Asia overview

Author: | Published: 10 Oct 2001
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If anyone had predicted two years ago that South Korea would be the second most active securitization market in the world behind the US, most people with any involvement in the market would have questioned that person's sanity (or, at least, judgement). But towards the end of 2001, South Korea prevails as the market with the most activity and potential. With issuance exceeding $45 billion last year, South Korea has out-stripped Japan and shows no signs of slowing down. What has happened to the other markets (ex-Japan) that showed so much potential? A brief review of Hong Kong, Singapore, South Korea and China will hopefully give some insight into the reasons for the relative lack of activity.

HONG KONG

It is almost a decade since securitization was introduced to Hong Kong as a workable funding technique. The first true securitization (involving residential mortgages originated by Bank of America) closed in 1993, with some other false starts in the early 1990s. Hong Kong has the most user-friendly legal, tax and regulatory environment of any country in Asia. This has helped bring about a number of securitizations involving several different asset classes, including residential mortgages, credit cards, commercial property, consumer loans, auto loans and trade-related receivables. It used to be the case that Hong Kong companies and banks were the most active users of securitization in Asia excluding Japan. This has changed markedly over the last few years with Hong Kong now falling well behind Japan and Korea.

A significant trend in Hong Kong has been the almost complete absence of residential mortgage securitizations since 1997, other than one synthetic offering and some back-to-back issues by the Hong Kong Mortgage Corporation. There has been a relative lack of commercial mortgage backed offerings — an area of the market that was quite active until 12 months ago. Altogether, there have been seven CMBS issues in Hong Kong, however, it is generally considered that liquidity in the traditional bank lending market has substantially reduced the likelihood of any CMBS issues in the foreseeable future. Indeed, the last CMBS issue involved two commercial properties owned by the Paliburg Group. The transaction had a number of unique commercial driving factors, factors that may well have ruled out other funding alternatives.

So what has happened to the residential mortgage securitization market? It is probably safe to say that the advent of he Hong Kong Mortgage Corporation has had a dramatic effect on the likelihood that bank originators will regularly securitize their residential mortgage portfolios. However, it should not be overlooked that the financial nature of residential mortgages has changed over the last few years. Residential mortgages used to be written at a substantial margin over Hong Kong Prime (the benchmark lending rate in Hong Kong). Residential mortgages are now written at a substantial margin below Hong Kong Prime due to the intense competition between banks for market share. In the absence of external support, the interest income produced on a typical residential mortgage portfolio is not sufficient to support an offering of residential mortgage securities. Banks are keen to keep relatively low risk and relatively high-yield residential mortgages on their balance sheet. In addition, there is a significant negative equity problem in Hong Kong. It is generally thought that most residential mortgages written from 1997 through to 2000 are in a negative equity position. Notwithstanding the fact that default and delinquency ratios have remained at comparatively low levels when compared with those present in almost all other OECD countries, rating agencies, investors and third parties (such as monoline insurers) have naturally taken a cautious approach.

SINGAPORE

With a high sovereign rating, high quality assets (ie low delinquency and default ratios) and a legal system conducive to securitizations, it is surprising that Singapore has not yet produced a significant level of securitization activity. Apart from some quasi-CMBS transactions and a number of conduit funded securitizations, very few transactions have closed. The bank market, in particular, has seen little activity. This has not been through a lack of encouragement from the Singapore regulatory authorities.

In response to the recent increase in potential securitization activity in Singapore, the Monetary Authority of Singapore (MAS) has issued prudential guidelines for securitizations of loans by banks, finance companies and merchant banks in Singapore. The guidelines have clearly been based on an amalgam of the Bank of England and Hong Kong Monetary Authority guidelines and cover both the criteria for excluding assets from the balance sheet of the seller and the circumstances in which mortgage-backed securities will qualify for a 50% risk weighting. There are certain aspects of the guidelines that warrant specific comment:

  • It is clear from the guidelines that only true sale structures will achieve off-balance sheet treatment for capital adequacy purposes (ie sub-participations which remove the economic benefit of assets will not achieve off-balance sheet treatment).
  • There is considerable emphasis on maintaining clear separation between the participating bank and the SPV to limit the participating bank's reputational risk with respect to the relevant securitization transaction. In particular, the MAS guidelines provide that banks participating in a securitization transaction must not own any share capital in the SPV, including any preferred share capital. However, the MAS has subsequently issued a circular whereby it has stated that it is prepared to consider allowing participating banks to hold preference shares in an SPV subject to certain conditions, including that the amount of preference shares held is limited to 10% of the original amount of the issue.
  • To qualify as a clean sale, the beneficial interest of the securitized assets must be transferred to the SPV, with the seller having no residual beneficial interest in the assets. Although this requirement should not pose any serious concern in relation to the structures normally employed for residential mortgage securitizations, the viability of the trust structures typically used for credit card and other revolving credit securitizations may be in question. It is usual in these trust structures for the seller to acquire a beneficial interest in those receivables that do not relate to the investors' funded amount. Experience in Hong Kong suggests that imposing an intermediate SPV between the seller and the trust may satisfy the MAS guidelines, although this is something that will need clarification.
  • To achieve a 50% risk weighting for any mortgage backed securities held by banks, "the documentation for the mortgaged backed securitization must not provide that the investors will absorb more than their pro-rata share of losses in the event of arrears or default in payment of interest on, or principal of, the underlying mortgage loans". It is assumed that this will not prevent the issue of subordinated tranches of securities. However, where the MAS regards such purchase by the bank as a form of credit enhancement to the SPV, the bank will be required to deduct the purchase from its capital base.

Generally, the guidelines provide a clear and sensible treatment for both off-balance sheet treatment and 50% risk weighting for the securities issued. The more troublesome issue that has yet to be addressed in Singapore is that in relation to accommodating the Central Provident Fund interest in properties the subject of a securitization transaction. When Central Provident Fund money is used for property purchases (which is the case with over 90% of home purchases), the Central Provident Fund has a preferential position as against the mortgagee. Public sector subsidised housing (where an interest subsidy is given) is also problematic. There are also certain taxation issues that need to be resolved, most notably withholding tax which effectively eliminates the possibility of assigning loan assets to an off-shore securitization vehicle. Incorporating the securitization vehicle in a double tax treaty country (eg Mauritius or the Netherlands) can provide some relief in this regard. Creating tax neutrality for a Singapore incorporated securitization vehicle is not straightforward.

KOREA

With total issuance reportedly exceeding $45 billion, 2000 has been a record year for securitization in Korea. Korea is now in the running for the title of the most active securitization market outside the US. As we approach the end of 2001 there has been a notable shift towards cross-border issuance, perhaps as the domestic market approaches saturation point and cross-border issuance becomes comparatively more cost effective.

The Act on Asset Backed Securitization (the Securitization Act), which came into force in 1998 has undoubtedly been the driving force behind the success of securitization as a financing tool. It is the simplicity of the Securitization Act which is its key — it attempts to achieve nothing more than addressing several key legal and regulatory hurdles within a frame work of market transparency. The market is starting to see increasing levels of sophistication evidenced by increasing interest in future flow transactions, commercial paper issuance and the use of trusts and multi-issuance vehicles.

KAMCO/KDIC

Last year, in the landmark Kamco securitization, a two-tier structure was adopted to securitize a pool of restructured loans purchased by Kamco from Korean financial institutions. The same structure, with the addition of a monoline insurer (Ambac), was adopted in the recently closed KDIC securitization.

In the Kamco transaction, Kamco, as the seller, sold to the purchaser (a special purpose company incorporated in Korea) a static portfolio of restructured loans denominated in dollars and yen, together with related security interests and put options. The purchaser funded the purchase price for these assets by:

  • issuing the purchaser junior note to the seller; and
  • paying cash from the proceeds of issuing the purchaser senior note to the issuer (a securitization vehicle incorporated in the Cayman Islands).

The issuer funded the purchase of the purchaser senior note by issuing secured floating rate notes to international investors.

The purchaser entered into hedge arrangements with a swap counterparty to hedge its exposure to the risks of:

  • a currency mismatch between payments receivable in yen under loans denominated in yen and US dollar payment obligations under the purchaser senior note;
  • interest rate exposure arising as a result of differences between the rate of interest generated by the loan portfolio and the rate of interest payable under the purchaser senior note; and
  • timing mismatches between the receipt of interest under the loan portfolio and the interest payment obligations under the purchaser senior note.

The Korean Development Bank entered into a credit facility with the purchaser pursuant to which it agreed to fund defaulted assets up to pre-agreed levels. The transaction was the subject of an ABS law filing and achieved true sale treatment.

The KDIC transaction involved a very similar structure, employing an Ambac guarantee rather than a KDB credit facility. The transaction presented some unique and challenging legal hurdles. HMSF (the seller and a KDIC subsidiary) was the subject of a recent merger with an insolvent company and was itself technically insolvent as a matter of Korean law. Shortly after the closing of the transaction there was a possibility that it would be placed in liquidation. Notwithstanding these hurdles, the transaction was the subject of an ABS law filling and achieved true sale treatment.

Future flow securitizations

The recently closed Asiana ticket receivables securitization shows that future flow securitizations in Korea are possible. Indeed, it would appear to be the case that a future flow structure is the only practical way to securitize revolving credits (such as credit card receivables).

The legal position in relation to the sale of future receivables is complex. For such a sale to be recognized under Korean law the following factors will be taken into consideration by the Korean courts:

  • the number of account debtors and whether the account debtors are identifiable;
  • whether the receivables are sufficiently specific;
  • whether the receivables have a legal maturity (ie a fixed or determinable payment date); and
  • the likelihood of the receivables being generated by the seller (by reference to historic data).

In the event that a seller of receivables is liquidated under the Korean Bankruptcy Act, all property of the seller as of the date of the declaration of bankruptcy will be considered to form part of the seller's bankruptcy estate (ie those assets available to meet the claims of creditors). In determining what assets comprise the bankruptcy estate, there is a risk that the Korean courts may characterize a transfer of receivables (whether future or present) as a transfer of title to the asset for the purpose of granting a security interest (a yangdo tambo) rather than a true sale of the assets.

Under Article 563 of the Civil Code of Korea and other Korean case law, there are three elements of a transfer of title pursuant to a sale transaction which distinguish it from a transfer for the purposes of granting a security interest:

  • there must be a transfer of ownership and the payment of a purchase price;
  • there must be no secured obligations owed by the transferor to the transferee; and
  • the transferee is not obliged to transfer title to the assets to the transferor upon satisfaction of the secured obligations.

A transferee of receivables should bear all risks associated with ownership (eg the risk of defaulted receivables). If the transferee has full recourse to the transferor, the transfer is likely to be characterized as the grant of a security interest. In a securitization of future receivables, the transferee often has recourse against the transferor in certain pre-determined and limited circumstances. The Korean courts have, however, acknowledged that recourse to the transferor under limited circumstances does not necessary mean that the transaction is the grant of a security interest.

If the purchase price payment is structured so that the amount paid for the transfer is adjusted for uncollected receivables, this may be construed as shifting the risk of defaulted receivables to the transferor. However, in the case of a sale of future receivables, it may be argued that the price for the sale of future receivables (as opposed to present receivables) is difficult to determine in advance and such deferred payment is not recourse to the transferor for "defaulted" receivables but is, instead, a pricing adjustment.

Trusts/master trusts

There is an increasing interest in Korea in the use of trusts as securitization vehicles — or more accurately, bank trustees — particularly for credit card securitizations. Specific legislation enhances the analysis that the assets the subject of a securitization are isolated from the bankruptcy of the originator and the bank trustee. In addition, trusts are probably the only workable securitization vehicle where the originator retains a fluctuating interest in the assets the subject of the securitization — for example, in a credit card securitization. It would seem unlikely that multiple issuance vehicles (such as US-style Master Trusts) will be approved by the FSC in the near future.

CHINA

In 1999, the Chinese government announced the establishment of a separate asset management corporation (AMC) by each of China's four state commercial banks. With over $160 billion of non-performing loans purchased so far, there is no doubt that these AMCs have a serious problem on their hands. Up to the end of 2000, the focus of each of the AMCs appeared to be directed towards establishing accurate records of the assets purchased. Debt-to-equity swaps were employed to give the AMCs a majority (or sizeable minority) stake in a number of state-owned and private enterprises. From the start of 2001, the AMCs appear to be refocusing their activities towards disposing of the non-performing loans and equity stakes acquired. Three main exit strategies are being contemplated:

  • sale of equity stakes to domestic and foreign investors;
  • loan portfolio sales; and
  • domestic and international securitizations.

China has had a solid track record of domestic and foreign investors acquiring equity stakes in Chinese enterprises, although it is likely that the nature of some of the enterprises will cause considerable due diligence and regulatory headaches for foreign investors (in particular).

The Chinese authorities have in the recent times indicated that they are receptive to the use of securitization techniques in providing alternative funding sources for Chinese companies. While the non-performing loan problem may provide the necessary impetus to overcome the complex web of regulatory constraints potentially surrounding securitization and loan portfolio sales, uncertainties inherent in key areas of Chinese law such as the insolvency regime and asset transfer will undoubtedly mean that investors and, in the case of securitizations, arrangers, rating agencies and credit enhancers will have to be willing to display considerable flexibility and ingenuity in structuring and executing transactions in China.

CONCLUSIONS

Although recently showing some signs of life, the Hong Kong securitization market remains relatively quiet. It is likely to remain this way until the current economics of CMBS and residential mortgages are reversed.

Singapore has some significant regulatory and structural issues that need to be overcome before securitization will become a realistic financing tool. These regulatory and structural issues are no less significant than those faced in South Korea and pale into insignificance when compared with those faced in China. One questions whether there is the impetus at originator and regulator level to overcome these problems.

In addition to a dramatic increase in issuance, the Korean market has seen increasingly complex structures being employed and originators turning more frequently to cross-border transactions. The regulatory authorities have indicated a willingness to assist the development of the market, although one can only wonder whether they have the capacity to deal with the volume of transactions that are likely to close this year.

The potential for securitization in China is vast. The non-performing loan problem alone should provide the lead for the Chinese government to create a legal and regulatory environment that is conducive to securitization and loan portfolio sale transactions. Much can be learnt from the way in which the South Korean government has proactively stimulated the market.


Clifford Chance
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