The aftershocks of the systemic crisis in Mexico’s banking system that followed the peso crash of 1995 can still be felt today. At the time, the recently inaugurated government of Ernesto Zedillo implemented a series of measures and programs to avoid bankruptcy and safeguard the savings deposited in all banks. In the end, the government managed to maintain confidence in the banking system, recapitalize the banks, and restore growth in the country’s economy after its dramatic collapse in the first half of 1995.

Nevertheless, the government took many arbitrary and discretionary actions due to inexperience and the need to implement effective measures urgently. This not only left a very high domestic debt, but also a bitter aftertaste and many doubts surrounding the legality and ethics of what was done. Eight years have passed and the issue is still on the front page of most newspapers. Its ultimate resolution remains uncertain but could seriously affect Mexico’s banks, most of which now are owned by European or US institutions.

Mexico’s bank bailout became a major controversy in early 1998 when President Zedillo asked Congress to recognize all debt issued by the Banking Fund for the Protection of Savings (Fobaproa) as regular public debt. Fobaproa was the deposit insurance trust fund in charge of protecting savings, helping banks deal with non-performing assets and implementing most measures associated with bailing out the banks. Between 1995 and 1997, Fobaproa issued large amounts of debt used in programs involving swaps with non-performing assets, which banks used to reconstitute reserve levels. Mexican law states that Congress must approve in advance all public debt issued by the federal government. The Fopabroa debt, however, was not only never authorized, but could not be actually considered public debt since Fobaproa was a privately owned trust fund. The trust was owned by the banks, which had supplied all of its funds through contribution fees, and the trustee (administrator) was the Bank of Mexico.

Recognizing the Debt
The debt issued by Fobaproa, known as the “Fobaproa pagarés,” consists mostly of zero-coupon bonds that are not marketable, that is, that cannot be traded in a secondary market. As a result, a large portion of bank reserves, which consist of these pagarés, is completely illiquid. The banks wanted these pagarés to be recognized as normal public debt in order to create a secondary market and obtain badly needed liquidity. The government wanted the pagarés to be converted into public debt in order to exchange them for longer-term and lower interest bearing bonds, and at the same time, provide legal guarantees. High-ranking government officials signed the pagarés, which could have led to possible criminal charges and a non-recognition of the debt. As a result, it made sense for the government to solicit authorization from Congress to convert the pagarés into normal public debt.

The problem was that the government’s party, the PRI, lost its majority in Congress in 1997 for the first time in 68 years. The main opposition party, the PAN, was not going to allow the government to get away with issuing the equivalent of at least $50 billion dollars without previous authorization. After intense negotiations, Congress approved a new bank savings protection law, which included the creation of a new deposit insurance institute, called IPAB (Institute for the Protection of Bank Savings). IPAB was authorized to issue public debt up to a limit approved each year by Congress, carry out the equivalent functions of the Resolution Trust Corporation established in the US in 1989, and be responsible for substituting the Fobaproa pagarés for new IPAB pagarés. The pagaré substitution, however, was to be carried out only after an audit was completed of all operations involved in the bailout to determine if illegal or irregular operations were involved in the non-performing assets used in exchange for the original Fobaproa pagarés. Once the exchange was finalized, Fobaproa would disappear.

The savings protection law includes 21 articles that govern the transition from Fopabroa to IPAB. The fifth transitory article became famous because it required that the audit be carried out within six months – a deadline that expired in July 1999. Congress hired a Canadian expert, Michael Mackey, to carry out the audit in order to find irregularities and illegal operations. Mackey finished the audit in time and handed over his final report to Congress. Since then, four years have elapsed and the pagaré substitution has not been consummated. If the new law stipulates exactly what and when has to done, why has the issue remained unresolved?

The problem originated in an inexplicable failure by Congress to spell out to Mackey exactly what was needed. It also chose to hire a foreigner who lacked the required legal expertise to determine the legality of some of the transactions between Fobaproa and the banks. Mackey ended up lumping together all operations that he found to be questionable and labeled them as “reportable.”

The term “reportable, however, lacks any legal definition and has been interpreted by many lawyers to be practically meaningless. Consequently, the banks argue that the required audit has been completed but found nothing relevant or new, implying that the pagaré substitution should be carried out involving the full sum. The banks also contend that a new audit would be politically motivated with the sole purpose of finding whom to blame for the enormous debt that was created. Prior to the Mackey audit, the banks were involved in at least three previous audits carried out by Fobaproa and the National Banking Commission. The Mackey audit found practically nothing that had not been discovered in previous audits.

Operational Definitions
More than anything else, at issue are the legal definitions of many of the operations. Under the original rules set by the Technical Committee of Fobaproa, the banks could not use certain loans in exchange for Fobaproa notes in the “Capitalization and Loan Portfolio Purchase Program.” These included non-performing assets that were classified as “E” (maximum) risk and loans considered to be illegal, given that they involved credit to shareholders to buy stock. In addition, the penalty interest proportion charged on loans could not be included in the transactions. Other operations, involving related lending, remained unclear. To make things even more complicated, the Technical Committee changed its own rules over time in a discretionary and arbitrary manner. Given that there was no law governing Fobaproa, it had a clean slate in establishing its own rules. The result is a very weak legal underpinning governing most operations.

Certain congressmen, lawyers and the board of directors of IPAB insist that the Mackey audit fell far short of its purpose and that another audit is required, which would involve more specific and transparent rules. Some even argue that the Mackey report cannot be considered a formal audit given that information was withheld and Mackey worked under pressure and threats. The other side wonders why Congress agreed to pay Mackey a $20 million honorarium if his report did not qualify as a complete audit.

Over the years, the issue has remained unsolved and has been bouncing back and forth in courts. About two years ago it was made public that Mackey’s audit included 24 individual bank reports that contained detailed analyses of how each bank negotiated with Fobaproa, but these reports were never made public. For example, the report for Banamex states that the bank did not qualify to participate in the Capitalization and Loan Portfolio Purchase Program under the original rules set forth by the Technical Committee. It was also found to have paid a dividend to stockholders before it was eligible to do so and at the same time, exchanging non-performing assets for Fopabroa notes.

The auditing branch of Congress decided to get involved in the investigation and initially found contingencies amounting over $4.5 billion dollars in questionable operations. If these are not clarified, they could be applied against the banks, reducing the amount of new notes that IPAB would substitute for the Fopabroa pagarés. While some of the issues have been resolved, there is still controversy involving what constitutes penalty interest payments. To make matters worse, the Finance Ministry has forced members of IPAB’s board to resign, replacing them with persons more apt to support the banks’ view.

The problem has become even more complex for many reasons, including a time constraint: the bulk of the Fobaproa notes come due in 2005. Unless the issue is resolved before then, the government will face a potentially dangerous liquidity crisis that would have to be negotiated in the 2005 budget negotiations. Given that it is unlikely that Congress would approve payment for these notes, some sort of a judicial settlement would be required.

Upon review of the bank reports, the board of IPAB decided to formally request a new audit, involving the four surviving banks (the rest were taken over by the government or merged with others in order to avoid bankruptcy). The banks immediately filed a petition to block the audit, which was successfully granted in May 2002. A higher court finally ruled against the banks, lifting the block, and soon after Congress approved a unanimous resolution requesting the audit and exhorting both IPAB and the banks to resolve their differences. The banks, however, returned to the same judge and got another court order to block the audit. Now IPAB is again petitioning the same higher court to once again remove the block.

Looking for Answers
Over the past few years, most of the irregularities and inefficiencies involved in the bank bailout have surfaced, as well as the abuses committed by the banks. This has led to dwindling support for the banks and a public perception that the bank bailout bill must be reduced. While the issue will finally be resolved by the courts or by a negotiated settlement, it is most likely that the banks will have to absorb a discount over the gross value of the outstanding Fobaproa notes. The remaining question is how much?

For many Mexicans the issue at stake is not simply how many bonds IPAB will wind up absorbing, but rather a clarification and public disclosure of how the 1995 bank bailout was executed. This includes unveiling cover-ups, errors, ambiguities and questionable actions carried out by Fobaproa, the banks and the government. It also means highlighting the extremely weak and vulnerable judicial framework that permitted so much abuse in the first place. Only then can we be best assured that the issue will be put to rest. LF

Jonathan Heath is an economic consultant based in Mexico City and a member of the Latin Source network of independent consultants.