'Tequila Effect' finally fading: rescued banks agree to write off some Fobaproa bonds and reluctantly accept limited audits.

A decade on from perhaps the most traumatic financial upheaval ever to hit Mexico, the government announced in July that the Institute for the Protection of Bank Savings (IPAB) and the country's surviving banks had reached a deal that looked like it would finally consign the episode to history.

The four banks--Banamex, Bancomer, HSBC and Banorte--agreed to write off 9.5 billion pesos worth of bonds used by IPAB's predecessor, the Banking Fund for the Protection of Savings (Fobaproa), to buy uncollectable loans after a 1994 peso crisis sparked the so-called "Tequila Effect." The peso devaluation sent interest rates skyrocketing and loan holders defaulted, bringing the banking system to its knees.

The banks also have agreed to accept a limited audit of the remaining loans included in the 223 billion pesos they received as part of a massive government rescue package. Mexico was forced to bail out its banking industry, now dominated by foreigners, after the currency crisis struck.

"We are witnessing, without a doubt, the closing of a chapter that began long ago and has delivered a severe blow to the public's finances," said Sen. Fauzi Hamdan Amad, president of the Senate Treasury Committee, when the deal was formally announced to Congress on July 26. "We need to learn from this sad lesson to ensure that it is never repeated."

BANKING TOOK A BODY BLOW

Controversy has raged over the bailout since the late 1990s, after it became the poster child for opponents of the crony capitalism that flourished under former President Carlos Salinas de Gortari.

In 1991 Salinas re-nationalized Mexico's banks, which had been nationalized in 1982 following a previous financial crisis. Trying to encourage a "culture of credit," regulation was light and most banks were capitalized at around 10 percent--below the 12 percent international standard. This lax regulatory structure enabled many bankers to make loans to other bankers, relatives, phantom businesses and, most audaciously, even to themselves.

After the peso devaluation in December 1994, interest rates soared to over 100 percent as the government tried to stem the flight of foreign capital. Ordinary debtors were unable to repay their loans at such high rates and a collapse of the banking system loomed. Faced with what it perceived as a liquidity crisis, the government instructed Fobaproa to set up the Credit Purchase and Capitalization Program (PCCC) to buy uncollectable debts with special promissory notes.

Eighteen banks participated in the program--only four survived the crisis.

As Fobaproa continued to buy bad debts through 1995, 1996 and then into 1997, it became clear that the problem was more than just a liquidity crisis and had structural roots. In 1998, Congress hired independent Canadian consultant Michael W. Mackey to conduct an complete audit of the bailout.

The Mackey Report was scathing in its conclusions. Forty-three billion pesos included in the PCCC were so-called "related party credits," made to relatives or associates of the bankers. Some 80 billion pesos Mackey diplomatically termed "reportable" loans, opaque credits that may not have qualified for inclusion in the bailout.

In his individual bank reports, Mackey also said some banks had not needed the financial assistance from the bailout, but were included in the PCCC so as not to be put at a competitive disadvantage to other banks. This was, in particular, the case with Banamex.

FRESH AUDITS

Disputes over the bailout became increasingly polemical. Opponents latched on to the Mackey Report, asking how many bonds relating to illegitimate loans had already been repaid by the government. And complicating the situation still further, in the years subsequent to the crisis three of the four banks that survived were bought out by foreign banks, leading to accusations that taxpayers' money was being used to subsidize multinational corporations.

In 1998, Congress passed a law establishing IPAB as the successor to Fobaproa. The law gave IPAB a mandate to replace the Fobaproa debt with new IPAB bonds. Unlike Fobaproa, the IPAB notes are to be underwritten by the government so repayments would not have to be approved by Congress in the annual budget. But the law required a new and more extensive audit of the loans--if they qualified as part of the original bailout--before they could be taken on by IPAB.

Although Mackey stated in the opening of his report that it did not constitute a financial audit but rather a review and analysis of the bailout, the banks disagreed and resisted further scrutiny. In 2000, they obtained a Supreme Court injunction preventing a new audit, a move that led to four years of legal dead-lock until July's agreement.

Under the new deal, the banks will return their Fobaproa notes (with a face value of 223 billion pesos) to the government and receive 107 billion pesos of IPAB bonds in return.

When the government announced the accord, it was billed as a 116 billion-peso reduction of public debt. This sleight of hand disguises the fact that the returned Fobaproa notes represented the face value of the government's debt, not its net value.

Of the reduction in the face value of the bonds, 99 billion pesos is money that would have been returned to the government when the Fobaproa notes matured, starting in 2005. This leaves the 9.5 billion pesos that the banks have agreed to write off, and a further 7.5 billion pesos that has been set aside for the audit.

Therefore the total value of the write-off could eventually come to 17 billion pesos if it is found that the loans to be audited did not qualify for inclusion in the original bailout package and must also be written off.

Legislators had threatened not to approve the rollover of millions of dollars worth in soon-to-expire notes owed to the banks unless they agreed to the audits.

Banamex was the most heavily exposed of the four banks, owing 6.2 billion pesos. It was reported that the bank had set aside enough reserves to cover this loss.

According to Finance Secretary Francisco Gil Diaz's July 26 testimony to Congress, the total cost of the bailout for the government at one stage reached 1.25 trillion pesos, or 18.5 percent of GDP.

REACTIONS AT HOME AND ABROAD

International bond markets greeted news of the deal with a narrowing of 15 basis points in the spread of Mexico's benchmark 28-day Cetes over U.S. Treasury bills. This reflected the feeling of global financial markets that a major source of uncertainty over the liquidity of a significant portion of the banks' assets had been removed.

However, Standard & Poors analyst Ursula Wilhelm told BUSINESS MEXICO the agreement would not impact on the agency's sovereign debt rating for Mexico because they had already assumed a settlement would be reached when they calculated their current rating.

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"Our analyses concluded that it would be far more costly for the government if it failed to repay the notes than it would be for the banks," she said. "If the government unilaterally decided not to meet its obligations or to forcibly renegotiate the debt, it would send a signal to international markets that it doesn't honor its agreements."

She added that foreign investment in Mexico was currently at a low level and unlikely to pick up in the short term as a direct consequence of the deal.

At home, the deal was supported by President Vicente Fox's National Action Party (PAN) and the Institutional Revolutionary Party (PRI), which ruled Mexico for 71 straight years until Fox's election in 2000.

It was immediately denounced, however, by the leftist Party of the Democratic Revolution (PRD), who said the deal was illegal because the reportable loans already identified by Mackey would not be subject to a fresh audit.

Andres Manuel Lopez Obrador, mayor of Mexico City and an early favorite for the 2006 presidential race, has been one of the fiercest critics of the settlement from the beginning.

"As far as closure is concerned, the bank bailout is going to stay alive because it's always been one of Lopez Obrador's favorite issues," said George Grayson, a Mexico expert at the Virginia-based College of William & Mary. "This is a drum he's going to keep on banging."

But he added that beyond talking about it, there is little a future President Lopez Obrador deprived of a majority in Congress would be able to do to change the deal.

PRD accountant Mario DiCostanzo, who in 1997 was on the national council of El Barzon, a movement of debtors bankrupted by the crisis, admitted as much in an interview.

"These IPAB bonds are now obligations that Congress will have to pay for even though some radical PRD-istas say otherwise," he said. "If you leave IPAB without resources you're leaving the economy without security."

Although he suggested that a future administration could order an investigation into the episode that could lead to prosecutions, it seems that for now international markets can rest easy in the knowledge that the Mexican government honors its debts.

Marcus Bensasson is the finance editor of the Mexico City edition of the Miami Herald.