantages and

disadvantages. The aim of this article is to review the issues raised and to analyse the effectiveness

of an alternative and rarely discussed potential sovereign’s funds-raising tool – securitization of a

sovereign’s future tax revenue stream. The key question addressed by the research is whether

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securitization of the sovereign’s tax revenue could be a more effective fund-raising tool for the

sovereign facing adverse financial market situations by providing cheaper funding.

The first chapter of the research is intended to provide a brief overview of the need for a sovereign

to be in a position to raise funds using various borrowing techniques. The second chapter provides

the analysis of s the securitization market trends in general and historical cases of securitization of

sovereigns’ receivables. The third chapter describes the benefits and constraints of a potential

sovereign’s tax revenue securitization. The fourth chapter is designed for presentation of the legal

issues of securitization which are among the crucial risk factors for investors and rating agencies.

The fifth chapter gives ideas for officials of sovereigns in seeking to potentially achieve as cheap as

possible funding via execution of tax revenue securitization deals.

It is expected that the research could give additional ideas for sovereigns’ officials and other finance

experts involved in preparation of contingency funding plans.

The rationale of increasing the number of funds raising tools in a sovereign’s

toolkit

In relatively normal markets sovereigns borrow by using standard fund-raising tools such as selling

direct debt – government bonds, Treasury Bills, Eurobonds – in own or foreign currencies.

Whenever the situation in the capital market worsens (recognised by the increased volatility, risk

aversion and lower liquidity), some sovereigns deemed to be at greater risk than others might be

forced to use a greater variety of debt instruments in order to fund borrowing requirements at

relatively acceptable cost. Therefore, everything else equal, the more fund-raising tools a

sovereign has in its toolkit, the better the liquidity position is achieved by the sovereign.

The tentative toolkit of debt instruments a middle-rated sovereign could use over the transitional

period from “good” market to “deteriorated” market is shown in Figure 1. The question that could

be asked is whether tax revenue backed sovereign bonds (aka tax revenue securitization) could stand

somewhere in the list before considering issuance of relatively high coupon bonds or applying for

stand-by agreements with the EU/IMF (aka bail-out programmes). Securitization is a type of

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structured financing in which a pool of financial assets is transferred to a “special purpose vehicle”

(SPV) that then issues debt – backed solely by the assets (collateral) transferred and payments

derived from those assets (PriceWaterHouseCoopers, 2005). The idea of securitizing sovereign’s

receivables is not unique. In 2001 S. Ketkar and D. Ratha summarized that during a liquidity crisis

developing countries need innovative ways to raise external finance. One of such mechanisms could

be securitization of future tax receivables.

Figure 1. A tentative toolkit of a sovereign’s borrowing instruments. (Author)

Before analysing the arguments for issuing tax revenue securitized bonds in the future, I will briefly

discuss some of advantages and disadvantages of issuance of high coupon bonds and/or signing of

stand-by agreements (or very similar) with multilateral financial institutions. The crisis has shown

how the former funding tool has a key disadvantage – sovereigns perceived to have higher default

risk face higher borrowing costs. Expensive borrowing (interest rates in double-digits or similar) of

relatively high amounts continuing over a long time period (12 months or more) might bring into

question the sustainable development of a sovereign. In such cases a high proportion of a

sovereign’s future budget would need to be allocated to just interest payments instead of fostering

economic growth or saving for future, potentially indeed raising the vicious circle of greater risks of

future default and thus higher borrowing costs.

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The “last resort” IMF/EU lending programmes (as stand-by agreements) raise sensitive questions for

distressed sovereigns. The sovereigns take various decisions whether or not to apply for multilateral

financial assistance. It is worth mentioning that sovereigns do not sign stand-by agreements (usually

it is the last resort support) unless exceptional adverse circumstances, including rocketed borrowing

costs, appear. Nevertheless, the key benefits of signing stand-by agreements should be mentioned.

The first and the most important benefit is assurance of the needed liquidity (financing) source in

adverse market situations and thus appeared ability to highly reduce default risk. Moreover, the

IMF/EU support in many cases is provided under more attractive economic terms as compared to

cost of funding in capital markets. Furthermore, application for funding instruments provided by

international financial institutions (such as the IMF, EU - the European Stability Mechanism) could

be treated as a rational solution if taking into account capital contributions made by sovereigns into

these institutions and mechanisms. On the other hand, there are sensitive outcomes of using

financial assistance from the EU/IMF. First and foremost, economic-adjustment programmes

attached as mandatory conditions for credit disbursements should be mentioned. Credit

disbursement conditionalities can reduce independence of the sovereign’s economic policy.

However, it should be added that the enforced economic policy (by the creditors) can be similar to

that one independently contemplated (by the sovereign). Further, using the last resort support means

equally the same as it sounds – usually none of other creditors stands behind the EU/IMF. Thus,

non-fulfilment of credit conditions can lead the sovereign to the debt restructuring or even the

sovereign’s insolvency. This kind of pressure can increase political risk, affect business entities and

demotivate society. In addition, sovereigns participating in bail-out programmes in some cases lose

investment grade ratings and thus disrupt sovereign’s credit history. Definitely, not the existence of

application for international financial assistance is the reason for losing the investment grade credit

rating. On the contrary, the received loans significantly strengthen the sovereign’s liquidity position.

The evaluations and assignments of ratings are done by rating agencies following discrete and

transparent methodologies. Nonetheless rating agency Moody’s Investors Service commented in

2013: “Many countries enter support programs when they are in distress and support is often a last-

resort crisis measure. <...> during the 1983-2012 period, from all sovereigns that entered IMF

programmes, 16.4% defaulted over five year horizon and this historical default rate is consistent

with Moody’s Investors Service practice of generally maintaining non-investment ratings on

countries in support programmes”. Among those Ireland and Portugal (financial assistance takers)

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could be mentioned which were downgraded by Moody’s substantially to non-investment grade

ratings after 2008. J. Pissani-Ferry, A. Sapir and G. Wolff (2013) made early assessment of the

EU/IMF lending to Portugal, Ireland and Greece programmes and concluded that the programmes

were successful in some respects and unsuccessful in others. The main success was the current

account deficits shrinking much faster than expected. This could, however, be attributed to both

positive and negative developments. The positive development, in particular in the Irish case, was

the improvement in exports. The negative development was the collapse of imports, which related to

one of the failures of the programmes: a much deeper and longer recession than expected. It was

also stressed in the early assessment that the three countries by and large adopted the austerity

measures prescribed to them by the Troika (IMF/EU/ECB). They had little choice, since lenders

were unwilling to provide more financing. The alternative to austerity would have been debt

restructuring.

The most difficult puzzle whether to ask or not for international financial assistance is for those

sovereigns which have manageable (relatively not high) borrowing requirements over market

turbulence periods. The rationale could whisper to try withstanding temporary financial difficulties

without signing cumbersome and resonant stand-by agreements and to issue few high coupon bonds

unless no demand from investors is recognized overall. However, this is a costly solution. Therefore

the goal of this research is raised to ascertain whether securitization of sovereign tax revenue could

be economically beneficial in the further described situations:

1. A limited size of the sovereign’s external funding requirement over one year period, for

example, a few hundred million or a few billion of euros depending on sovereign’s size;

2. Adverse situations in capital markets and the trend of risk aversion;

3. Unaffordable high levels of unsecured borrowing cost.

The securitization of a sovereign’s tax revenue could be treated as beneficial in the described

situation if:

1. There is a demand among investors for such financial product in adverse market

situations;

2. The securitization generates a lower sovereign’s borrowing cost as compared to the cost of

unsecured borrowing;

3. There is a clear possibility to “exit” from borrowing via the securitization after a certain

time period and to resume issuing unsecured Eurobonds.

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In addition, it is rational to analyse securitization of tax revenue due to the fact that usually

sovereigns formally or informally prioritize debt servicing payments as compared to payments for

other purposes. Therefore, tax revenue to some extent is already implicitly allocated to (secured for)

debt servicing payments. Then we can ask why we should not encapsulate the factual processes into

the appropriate legal and structural framework and get the biggest financial benefit whenever the

benefits can be expected.

Securitization market trends and historical cases of securitization of sovereign’s

receivables

Securitization market nowadays

Among key incentives for originators to execute securitization are diversification of funding sources

and lower funding costs. Another observation of the funding via securitization benefits is credit

ratings enhancement. Improvement of credit ratings can be achieved when the financial asset is

separated from the credit quality of the originator. Other incentives for securitization - risk transfer,

revenue generation and others (BIS, 2011). In this research on securitization of the sovereign’s tax

revenue the most important aspects to be explored are diversification of funding sources and

reduction of borrowing costs.

According to the European Central Bank and the Bank of England (Joint Report, 2014)

securitization in general today suffers from stigma reflecting both its adverse reputation among

investors and conservatism among regulators and standard-setters. This is the consequence of

misaligned incentives in the years prior to the financial crisis. As it was noticed by H. J.

Blommestein, A. Keskinler and C. Lucas (2013), the failure of the US subprime securitization

market was a key catalyst for the global liquidity crisis that mutated into a full-blown credit crisis

bringing the international financial system to the edge of the abyss. Proper risk evaluation was not

always undertaken by professional investors and intermediaries, while too much faith was put in

credit rating agencies whose own methodologies for valuing complex structured finance products

were at times flawed.

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The securitization market trends in nominal terms verify the effect of crisis on the securitization

market (Figure 2). Currently, the recovery of the securitization market is recognised in the US

market, while further adverse trend is yet clear in Europe.

Figure 2. Issuance of securitization deals, EUR billion. (AFME)

The concerns raised by the ECB and the Bank of England (BoE) (2014) disclose that the new

regulations to protect investors, efforts of policy makers and authorities to reduce the perceived

regulatory stigma of ABS and to clarify their support for simple and more transparent securitizations

have so far failed to kick-start the EU securitization market. On the other hand, it was noticed that

the availability of cheap funding and thus no need for the securitization is among factors to deter

ABS issuance currently. Ongoing macroeconomic weakness in several European countries is an

additional reason of the weak securitization market. However, the ECB and the BoE insist that there

is room for improving such issues as regulatory treatment, reliance on credit rating agencies and

transparency and harmonization in order to foster the securitization market recovery in Europe. The

Association for Financial Markets in Europe (2013) also points out that a regulatory framework

which creates a well–functioning, transparent securitization market is necessary; its unintended

consequences need to be considered. Under Basel III/CRD IV, banks, traditionally the key investors

in the securitization sector, will now be forced to increase capital, deleverage and change the mix of

assets they have available to meet regulatory standards; as a consequence, a reduction in their

exposure to securitized products is likely.

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Securitization market and sovereigns: retrospection

Involvement of sovereigns in securitization of the sovereign’s tax revenue receivables is a rare case.

The reason can be hiding behind unattractiveness of tax revenue stream as the underlying assets.

According to S. Ketkar and D. Ratha (2001), the most secured assets of sovereigns to be securitized

are heavy crude oil receivables. They are followed by airline tickets receivables and similar, oil and

gas royalties and export receivables, and remittances. Only then tax revenue receivables stand in the

ranking. Perhaps due to that many of publicly available working papers, most of them published

approximately ten and more years ago, focus on securitization of sovereigns’ export, in most cases –

oil receivables. This correlates with the evidences of factually executed transactions.

An example of benefit received as a result of securitization of receivables could be a case of the

Government of Mexico in 1995 (S. Ketkar, D. Ratha 2001). In early 1995 the Government of

Mexico began the process of issuing floating rate notes backed by oil export receivables. The

securities issued in 1996 received BBB- ratings from Fitch Ratings and S&P, which are two notches

higher than Mexico’s sovereign rating of BB. In late 1998 Pemex Finance Ltd. (the state-owned

company of Mexico) issued a series of securities backed by oil export receivables. According to S.

Ketkar and D. Ratha (2001), due to securitization Pemex saved somewhere from 50 basis points to

337.5 basis points from what it would have had to pay on senior Pemex debt. Securitization of

natural resources export receivables was quite a popular solution for many Latin American

sovereigns until 2000.

Leaving aside securitization of the sovereign’s receivables related to exports, I further take a look at

historical cases of securitization of tax receivables. Securitization of tax ownership future

receivables or payroll tax receivables was quite common for Mexico’s states in the years 2002-2007

and resulted in achievement of relatively high ratings – double A or similar (N. Gelinas, 2008).

There were securitization cases in Europe as well. First of all, we should note the cases of Italy. Italy

is peculiar among developed economies for its large recourse to securitization (a series of operations

summing up to some EUR 35 billion in the period 1998-2003), involving future revenue from

lottery, uncollected credits of social security entities, and revenue from real estate sales (Giuseppe

Pisauro, 2004). The Italian cases regarding cost-benefit were different comparing to the

aforementioned Government of Mexico cases. In 2003 Italy found no difficulties to raise funds in

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the bond market under attractive terms. Due to the lower liquidity and absence of explicit state

guarantee, Italian bonds associated with securitization paid an interest higher than that associated

with the standard Italian government debt, even though the credit rating attributed to bonds issued

by the Special Purpose Vehicles was higher as compared to the sovereign’s ratings. The same

duration unsecured Italian bonds in 2001-2002 had negative spreads versus interbank interest rates

(about minus 4-12 basis points), while bonds associated with securitization had positive spreads (up

to 117 basis points) for durations up to 4 years (Giuseppe Pisauro, 2004). Besides, the additional

cost associated with securitization lies within administration costs, although there is no enough

available information to analyse the total administrative cost. Thus, rationality of Italian

Government’s securitization was not a search for cheaper funding. As it was summarised by

Giuseppe Pisauro (2004), in the Italian case the main motivation of securitization in public sector

was to use a useful tool to overcome short-term difficulties in complying with the limits to public

deficit and debt embedded in the Stability and Growth Pact under the European Monetary Union.

Securitization does not seem able to provide long term benefits as general public finance instrument

in developed economies. Otherwise, according to Giusepe Pisauro, securitization as a public finance

instrument seems more adaptive to developing countries (or, more generally, countries in fiscal

distress) that find difficult to gain access to the capital market.

Portugal is definitely worth mentioning while navigating other sovereigns that launched securitized

instruments in the past. In 2003 the Portuguese Republic through its Government made a decision to

securitize fiscal and social security claims (aka Explorer transaction). Around EUR 9.44 billion of

fiscal and EUR 2 billion of social security claims were securitized totalling EUR 11.44 billion in

claims (Direccao Geral Dos Impostos, 2010). The Explorer transaction arranged by Citigroup Inc.

was a very significant securitization for the Portuguese market in several respects. It was the first

securitization to be undertaken by the Republic of Portugal. It was the first use of a securitization

company structure in a public transaction. SAGRES STC, S.A., which was owned by an entity

within the Citigroup Group, issued an EUR 1.7 billion series of rated notes and applied the proceeds

of the note issue in acquiring an EUR 11.44 billion portfolio of tax and social security payments due

from individuals and companies in Portugal which were in default at that time. These assets were

held by SAGRES STC, S.A. on a segregated basis (V. Keaveny, Norton Rose, 2004). In 2004 rating

agency Moody’s Investors Service assigned the highest credit rating AAA to the deal. The sovereign

was rated by the lower rating at that time - Aa2 (Moody’s, 2004).

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In 2005 the Kingdom of Belgium, following the Portuguese delinquent tax receivables deal, became

a new member of sovereigns ABS originators’ club with the issuance of EUR 500 million in notes

for the purchase of the EUR 9.5 billion unpaid tax portfolio (Jan Job de Vries Robbe, Paul U. Ali,

2006). As it was emphasized in the Belgian case review, the servicer, i.e. the Kingdom of Belgium,

acting through the Ministry of Finance – could not be replaced, even in case of poor performance.

The conclusion was driven from the sovereign nature of the tax collection task, which due to the

constitutional concerns, could not be transferred to private entities. In the Belgian case Poste

Financiere S.A. held accounts the collections were being paid in. The Belgian case also included a

commitment by the sovereign to transfer any amounts not paid by Poste Financiere S.A. in order to

receive the targeted AAA rating (as Poste Financiere S.A. was not rated). The Kingdom of Belgium

had the highest ratings.

It is important to note that the securitization in Portugal and Belgium and some cases of Italy was

not the securitization of “life” tax receivables. In most cases it was securitization of delinquent

(defaulted) tax receivables. Therefore, although overcollateralization ratios in Portugal and Belgium

were very high, they should not be comparable to securitization of “life” tax receivables (non-

defaulted tax receivables). The more relevant and recent evidence of “life” tax receivables

securitization effect on cost-benefit in the case of the Commonwealth of Puerto Rico is worth

exploring. This is despite the fact that the Commonwealth of Puerto Rico being located far from

continental Europe and having peculiarities as regards the sovereigns sector. In October 2013

Moody’s Investors Service announced that Puerto Rico senior sales tax revenue bonds (USD 91

million) were rated A2 (after downgrade from Aa3), while the rating of Puerto Rico itself remained

far lower – Baa3. According to Moody’s Investors Service, a broad and diversified economic base

supported the sales tax pledge of Puerto Rico, including many products and services, but excluding

the more volatile sectors of automobiles and energy and strong long-term growth of personal

consumption expenditure. One more securitization benefit is a strong legal structure, including a

pledge of the larger of either 2.75% of the first dollars collected from the Commonwealth's 7% sales

tax or a minimum, certain fixed base amount, and a collection mechanism that segregates those

monies from the General Fund of Puerto Rico.

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The result of securitising a part of sovereigns’ revenue (which in general covers all unsecured debt

payments) for some particular debt issuance is the issue for investigation. Securitization of the part

of revenue means that the part of revenue does not cover the whole unsecured debt obligations

anymore. Thus smaller amount of sovereigns’ receivables back the remaining (unsecured) interests

of investors. The higher the segregation amount of revenue, the lower the insurance for unsecured

debt. This could trigger a higher unsecured borrowing cost for a sovereign and thus potential benefit

of securitization might be highly overlapped by negative consequences for the unsecured borrowing

section. The relative indicator of inefficiency is a downgrade of unsecured bonds. The historical

analysis of Mexico and Venezuela securitization deals (in the last decade of the 20th century) shows

that the rise of capital via securitization (of export receivables) equals approximately 15% in the

total debt portfolio and does not jeopardise the sovereign’s overall creditworthiness. There were no

ratings downgrades due to that. Venezuela had 18% and Mexico - 16% of the debt portfolio related

to securitized products (Suhas Ketkar, Dilip Ratha, 2001).

In 2012 Philip Pilkington and Warren Mosler suggested tax revenue backed bonds as a solution for

the financial crisis. The key of the idea was to use tax revenue backed bonds (if bonds were not

redeemed by a sovereign) as substitutes for cash to pay taxes. According to the publication, the

question was raised by economists and by money managers why a defaulting government could not

simply refuse to accept the defaulted-on bonds in the payment of taxes. To ensure this does not

occur, Philip Pilkington and Warren Mosler advocated that bonds should be written under the

United Kingdom (international) law. That would mean that the government would have no legal

standing to make such a claim. The authors considered that yields would reflect the low risk

associated with the new bonds and would be significantly below the yields at that time being

demanded by the markets.

The key benefits and constrains of tax revenue securitization

Benefits of tax revenue securitization

1. Potentiality of cheaper borrowing is among the key benefits of securitising the sovereign’s tax

revenue, especially for developing countries possibly achieving the higher credit ratings. As

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historical cases of Mexico, the Commonwealth of Puerto Rico, Portugal show, hypothetically there

could appear beneficial improvement in credit ratings of approximately two notches among secured

bonds and unsecured bonds. A natural question could be asked how different credit ratings reflect

yield spreads of different sovereigns bonds? The indicative results are shown by analysing yields of

bonds with duration of 5 years of differently rated sovereigns.

Table 1. Sovereigns’ 5-year bond yields at 13 June 2014, www.investing.com, www.moody’s.com.(Author’s

calculations).

In Table 1 average yields of sovereigns’ bonds are listed by corresponding credit rating assigned by

rating agency Moody’s Investors Service. The yields of sovereigns of the world bonds represent the

credit rating impact on the higher variety of credit ratings groups due to the higher number of

sovereigns included in the analysis. The disadvantage of the comparison lies in the fact that due to

specific reasons, yields of bonds denominated in different currencies are not equally comparable.

For example, an average yield of sovereigns rated Baa1 (or even Ba1) is lower as compared to that

of sovereigns rated A3. In addition, different liquidity of various bonds reduces the equality in the

comparison. Nevertheless, if we take the average yield of sovereigns from the credit rating groups

with the highest concentration, i.e. Baa3 and Baa1 (two notches difference), the yield spread is over

200 basis points. However, the results appear different if we remove the currency factor, i.e. if we

keep reliance on the same currency – euro – denominated bonds. The yield spread between the

bonds issued by the members of the eurozone, rated, respectively, Ba1 and Baa2 (difference of two

notches) is just over 40 basis points. The drawback of the latter outcome lies within the fact that

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much lower number of sovereigns are taken into the analysis of relevant euro – denominated bonds.

The liquidity factor of different bonds among issuers, which reduces the possibility of objective

comparison between bonds, even among the eurozone members yet remains a relative constraint of

the comparative analysis.

The calculation of discrete savings due to securitization is a kind of puzzle. The historical analysis

of Mexico’s deals hints savings from over 50 basis points to over 300 basis points. The analysis of

the world and eurozone’s sovereign bonds based on the assumption that securitization could

determine the achievement of the higher ratings by two notches hints the potentiality of savings

from over 40 basis points to over 200 basis points. Due to high uncertainty, the conservative

assumption of potential savings on borrowing due to securitization will be represented from 50 to

100 basis points further in this analysis. The assumption excludes the implicit factor of higher,

though practically not publicly disclosed, administrative fees of securitization deals. According to

Suhas Ketkar and Dilip Ratha (2001), the specialized skills necessary to structure asset-backed

transactions together with the long lead times imply that promoting this business becomes an

expensive proposition for investment banks and issuers who eventually bear these costs. Legal costs

involved in structuring these transactions are reported to be particularly steep at about USD 2

million to USD 3 million per transaction and may deter many issuers from using this financing

mechanism.

Figure 3. Potential savings in 5 years for the issues of EUR 0.5 billion and EUR 2 billion securitized bonds. (Author’s

calculations)

Figure 3 shows the preliminary results of eventual savings on borrowing due to securitization of

tax revenue flows. As it was preliminary concluded, the potential savings of borrowing can

comprise around 50-100 basis points. Thus, the two graphs show potential savings on the

accumulative basis in 5-year period given two scenarios. The first scenario is savings of 50 basis

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points (left side figure), the second – savings of 100 basis points. The results are shown for two

different face amounts of securitized bonds: EUR 500 million and EUR 2 billion. Interest

expenditure savings would comprise from EUR 12.5 million to EUR 50 million in 5 years for the

issues of EUR 0.5 billion and EUR 2 billion securitized bonds, respectively, in a case the secured

borrowing results in yield reduction by 50 basis points. After deducting from that amount the

implicit deal organisation fees (for example, EUR 3 million in total), potential savings would

comprise close to EUR 9.5 million for a EUR 500 million deal in 5 years. A securitization of 3 year-

maturity deal worth the same EUR 500 million would save somewhat below EUR 6 million. It is

notable that the potential savings when using securitization would be somewhat further lower

depending on the investors’ view regarding the liquidity premium. The securitized bonds due to deal

peculiarities are usually less liquid as compared to the regular unsecured bonds. Still, there are

reasonable expectations that the higher organisation costs of securitization deals and higher liquidity

premiums are out-passed by the outcome of the potentially achieved higher credit rating whenever it

happens.

2. The quality of tax revenue stream as the underlying assets in the securitization deals might appear

to be undervalued. Referring to the earlier literature analysis related remarks, many other types of

underlying assets are treated as of better quality (Suhas Ketkar and Dilip Ratha, 2001). In reality,

tax revenue inflows can represent quite qualitative underlying assets for securitization. The

financial crisis of 2008 showed that even during the sharp GDP decrease periods some types of tax

revenue, such as, for example, from excise taxes, remain relatively stable and far away from the

drained cash flows. Figure 4 represents the monthly revenue flows from excise duties in the

Republic of Lithuania and the quarterly nominal Lithuania’s GDP growth trends in 2007-2010.

Although the time series include a sharp GDP contraction in 2009, revenue inflows from the

collected excise duties in Lithuania over the aforementioned period still remained relatively stable.

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Figure 4. Lithuania’s revenue from excise duties and nominal GDP growth. (Ministry of Finance of the Republic of Lithuania, Statistics

Lithuania)

According to Niegel A. Chalk (2002) and Suhas Ketkar and Dilip Ratha (2001), the main types of

risk involved in the future flows securitization are as follows: sovereign risk, performance risk,

product risk, diversion risk, and exchange rate risk. There are other risks as well. In Table 2 I briefly

analyse the key risk sources and the mitigation of risks when choosing tax revenue as underlying

assets for securitization.

Type of risk Risk description Risk evaluation of tax revenue inflows as underlying

assets in sovereigns’ securitization deals

Sovereign Risk Will the originator’s government take steps to disrupt the payment arrangement set out in the structured transaction?

This is the key risk to be solved via the proper legal

framework and legal structure of a securitization transaction.

The key weakness of tax revenue (as a domestically

generated revenue source) being the underlying assets in a

sovereign’s securitization deal is the sovereign’s

(Parliament’s) ability to change national laws. Risk exists.

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Type of risk Risk description Risk evaluation of tax revenue inflows as underlying

assets in sovereigns’ securitization deals

Performance Risk Will the originator have the ability and willingness to produce and deliver the product?

Tax revenue, especially - indirect taxation - is the main

financing source among sovereigns in many cases. It is

hardly possible that a sovereign could reject an intention to

collect the VAT, excise duties or similar taxes. Moreover,

due to harmonisation of excise duties around the European

Union, the member states of the EU are on the obligatory

path to achieve a certain level of excise duty rates.

Risk is low.

Product Risk Will there be a sufficient demand for the product at a stable price and will the buyer meet his payment obligations?

As it is shown in Figure 3 as an example, even in the

circumstances of the sharp GDP contraction, revenue flows

can keep remaining at significant levels and do not vanish.

The level of (monthly) revenue flows fluctuates due to

economic cycles, though the significant flows yet remain,

especially in terms of taxes on less elastic goods.

Risk is low.

Diversion Risk Can the product or the receivable be diverted to customers other than designated customers?

In a case of the sovereign’s future tax revenue securitization,

the duty to pay taxes is securitized, rather than payments

from particular customers (payers). The particular tax payers

change, but the duty to pay taxes remains constant.

Risk is low.

Exchange Rate Risk Are there currency mismatches

between the receivable inflows

and the debt service outflows?

The risk might be significant in a case of currency mismatch.

It is up to investor on the hedging strategy. In a case of

eurozone member states, the risk is mitigated when issuing

the euro - denominated bonds.

Risk depends on a case.

Table 2. Risk types involved in securitization deals. (Suhas Ketkar and Dilip Ratha (2001), Niegel A. Chalk (2006)).

Author’s evaluation of tax revenue inflows.

3. Securitization of a sovereign’s tax revenue could predetermine maintenance of access to capital

markets constantly including market turbulence periods and thus help keeping good credit

history of a sovereign. A sovereign able to withstand any disturbances on its own predetermines

resistance to various shocks and increase confidence into the sovereign’s willingness and ability to

service future debt liabilities.

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4. Development of securitization of tax revenue tools would increase diversification of funding

sources for a sovereign. Diversification of funding sources is critically important in adverse market

periods.

5. Practicing sophisticated debt instruments and mastering them well presents a sovereign as

being advanced in finance management and having appropriate level of skills. Highly skilled

sovereign’s debt managers could increase the overall confidence in a sovereign. That could increase

the overall recognition of a sovereign’s name among international and domestic investors.

6. Securitization of a sovereign’s tax revenue might work as an additional accelerator to improve

tax revenue collection and administration. The quality of tax administration would be directly

tied to the quality of the underlying assets and thus to the yields of asset-backed bonds. The better

the tax administration - the lower the bonds yield there would be. Otherwise, nobody will buy bonds

if consider underlying assets (tax receivables) as of poor quality.

7. The securitization tool predetermines better asset-liability management of a sovereign. The tax

receivables (assets) would be used prior to the physical cash reception in order to get economical

benefit via the form of reduction in debt costs.

8. Securitization of a sovereign’s tax revenue determines more financing options for a sovereign

and thus improves sovereign’s ability to service its overall debt portfolio. In adverse market

situations there might appear cases when a sovereign uses securitization tools to cover unsecured

debt redemptions.

Constraints of tax revenue securitization:

1. One of the key constraints in contemplating issuance for a sovereign of the tax revenue

receivables-backed securities is deficiency of this kind of deals. At least in the latest years, since

2008. A middle - rated European sovereign would be some kind of pioneer if decided to start

development of “life” tax revenue securitization. However, sometimes pioneers are the winners.

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2. The methodologies of rating agencies evolved since the financial crisis of 2008. Due to the

lack of historical tax revenue securitization cases there appears uncertainty about the probability

to achieve better credit rating for bonds backed by a sovereign’s tax revenue receivables (as

compared to the ratings of unsecured bonds). Detailed discussions with credit rating agencies should

be organised in order to reveal the conjunction between securitization of some certain types of tax

revenue and the fiscal score or the fiscal flexibility assessment (as based on the Sovereign

Government Rating Methodology and Assumptions by Standard&Poor’s, 2013).

3. As it was revealed earlier, the securitization market in the EU (across all groups of issuers) is

shrinking and the recovery is yet to appear some time later (if it appears). This is a different trend as

compared to the securitization market trends in the US. While the overall EU securitization

market is moribund, there is not much of the substantiated optimism about the successful

securitization. However, at least in the meantime.

4. Securitization represents higher deal organisation and administration costs, especially in

terms of legal services, as compared to those of regular unsecured issuance of Eurobonds. The deal

organisation costs incur at the issuance year. Due to the high commissions, securitization deals

might appear less attractive despite the possible overall cost-benefits.

5. Securitization of sovereigns’ tax revenue would be limited to some amount (potentially

represented as a ratio to total debt) in order to avoid negative influence on the credit ratings of

unsecured borrowing. Therefore, the liquidity due to the latter, also due to the use of securitization

in the high scope just over periods of financial crisis (credit crunch) and due to other reasons (more

narrow investors base; unattractiveness due to the complexity) of securitized bonds would be

lower as compared to the regular unsecured Eurobonds. The high liquidity of debt securities is

among top strategic goals of many sovereigns.

6. Securitization deals are complex deals. Special trainings for the staff of sovereigns might be

needed. Trainings are costly and take time to produce the outcome.

7. The legal structure is crucial in ensuring that the asset involved in securitization is not adversely

affected by any risk associated with the originator (borrower). Unless this is the case, rating agencies

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will not be able to separate the ratings of the notes from the borrower (Rick Watson, Jeremy Carter,

2006). As regards the sovereigns, the significant risk lies within the sovereign’s (Parliament’s)

power to change national laws, therein - laws on taxes, collateral, etc. In addition, the legal risk

lies within the consistency between the securitization terms and the terms of issued unsecured

regular Eurobonds (for more details on legal issues - see other paragraph).

8. Social pressures might appear due to a decision to securitize tax revenue. The case of

securitization of delinquent social security taxes in Portugal (2004) caused political debates. The

Finance Minister of Portugal was called to the Parliament on several occasions to justify the deal

after the opposition politicians raised queries about selling government receivables to the US bank

Citigroup (www.iflr.com, 2004). Therefore, there would be a need to educate the society well in

advance about the basics of securitization of a sovereign’s tax revenue (if any) and to point out

clearly the key reasons of doing securitization.

9. Uncertainty about potential exit from securitization could make sovereigns distrustful

regarding this type of borrowing technique. There might be a fear that once the tax revenue

securitization issues are done, the abilities to return to unsecured borrowing will appear challenging.

A fear on the need for much of efforts to convince market participants that a certain sovereign is

already ready to issue and ready to accept (be given) reasonable unsecured borrowing costs. The

described risk could be material. A possible solution to mitigate the related risk is to set very

publicly the limit for a sovereign’s tax revenue securitization, for example, 5-10% of total

sovereign’s debt portfolio. Thus it should be clear in advance for all market participants that a

sovereign is not going to use securitization permanently, there exists unbreakable limits and the use

of securitization as a funding tool is limited in terms of amounts.

10. There might appear that a part of investors already implicitly in-calculate tax revenue as the

asset to be used by a sovereign for debt payments on priority basis. Therefore, the enhanced

structure of borrowing via asset (tax revenue) - backed securities cannot result in substantial cost-

benefit for a sovereign. However, this is not an unambiguous finding, in particular, if the higher

rating for a securitization deal were achieved. In addition, a goal for a sovereign to remain as a

capital market participant during a financial crisis yet could be solved via tax revenue securitization.

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Tax revenue securitization structure, recording and legal issues

The key participants in the securitization process

The common participants in securitization deals are as follows (PriceWaterHouseCoopers,

2005) :

- Originator (the entity assigning assets or risks in a securitization transaction);

- Investor (buys the securities and overtakes the risks)

- Special Purpose Entity or Vehicle (a pool of financial assets is transferred to a

“special purpose vehicle” (SPV) which then issues debt – backed solely by the assets

(collateral) transferred and payments derived from those assets).

- Trustee (the legal responsibility for the activities of the securitization vehicle and

the receipt and disbursement of coupon payments to the investors). In other words, a security

trustee is the entity holding the various security interests created on trust for the various

creditors, such as banks or bondholders (www.uk.practicallaw.com).

- Investment banks (the main functions include structuring, underwriting and

marketing of the transaction).

- Rating agencies (based on the expected performance of the underlying asset

portfolio, rating agencies set credit enhancement levels to achieve the desired credit ratings

of offered securities, assign rates to the bonds issued, evaluate the servicing capabilities and

monitor the performance of the transactions).

- Paying agent (responsible for making the principal and interest payments to the

security holders).

- Others (legal advisers, calculation and reporting agents, tax advisers, others).

An example of the potential structure of tax revenue securitization might be presented as in

Figure 5.

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Figure 5. Potential sovereign’s tax revenue securitization scheme. (Author)

The recording of securitization

As set out in the ESA’2010 Manual on Government Deficit and Debt prepared by Eurostat (2013

edition), Governments sell financial and non-financial assets to raise cash or to optimise the size of

assets. Governments might also transfer flows of receipts or incur a future obligation to make

payments in return for cash today. In most cases, a sale of an asset is recorded as a sale for the value

of the transaction in national accounts. However, some cases are more complicated, particularly

when:

o Sales take place through public corporations.

o The economic risks and rewards are not fully transferred (no “true sale”).

o The government’s proceeds for the sale are not in cash or differ from the

market/fair value of the assets sold.

o The asset that appears to be sold is not recorded in the Government’s balance

sheet in national accounts.

Assuming that the securitized items are recognised as transferable assets in national accounts, a sale

of these can only be recorded in national accounts if there is the transfer of economic ownership

from the government to the securitization entity. There is a transfer of economic ownership of assets

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when the risks and rewards that are attached to these are completely transferred (aka the “true sale”).

If the risks and rewards are not completely transferred from the government to the securitization

entity, the securitization is recorded as government borrowing; especially whereas a precondition for

the market unit to return receipts exceeding debt payments to a government exists, and/or the

government remains in charge of covering the insufficiency of receivables (meaning existence of

contingent liability).

A transaction recorded as not a “true sale” would be quite common for securitization of the stream

of “life” taxes. Whereas there is a securitization of delinquent tax receivables and a government

does not bear any additional risk and no excess of receipts is returned to the government, the

transaction could be recorded as a “true sale” (depending on some other specific factors). The “true

sale” is also aligned with the fact whether the asset of pool sold to the SPV is isolated from any risk

(credit, legal and other) of the originator.

The key elements for the strong legal structure

The key legal elements are necessary for the effective sovereign’s tax revenue securitization. There

should be trust concept in place. A trust is a legal relationship created by a settlor when assets are

placed under the control of a trustee for the benefit of a beneficiary or for a specified purpose. A

trust has the following characteristics:

o The trust assets constitute a separate fund and are not a part of the trustee's own estate.

o The legal title for the trust assets stands in the name of the trustee or in the name of another

person on behalf of the trustee.

o The trustee has the power and the duty, in respect of which he is accountable, to manage,

employ or dispose of the assets in accordance with the terms of the trust and the special

duties imposed upon him by law (www.uk.practicallaw.com).

The fundamental concept of trust is the splitting of ownership into two classes: legal and beneficial.

The former has a title; the latter merely has some of benefits that would normally be associated with

legal ownership (Rick Watson, Jeremy Carter, 2006). The SPV should be bankruptcy remote. There

should be a clear and smooth way to in-force security. Also, a separate law on securitization, where

inter alia it would be clearly stated what can be securitized.

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Figure 6. The key elements of legal infrastructure.(Author)

The splitting of legal ownership and beneficiary interest might appear a challenge in implementing

securitization of sovereigns’ tax revenue. The splitting means that the legal right to collect taxes

remains on the sovereign’s side, although the beneficiary (receiver) of certain tax inflows is not the

sovereign - it is the SPV in connection with the Trustee. That may raise the constitutional concerns,

as the future tax revenue is the assets of sovereigns and it may not be transferred to private entities

for further disposal.

In implementing the effective SPV bankruptcy remote is one more and very important challenge

for the effective securitization of sovereigns’ tax revenue. The SPVs have to be separate from the

parties (originators) that set them up for the accountancy, tax and insolvency purposes. Whenever

the originators of securitizations are private companies, lower governmental level entities

(municipalities, public agencies) or state-owned enterprises, the separation of secured assets

(receivables) from the originator’s balance and originator’s insolvency is effective within the clear

legal framework ensured by national laws on securitization. There is no legal “conflict” between the

originator and the right to set-up legal framework for securitization, as the laws are issued by

parliaments, while the originators belong to the lower governmental level entities or private

companies (having no legislative powers). Therefore, the lower governmental level entities or

private companies can achieve the lower borrowing cost which is closer to that of the sovereign

level as government bonds yields usually are benchmarks. Whereas in the case of sovereign’s tax

revenue securitization the legal “conflict” exists as the originator (a government) is the same entity

having legislative power (executed via national parliaments). Thus investors’ trust (reliance) in

ensuring the SPV being bankruptcy remote is vague. The essence lies within the fact that investors

might not be willing to give a cheaper credit (aka to buy asset-backed securities with the lower

yield) to a sovereign without being confident about the effective security of underlying assets in a

case of sovereign’s insolvency. The same uncertainties could appear on the rating agencies side.

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This situation is especially relevant for the domestically generated receivables - tax revenue inflows.

There would be not enough to apply international law for domestically generated assets (future

receivables) without analysing the national court system and other matters. Probably that is why

historically many cases of receivables securitization in sovereigns’ sector (largely in Latin America)

were either relevant to export receivables (with possible application of international law as cash

flows and the trustee located offshore) with the purpose to get a cheaper credit. It might also be

securitization of delinquent tax revenue which was securitized for other than the cheaper credit

purposes (cases of Italy, Belgium). However, the cases of Portugal’s delinquent tax securitization

deals showed significant credit rating improvements and opposed the former conclusions. It is

important to remember that securitization of the delinquent tax revenue is kind of a “true sale” (of

course, depending on an individual case). Whereas securitization of “life” tax receivables in most

cases would not be a “true sale”, as excess inflows would be returned to state treasuries and the

segregation of tax receivables would be temporary (for the fixed maturity tight to the bond’s

redemption date), then the duration of “life” tax receivables would be undefined (unless otherwise

prescribed by laws).

Consistency among legal conditions of different finance products

The nature of tax revenue securitization should be consistent with the two covenants set out in the

standard bond instrument - the “parri passu” and the “negative pledge”. The standard parri passu

covenant is as follows: “The bonds and coupons constitute direct and unsecured obligations of the

Issuer and shall rank parri passu and without any preference among themselves. The payment

obligations of the issuer under the bonds and coupons shall at all times rank at least equally with

all its present and future unsecured and unsubordinated obligations”. Thus securitization of tax

revenue-backed securities (securitization) is consistent with this covenant as securitization by its

nature is not relevant to standard unsecured bonds.

There is somewhat less clarity regarding another covenant – a negative pledge. According to the

International Capital Market Association (ICMA), “negative pledge” is a term used to describe a

covenant by the issuer in the terms and conditions of the issue which restricts the freedom of the

issuer (and possibly other entities related to the issuer) to grant security for other debts without

granting equal security for the debt in question. That means that granting of security to some

25

creditors - buyers of sovereign tax revenue-backed bonds - might raise a legal conflict with the

existing agreements on the issued unsecured government bonds. In 2006 the ICMA issued a

commentary and clarified the following: “Existence of a negative pledge therefore only means that

the freedom of the issuer to grant security for its other debt is limited rather than unlimited.

Conversely, existence of negative pledge therefore does not mean that:

• The issuer is not permitted to give any security for its other debt at all. In particular, it could be

expected that the issuer will be permitted to give security for its bank loan debts.

• The issuer is not permitted to dispose of its assets, e.g. for the purpose of securitization.”

Further the ICMA (2006) recommended not to rely solely on the indication of the existence of a

negative pledge and to analyse carefully the language of the negative pledge focussing, in particular,

on the entities covered by the prohibition, the definition of security and specification of debt covered

by the negative pledge.

Ideas for sovereigns’ managers seeking to achieve a lower borrowing cost via

securitization of the tax revenue stream versus unsecured borrowing

It is advisable:

� To have in place the necessary legislation, therein laws on securitization that very clearly

implement the trust conception and to make available to the public legal opinions prepared by

worldwide recognised law companies.

� To ensure that the court system is smooth and reliable and well-recognised by international

institutions (World Bank and other).

� To ensure that the institutional strength is recognised as very high by international institutions

and credit rating agencies. This (and the recognition of the court system) is very important in

trying to convince the market participants of the effectiveness of the SPV insolvency remote.

� To pick-up the “correct” kind of tax revenue for securitization, for example, excise duties or a

part of them which are regulated to some extent internationally by the EU. Thus reducing the

performance risk from investors’ point of view. Furthermore, inflows should be frequent (not

once a year) for the risk mitigation purposes and ability to make estimates.

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� To ensure the effective tax administration function and to give public evidence on the

improvement trends. The effective tax administration is tightly related to the quality of the

underlying assets in securitization.

� To consider triggers in securitization documents, for example, a higher amount in trust accounts

when ratings drop below certain levels or similar.

� To consider execution of tax collection and transfers to a Trustee via highly rated domestically

operating banks (branches of foreign banks) which have higher ratings as compared to the

sovereign.

� That could be rational to test tax revenue securitization with low amounts in good times and to

keep low amount issues permanently with the option to use securitization of tax revenue in high

scale when it is necessary.

� To consider the maturity of securitization deals of approximately 3 years in order to reduce the

legal (change of laws) risk from investors’ point of view.

� To receive technical assistance and/or to obtain an independent opinion from the IMF/WB that

could be beneficial for investors, as it is always the more transparency the better.

Conclusions

There is a rationale for having a portfolio of reputable borrowing tools in a government’s

tool-kit that can be called upon in different circumstances and that raise the incentive for better long-

term prudent fiscal performance. The significance of doing that reveals itself during the liquidity

crisis in the markets. Securitization of the sovereign’s tax revenue appears to fit well among the

borrowing tools for sovereigns seeking to reduce long-term and short-term borrowing costs. The

tool appears plausible based on theoretical and similar deals analysis. However, measuring of the

practical effectiveness - potentiality to cheapen borrowing, especially during the bad times, is very

difficult currently. There are no historical cases of securitization of “life” (as opposed to delinquent)

tax receivables. For the eurozone, in particular, the private securitization market in Europe is

currently moribund. In addition, there are significant legal issues concerning clear assurance of

segregation of special purpose vehicle performance from originator’s (sovereign’s) credit risk. This

is due to originator’s legislative power (ability to change laws). We should wait for an example of

executed tax revenue securitization transactions. They could reveal the real outcomes and benefits as

well as better support the market measurement of various risk fears.

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3. Philip Pilkington, Warren Mosler “Tax-backed bonds - a national solution to the European

debt crisis”, 2012.

4. Nicole Gelinas “Latin American Project Finance”, 2008.

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market”, 2011.

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2013.

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19. Moody’s “Moody’s assigns definitive ratings to notes issued by Sagres”, 2004.

20. Moody’s “Moody’s downgrades $6.8 billion Puerto Rico Senior Sales tax revenue bonds

to A2 from Aa3 and affirms $9.2 billion subordinate bonds at A3”, 2013.