Asset Securitization, Regulation and Its Practice in China

Part I What Is Securitization

1. Definition of Securitization

Asset securitization is a structured finance technique that allows for credit to be provided directly to market investors rather than through financial intermediaries. The term securitization[1] refers to the process of converting assets with predictable cashflows into securities that can be bought and sold in financial markets, a course of refinancing a diversified pool of illiquid present or future receivables financial and/or non-financial receivables through the issue of structured claims into negotiable capital market paper issued to capital market investors.

According to Dodd Frank Act[2], the term asset-backed security (in a broad sense) means a fixed-income or other security collateralized by any type of self-liquidating financial asset (including a loan, a lease, a mortgage, or a secured or unsecured receivable) that allows the holder of the security to receive payments that depend primarily on cash flow from the asset. The act explicitly excludes any security issued by a finance subsidiary held by the parent company or a company controlled by the parent company, if none of the securities issued by the finance subsidiary are held by an entity that is not controlled by the parent company.

Comparison definitions between DFA and SIFMA will lead us to a clear observation of three key components of asset securitization: a pool of non-liquid assets, securities issued by a specially created investment vehicle (Special Purpose Vehicle, SPV) backed by the assets, and investors who purchase such securities. In principal, securitization serves as a refinancing mechanism to diversify external sources of funding and to transfer risks. Conceptually, asset securitization converts regular and classifiable cash flows from a diversified portfolio of illiquid present or future receivables of varying maturity and quality into negotiable capital market instruments issued by a single-asset SPV. So securities are contingent claims on a designated portfolio of securitised assets, which can be divided into different slices of risk to appeal to different investors.

Asset securitization come in two broad classes of securities: debt-like (secured) instruments and equity. Whilst the holders of debt-like notes establish prior claim to the underlying reference portfolio of loans in order of agreed seniority, issuers and/or asset originators frequently retain a residual equity-like class as illiquid first loss position, required by rating agencies as bad debt provision for expected loss.

Securities created by securitizing mortgage loans are known as mortgage-backed securities (MBS), and those collateralized by other types of assets, such as student loans, small business loans, or credit cards, are generally referred to as asset-backed securities (ABS). In theUS, MBS may be further divided into two general categories: agency MBS, which is issued by Government-Sponsored Enterprises (GSEs), like Fannie Mae and Freddie Mac; and private MBS, which is issued by private financial institutions.

Securitization could be categorized into a traditional securitization or a synthetic one. A traditional securitization[3] is a structure where the cash flow from an underlying pool of exposures is used to service at least two different stratified risk positions or tranches reflecting different degrees of credit risk. Payments to the investors depend upon the performance of the specified underlying exposures, as opposed to being derived from an obligation of the entity originating those exposures. The stratified structures that characterize securitizations differ from ordinary senior/subordinated debt instruments in that junior securitization tranches can absorb losses without interrupting contractual payments to more senior tranches, whereas subordination in a senior/subordinated debt structure is a matter of priority of rights to the proceeds of liquidation.

A synthetic securitization[4] is a structure with at least two different stratified risk positions that reflect different degrees of credit risk where credit risk of an underlying pool of exposures is transferred, in whole or in part, through the use of funded (e.g. credit-linked notes) or unfunded (e.g. credit default swaps) credit derivatives or guarantees that serve to hedge the credit risk of the portfolio. Accordingly, the investors’ potential risk is dependent upon the performance of the underlying pool.

Sometimes people are confused between covered bonds and securitization. It is important to distinguish between these two. A covered bond is a corporate bond with one important enhancement: recourse to a pool of assets that secures or covers the bond if the originator becomes insolvent. Liquidity is the only reason to securitize through covered bonds, since the risk or the capital requirements do not change with the issue, and the assets backing the covered bond remain in the balance sheet. However, in the case of the securitization, banks might also securitize so as to transfer risk and/or arbitrage capital requirements.

For investors, one major advantage to a covered bond is that the debt and the underlying asset pool remain on the issuer’s balance sheet, and issuers must ensure that the pool consistently backs the covered bond. In the event of default, the investor has recourse to both the pool and the issuer.

2.  A Brief History of Asset Securitization[5]

In February 1970, the U.S. Department of Housing and Urban Development created the first transaction using a mortgage-backed security. Under the deal, the Government National Mortgage Association (GNMA or Ginnie Mae), acting as the originator, sold securities backed by a portfolio of mortgage loans.

Year 1985 saw for the first appearance of ABS, where a class of automobile loans was securitized. Marine Midland Bank originated this first auto loan deal worth $60 million which was securitized by the Certificate for Automobile Receivables Trust (CARS, 1985-1).

The first bank credit card sale came to market in 1986 with a private placement of $50 million. This transaction demonstrated to investors that, if the yields were high enough, loan pools could support asset sales with higher expected losses and administrative costs could also enter market. Starting in the 1990s, securitization was applied to sectors of the reinsurance and insurance markets including. The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are loans targeted to low and moderate income borrowers and neighborhoods.

Europe is a late comer in securitization, and the first securitizations of mortgages appeared in theUKin the late 1980s. The European market took off since early 2000s, thanks to the innovative structures implemented across the asset classes, such as UK Mortgage Master Trusts.

As a result of the subprime crisis from 2007-09, the bond market backed by securitized loans has become very weak, and investors are reluctant to participate in this market unless the bonds are guaranteed by a credit-worthy third party. That in turn leads heightened interest rates for loans that were previously securitized such as home mortgages, student loans, auto loans and commercial mortgages. Many industry bodies, like the IIF and SIFMA, call for to revive the market.

3. Structure, Pooling and Transfer

It is without doubt that securitization structure is very complex. Each securitization transaction will be specially tailor- made to suit for its particular needs. However the basic structure remains more or less the same, as shown in Chart 1 below.

Chart 1: Securitization Structure

The originator initially owns the assets engaged in the deal. This is typically a bank looking to seek funding. According to traditional corporate finance concepts, such a company would usually have three options available: a loan, bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company, while loan or bond financing is often prohibitively expensive. The consistently cash-generating asset part of a company could have a much higher credit rating than the company itself. Where the originator is a bank that must meet capital adequacy requirements, the structure is usually more complex because a separate company is to be established to buy the assets.

A suitably large portfolio of assets is pooled and transferred to an SPV (the issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are transferred to the issuer, there is normally no recourse to the originator (bank remoteness). The true sale effectively ring fences the pooled assets, separating securitized assets from other assets of the originator. The true sale works both ways, protecting investors as well as the originator. If the asset transfer is not a true sale, investors are vulnerable to claims against the originator, including the claims of a bankruptcy trustee that might be appointed if the originator were to file bankruptcy. A true sale also protects the originator from claims by investors. If the pooled assets are sold into an SPV, the investor can only seek payment from that entity, not from the general revenues of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to only those necessary to complete the issuance of securities.

In order to purchase the assets from the originator, the issuer SPV issues tradable securities which will be sold to investors through a private placement or in the open market. The performance of the securities is then directly linked to the assets. To facilitate the sales, the securities will be rated by a credit rating agency to help investors make a more informed decision (in theory at least).

Unlike conventional corporate bonds, securities under a securitization deal are credit enhanced, meaning their credit quality is increased over that of the originator’s unsecured debt or underlying asset pool. This increases the likelihood that the investors will receive cash flows to which they are entitled, and thus causes the securities to have a higher credit rating than the originator. Credit enhance is achieved through external enhancement (such as a third-party guarantee, or surety bonds) or with internal enhancement (security tranches, over collateralization, or excessive interest spread accounts).

Individual securities are often split into tranches, and each tranche has a different level of credit protection or risk exposure from another: There exist at least two layers of securities. A senior class of securities have first claim on the cash that the SPV receives and one or more junior subordinated classes function as protective layers for the senior class. The more junior classes only start receiving repayment after the more senior classes receive repayment. The most junior class (often called the equity class) is the most exposed to payment risk, which is usually retained by originators to offer extra protections. In some cases the equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the other classes have been paid.

In addition to subordination, credit may be enhanced by a reserve or spread account or over-collateralization. A reserve or spread account is kept after expenses such as principal and interest payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPV expenses are greater than its income. This residual amount normally reverts to the seller as additional profit[6]. However, it is also commonly available to the trust to cover unexpected losses.

A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The servicer can often be the originator, because the servicer needs very similar expertise to the originator and would want to ensure that loan repayments are paid to SPV. The servicer can significantly affect the cash flows to the investors because it controls the collection policy, which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on the performance of the collateral pool, the credit enhancements and the probability of default.


Part II             Benefits and Risks of Securitization

1. Benefits of Securitization

Funding costs and asset-liability management might be the top concern for asset securitization. Because of the credit enhancements, the rating of asset-backed securities is often higher than that of the originator. For example, a small bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans to remain with the bank, the borrowers may effectively be paying higher interest. This might be the number one reason to securitize a cash flow and can have tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple hundreds of basis points. Essentially, in most banks and finance companies, the liability book or the funding is from deposits. Their maturity is often short-lived, more likely shorter than one year. On the asset side, most assets (loans) will be more than one years. Securitization allows such banks and finance companies to create a self-funded asset book, thus great alleviate the asset liability mismanagement.

Securitization might ease capital requirements and lock in profits. The main benefit from asset securitization is that it enables banks to pass the risks of lending on to other parties and remove assets from their balance sheets, thus freeing capital resources to back new lending which would otherwise be beyond their capacity. The funding and liquidity benefits of the securitization process derive from the conversion of illiquid assets into liquid funds available for additional lending. Some firms, especially banks, are subject to capital adequacy requirement and have a limit or range that their leverage is allowed to be. By securitizing some of their assets, which qualify as a sale for accounting purposes, these firms will be able to remove assets from their balance sheets while maintaining the earning power of the assets. Securitization makes it possible to transfer risks from an entity that does not want to bear it, to one that does. Interest rate risk can be reduced by passing it on to the investors. A bank wishing to extend its lending but not having funds of adequate maturity can avoid a maturity mismatch by securitizing the new loans. On the other hand, for a certain line of business, the total profits have not yet emerged and thus remain uncertain. Once the assets under line have been securitized, the level of profits has now been locked in for that company.

In addition, securitization may transfer risks. A bank, which is heavily exposed to a particular region or economic sector, could transfer part of its loan portfolio and also could purchase with the proceeds other types of securitizations, thus achieving a more diversified loan portfolio.

Advantages to investors: highly rated entities have always been the rarity in the financial world. Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, therefor provide good investment opportunities for risk-averse institutional investors, or investors required to invest in only highly-rated assets. Hedge funds as well as other institutional investors tend to like investing in bonds created through securitizations because they may be uncorrelated to their other bonds and securities, therefore achieve a diversified portfolio. Critics have suggested that the complexity inherent in securitization can limit investors’ ability to monitor risk, and that competitive securitization markets with multiple securitizers may be particularly prone to sharp declines in underwriting standards. Private, competitive mortgage securitization is believed to have played an important role in theU.S.subprime mortgage crisis.

There are a few disadvantages to issuer. Even though it lacks empirical evidence, securitization may reduce portfolio quality. One could argue that, if the AAA risks are being securitized out, this would leave a materially worse quality of residual risk. Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating fees and ongoing administration. Securitizations often require large scale structuring, and thus may not be cost-efficient for small and medium transactions.

2. A Case Study

In this section we examine the leverage effect of securitization on the return on equity for a true sale structure, which by definition changes the balance sheet composition of the asset originator. For the purpose of simplicity, let us assume that the issuer holds 8% equity[7] and shareholder require 15% return on equity at a debt-to-equity ratio of 0.08/ 0.92 ≈ 8.7%。By accepting a first loss position (equity portion) of 5%, the issuer now holds 5% instead of 8% equity after completion of the securitization transaction.

In the calculation, we further suppose the rating for the issuer is “A”, while the securities under the securitization with proper credit enhancement get a rating of “AAA”. The company may finance its assets either through conventional corporate bond or through securitization. We assume that for an A-rated company, market will demand an interest spread of 80 bps, while 50 bps is needed for an AAA- rated security. The default rate for the pooled assets is 1% under both conditions.

We calculate the net return before cost of equity (COE) by subtracting the total direct cost (5.42% /5.78% respectively) from return of underlying assets (7%). In the case, the net return under conventional funding is 1.58%, much higher than 1.23% under securitization. Dividing this result by total equity capital yields the return on equity (ROE), which clearly indicates a higher figure of securitization (24.50%) compared to conventional on-balance sheet funding (19.80%).

            Table 1: Securitization Impact on Performance

  Conventional Funding Securitization
Debt capital

92.00%

95.00%

Equity Capital

8.00%

5.00%

Total Capital

100.00%

100.00%

     
Return of underlying assets

7.00%

7.00%

Risk-free rate

4.00%

4.00%

Expected Return of Equity

15.00%

15.00%

Interest Rate spread

0.80%

0.50%

     
Weighted cost of equity (CoE)

1.20%

0.75%

Weighted cost of debt (CoD)

4.42%

4.28%

Weighted Average Cost of Capital (WACC)

5.62%

5.03%

Expected Credit loss (EL)

1.00%

1.00%

Fees of Securitization

0.00%

0.50%

Total Direct cost (CoD + EL+Fees)

5.42%

5.78%

     
Net return    
    before CoE

1.58%

1.23%

    after CoE

0.38%

0.48%

Return on Equity (RoE)

19.80%

24.50%

3. Risks Associated with Securitization

Credit/default Risk. Default risk is generally defined as a borrower’s inability to meet interest payment obligations on time. For securitization, default may occur when cash inflow from the underlying assets are not sufficient to met the obligation in its prospectus. A key indicator of a particular security’s default risk is its credit rating. Different tranches within the securitization are rated differently, with senior classes of most issues receiving the highest rating, and subordinated classes receiving correspondingly lower credit ratings. The granularity of pools of securitized assets is a mitigant to the credit risk of individual borrowers. Unlike general corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are time-dependent and structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit risk of all tranches of structured debt improves.

In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an under-pricing of credit risk. Off balance sheet securitizations are believed to have played a large role in the high leverage level ofU.S.financial institutions before the financial crisis, and the need for bailouts.

However, the credit crisis of 2007–2009 has exposed a potential flaw in the securitization process. Loan originators retain no residual risk for the loans they undertake, but collect substantial fees on loan issuance and securitization, which doesn’t encourage stringent undertaking criteria or any further improvement.

Prepayment risk. The majority of revolving securitization is subject to some degree of early amortization risk. The risk stems from specific early amortization events or payout events that cause the security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying borrowers, insufficient excess.

Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate securitization move in response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy. Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while auto loans, student loans, and credit cards are generally less sensitive to interest rates.

Moral hazard: Investors usually rely on the deal manager to price the securitizations’ underlying assets. If the manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal’s excess spread.

Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes insolvent. This risk is mitigated by having a backup servicer involved in the transaction.


Part III           Systemic Implications and Regulatory Development

1. Implications for financial systems

Securitization allows banks to transform into liquidity assets that otherwise would be stuck on the balance sheet until their maturity. With new funds raised, they can increase lending. At the same time, risk transfer has increased significantly thanks to securitization. In fact, some banks are becoming more and more mere originators of loans and distributors of their risk: soon after the loan has been granted, it is packaged into a bundle of other mortgages, given a risk assessment by a rating agency and sold out through securitization. Securitization is, thus, shaping a new type of banking, one where relationship with the costumer is fading in favor of a transaction-based bank where its main proceeds come from the fees they earn originating and packaging loans.

This “originate to distribute” model is not free of risks as the recent turmoil in financial markets has shown. There are two main problems. The first one is the incentives that the lender has to properly screen and monitor borrowers, since it is going to get rid off the credit risk quickly. A bank selling loans must continue to convince loan buyers of its commitment to evaluate the credit quality of borrowers by maintaining a portion of the loan’s risk. That makes asset securitization incentive compatible. The fact that some loan originators might have shed off all the credit risk in a loan securitization made the lack of confidence from investors in those asset securitization an accident to happen. The second problem is an excessive reliance on the wholesale market to fund lending growth (as in Northern Rock). The fact that the alternative “originate to maturity” model (i.e. the bank loan is kept in the balance sheet until maturity) has been eroded during the last years makes even more compelling to understand why banks securitize.

Moreover, the securitization process might lead to some pressure on the profitability of banks if non-bank financial institutions exempt from capital requirements were to gain a competitive advantage in investment in securitised assets. Although securitization can have the advantage of enabling lending to take place beyond the constraints of the capital base of the banking system, the process could lead to a decline in the total capital employed in the banking system, thereby increasing the financial fragility of the financial system as a whole, both nationally and internationally. With a substantial capital base, credit losses can be absorbed by the banking system. But the smaller that capital base is, the more the losses must be shared by others. This concern applies, not necessarily in all countries, but especially in those countries where banks have traditionally been the dominant financial intermediaries.

While asset transfers and securitization can improve the efficiency of the financial system and increase credit availability by offering borrowers direct access to end-investors, the process may on the other hand lead to some diminution in the importance of banks in the financial intermediation process. In the sense that securitization could reduce the proportion of financial assets and liabilities held by banks, this could render more difficult the execution of monetary policy in countries where central banks operate through variable minimum reserve requirements. A decline in the importance of banks could also weaken the relationship between lenders and borrowers, particularly in countries where banks are predominant in the economy.

2. Regulation Development of Securitization

Banks need to hold a minimum level of regulatory capital against risks. UnderBaselI framework, capital is a very rough function of the level of riskiness in their assets. For instance, a loan to a firm need 8% of capital no matters how risky the firm is. Risk insensitivity might be the main thrust for great efforts undertaken by the Basel Committee on Banking Supervision (BCBS) to overhaul the capital regulatory framework. That process ended up in the Basel II framework in 2004, in which the capital requirements of banks will be better aligned with the risk profile of their portfolios. In this way, they will be obliged to hold a higher level of capital for loans granted to high-risk borrowers. However, thanks to securitization it is possible that banks sell a part of those loans (in particular that of better quality) and with the proceeds, lend to riskier borrowers so as to increase the expected returns of their portfolio with no change in capital requirements. Table 2 summarizes the regulatory developments in the field of securitization.

Table 2:  BCBS Regulations on Assets Securitization

 

Issue Date Document
September 1992 Asset Transfers and Securitization
June 1999 The new Basel Capital Accord First Consultative Paper
January 2001 The NewBaselCapital Accord Second Consultative Paper and Asset Securitization: Supporting Document to the NewBaselCapital Accord
October 2001 Working Paper on the Treatment of Asset Securitizations
October 2002 Second Working Paper on Securitization
April 2003 The NewBaselCapital Accord Third Consultative Paper
January 2004 Changes to the Securitization Framework
June 2004 International Convergence of Capital Measurement and Capital Standards: a Revised Framework
June 2006 International Convergence of Capital Measurement and Capital Standards, a Revised Framework Comprehensive Version
July 2009 Enhancements to the Basel II framework
December 2010 A global regulatory framework for more resilient banks and banking systems
June 2011 A global regulatory framework for more resilient banks and banking systems (revised version)

The subprime crisis exposed inherent deficiency within the Basel II. The international community took step to correct those weaknesses. Mainly the goals are achieved through strengthening the treatment for certain securitizations in Pillar 1 (minimum capital requirements), and introducing higher risk weights for resecuritizations exposures (so-called CDOs of ABS) to better reflect the risk inherent in these products, as well as raising the credit conversion factor for short-term liquidity facilities to off-balance sheet conduits. The BCBS also require that banks conduct more rigorous credit analyses of externally rated securitization exposures.

It is generally expected that tougher treatment of securitization exposures under Basel II.5 (effective December 2010) and Basel III will raise the costs of securitization.  These include changes to both capital and liquidity requirements.

2.1 Capital

In July 2009, the BIS announced new capital requirements for banks in relation to market risk as part of Basel II.5.  The specific changes to banks’ treatment of securitization exposures include:

  • More conservative collateral haircuts for securitization collateral with respect to counter party exposure.  Basel II did not require explicit haircuts for securitization exposures.  Under Basel III haircuts for securitization exposures will be higher than for other types of collateral in the same rating category and with similar maturity profiles e.g. haircuts are two times that of corporate bonds.  In addition, resecuritizations, irrespective of credit ratings, are not eligible collateral.
  • Specific risk haircuts for securitization exposures when calculating capital treatment related market risk.  Basel III will require that banks treat securitization exposures the same when calculating market risk whether they are held in the trading or banking book.  Previously, Basel II allowed for lower capital charges for securitizations in the trading book than those in the banking book giving raise to capital arbitrage opportunities. Moreover, only the standardized approach may be applied when calculating specific risk capital charges.  Specific risk capital changes under the standardized approach will be higher for securitization exposures than for similarly rated government and corporate securities.  However, there will be an exemption for correlation trading books from the full treatment for securitization positions.  They would qualify either for a revised standardized charge or a capital charge based on a comprehensive risk measure.

In September 2010, the BIS announced further new and stricter capital requirements for banks. The change in treatment of securitization exposures when calculating capital requirements is:

The application of a 1250% risk weight to lower rated (BB+ or below) and unrated securitization exposures.  Basel II required banks to deduct certain unrated or non-investment grade securitization exposures from regulatory capital (50% from Tier 1 capital and 50% from Tier 2 capital).  The overall increase in the bank’s overall risk-weighted assets affects several capital ratios.  The addition of some bank securitization exposures with a 1250% risk-weight may well force banks to raise additional common equity to maintain the increased common equity requirement under Basel III.

2.2 Liquidity

In December 2010, the BIS published its final reforms to strengthen liquidity risk management.  The liquidity framework sets out two minimum standards for funding liquidity:

Securitized assets are generally not considered liquid assets under either of those ratios.  The LCR is defined as the ratio of the bank’s stock of high-quality liquid assets divided by its total cash outflows over the next calendar days.  The LCR must be at least 100%.  Apart from market securities issued by public sector entities (PSEs) e.g. Fannie Mae and Freddie Mac which may (under supervisory approval) be considered Level 2 assets (subject to a 15% haircut and are limited to 40% of the total stock of liquid assets after haircuts), all other asset backed securities are not considered liquid assets.  In addition, with respect to the cash outflows component of the LCR, asset backed securities are considered a 100% cash outflow as it is assumed the re-financing market will not exist.

The NSFR is defined as the ratio of the bank’s available amount of stable funding (ASF) divided by its required amount of stable funding (RSF).  Encumbered assets including those backing ABS on the balance sheet receive a 100% RSF unless there is less than a year remaining in the encumbrance period.

Basel III liquidity requirements can be considered rather punitive for securitization.  Although covered bonds are also considered 100% cash outflows for purposes of the LCR and assets backing covered bonds are generally considered encumbered assets for purposes of the NSFR, unlike ABS, qualifying covered bonds  rated AA- or higher are included as Level 2 liquid assets for the LCR requirement.  This begs the question of why the liquidity requirements do not distinguish between securitizations with high credit ratings with below investment grade securitization.  Some note that traditional high quality lines of business e.g. vanilla senior securitization performed well throughout the crisis.  It should also be noted that for purposes for capital i.e. application of risk weights, the BIS does distinguish between above and below investment grade (and unrated) securitization exposures.

ForU.S.banks implementing Basel II, such changes give subordinate tranches of securitizations—and all resecuritizations— significantly higher capital weightings. However, investment-grade tranches receive more favorable treatment, particularly those classified as “granular,” or well diversified. These changes will lower charges for most securitizations (e.g. Chart 9), but discourage securitization of lower-quality loans and re-securitizations. For example, an originating bank owing $100 million of loans would face a capital change of $8 million (or 8%). If the loans were securitized, with the AAA tranches receiving 90% subordination, the capital charge to a bank holding such securitized products would be only $0.73 million. Hence the changes to capital weightings under Basel II in and of themselves

should not present an obstacle to reviving securitization markets; however, their impact when combined with that of the accounting changes of SFAS 166/167 and the risk retention measures noted below could be considerable, particularly for U.S. issuers (SFAS 166/167 will bring U.S. accounting standards closer to IFRS, which already requires far more extensive consolidation of securitization transactions).

Many market participants estimate that the aggregate impact of these three sets of changes could drive up capital requirements forU.S.issuers dramatically—making other means of bank funding such as traditional customer deposits markedly more attractive. However, it is not clear if these traditional sources could satisfy the current funding gap.

2.3 Accounting

In order for an originating bank to remove a pool of securitised assets from its balance sheet for purposes of calculating risk-based capital, the bank must transfer the assets legally or economically via a true sale[8], e.g. novation, assignment, declaration of trust, or subparticipation. More specifically, a clean break has occurred only if:

(a) The transferred assets have been legally isolated from the transferor; that is, the assets are put beyond the reach of the transferor and its creditors, even in bankruptcy or receivership. This must be supported by a legal opinion;

(b) The transferee is a qualifying SPV and the holders of the beneficial interests in that entity have the right to pledge or exchange those interests; and

(c) The transferor does not maintain effective or indirect control over the transferred assets.

Clean-up calls should represent a relatively small percentage of the overall issuance of securities backed by the securitised assets. If such call arrangements are not a relatively small percentage of the total security issuance or if the sponsoring bank wishes to exercise the clean-up call at a level greater than the pre-established level, then the bank should consult with its national supervisor prior to exercising the call.

If the minimum requirements described above are not met, then the securitised assets must remain in the originating bank’s risk-weighted assets for purposes of calculating its risk-based capital ratios – even if the transaction otherwise would be treated as a “true sale” under the home country’s accounting or legal systems.

Accounting standards govern when such a transfer is a sale, a financing, a partial sale, or a part-sale and part-financing. In a sale, the originator may offload the transferred assets from its balance sheet; in a financing, the assets should remain the property of the originator (as the case for covered bonds). Under US accounting standards, the originator achieves a sale by being at arm’s length from the issuer, in which case the issuer is classified as a qualifying special purpose entity or “qSPE”. Because of the complexity of securitization, the originator typically needs the help of an investment bank (the arranger) for proper structuring the transaction.

The accounting changes of SFAS 166/167 For U.S. banks, SFAS 166 and 167 have raised the bar for de-recognition and consolidation of assets, which is at the heart of securitization. This could in some cases trigger consolidation of underlying loans on balance sheet. The criteria for determining whether consolidation is required are based on two key questions: first, whether an institution has or could have the power to significantly impact the economic performance (i.e., of underlying loans) of a securitization, and second, whether it has the right to receive benefits or absorb losses. If the answer to both these questions is yes, then the institution must consolidate the underlying loans of the securitization on its balance sheet. Firms that must consolidate will need to retain capital against these assets on their balance sheets.


Part IV            Securitization in China

1. Summary of Securitization in Chinese market

As early as in the early 1990s,Chinabegan the exploration of asset securitization. In 1992 Hainan Development Construction Corporation issued RMB200 million in real estate investment bonds. In April 2004, it was the first time that asset securitization was utilized to dispose non performing loans (NPLs) when ICBC Ningbo Branch disposed assets worth of RMB2.602 billion. Strictly All those securities are not securitization, but they help to foster further market development (please refer to Table 3 for relevant developments).

Table 3: Milestones forChina’s Securitization Development

Year

Event

1992 Hainan Development Construction Corporation issued RMB 200 million investment bond,  using capital from sale of land and interests of depots as future ash flow from 800 acre land
1994 The People’s Republic ofChina’s Company Law was promulgated
1996 Guangdong Zhuhai Highway Ltd. Issued $200 million securitization in US
1999 The People’s Republic ofChina’s Contract Law was promulgated
2000 China Development Bank (CDB) and Industrial and Commercial Bank of China (ICBC) were designated as pilot banks to issue securitization
2000 Four Asset Management Corporations (AMCs) were established to purchase NPLs from the big four Chinese banks
2001 The People’s Republic ofChina’s Trust Law was promulgated
2002 PBOC issued Provisional Rules on Entrusted Funds Management of Trust and Investment Companies
2003 China Cinda AMC sold NPLs to Deutsche Bank
2003 China Security Regulatory Commission (CSRC) issued Interim Rules on  Asset Management Business for Securities Companies Clients
2004 Huarong AMC and ICBC utilized trust-based structure in quasi-securitization transactions to dispose of NPLs
2005 PBOC and CBRC jointly released the Administrative Rules of Pilot Projects of Credit Assets Securitization
2005 CBRC released the Interim Regulatory and Supervisory Rules on Pilot Projects of Credit Assets Securitization for Financial Institutions
2005 CDB and CCB were designated as first batch of pilot banks to conduct asset securitization, with total quota of RMB10 billion
2005 China Unicom issued short-term securitization backed by CDMA rental and raised RMB 9.5 billion
2005 CDB issued short-term industrial loan securitization of RMB 5.73 billion
2005 China Construction Bank (CCB) issued long-term mortgage loan securitization of RMB 3.04 billion
2007 The People’s Republic ofChina’s Property Law was promulgated
2007 China Merchant Bank, Industrial Bank and Shanghai Pudong Development Bank were designated as the second batch of pilot banks to conduct asset securitization, with total quota of RMB60 billion.
2010 CSRC issued the Interim Guideline on Pilot Business of Asset securitization Business for Securities Companies
2010 CBRC issued the Guideline of Capital Calculation for Asset Securitization Exposure for Commercial Banks

There are two separate securities markets inChina, the National Inter-Bank Bond Market (NIBBM) which is supervised by the PBOC, and the two local stock exchanges, which are supervised by the CSRC. Asset securitizations of banks and non-bank financial institutions are issued and traded in the interbank market, and their activities are regulated and supervised by the PBOC and the CBRC. On the other hand, corporate securitization, which is regulated under the CSRC as Special Assets Management Plan (SAMP), is issued and traded in stock exchanges. Such a segmented market severely affects the pace of development of securitization. Since most institutional investors are NIBBM participants and NIBBM dominatesChina’s bond market, PBOC’s interbank market appears to be the ideal place for securitization.

Year 2005 witnessed a comparatively rapid development in securitization market. The most important effort has been the joint administrative decree in April 2005 by the PBOC and the CBRC on the Administrative Rules of Pilot Projects of Credit Assets Securitization (the Rules). In the absence of other matching laws, this decree sets out a relatively complete framework for the securitization process. Prior to the Rules, the Chinese legal system could not accommodate securitization projects because it was unlawful for SPVs to hold assets and issue securities according toChina’s Company Law. However, the Rules do not carry the same authoritative weight as laws. In times of conflict, laws will prevail over the Rules.

As a result, the scale of security issuance in 2005 exceeded total volume of the previous 10 years. In March 2005, the CDB and the CCB were allowed to carry out the pilot securitization of corporate loans and mortgage. Combined, two pilot bank issues, one MBS and one CLO, raised nearly USD 1 billion. Such securities are now trading in the NIBBM. Another issues by a non-bank corporate originators raised more than $1 billion, though a bank guarantee was used for credit enhancement. The non-bank deal took place entirely outside the PBOC/CBRC framework mentioned above, with the securities traded on theShanghaistock exchange (please refer to Case Studies below for details).

The global financial crisis caused by the subprime turmoil in theUSled to a reasonable argument that securitization did not function as well as it should have, instead, it encouraged high risk lending and distributed risks globally, with the help of derivative products. With such a mentality, the Chinese securitization market was practically suspended in 2008.

In order to counter negative impacts from global financial crisis, Chinese banks grants huge amounts of loans to local governments financial vehicles (LGFVs), the amount of which could reach RMB 8 trillion. It is of no question that part of those LGFVs will become bad debts, and there are a lot of suggestions that securitization could be tapped to offload these burden from banks. On the other hand, Basel III has tightened the capital requirements for banks, and banks are eager to find way to raise money or streamline its balance sheets. Securitization has major benefits for financial institutions inChina: capital releases, new tool for asset-liability management, alternative source of funding, and disposal of NPLs. So that is very natural to see many calls recently from private sectors as well as regulators to reopen the securitization market. It is expected that local securitization market will be reopened shortly.

2. Case Studies

2.1 ChinaUnicom[9]

The China Unicom’s securitization is the first proper ABS after the Rules were issued. China Unicom was successfully raised RMB9.5 billion through five separate transactions which listed in the Shanghai Stock Exchange for qualified institutional investors, as table 4 shows.

Table 4: Securitization ofChinaUnicom (RMB)

  01 02 03 04 05
Issuance Date 09/06/2005 06/06/2005 12/28/2005 02/06/2006 02/06/2006
Amount (BN) 1.6 1.6 2.1 2.1 2.1
Interest (%) 2.55 2.8 3.1 2.55 3
Maturity Date 02/16/2006 08/14/2006 02/14/2007 05/22/2006 11/14/2006
Credit Rating AAA AAA AAA AAA AAA

All five issuances of securitization were backed by the revenues gained from leasing CDMA network capacity by CNHL[10] to CUCL[11], and the raised capital through issuances would be used to purchase the income rights of specified seasonal revenues from CNHL, and to pay the interests and nominal amounts to the investors on a pro-rata basis, which would be completed through periodical dates or at maturity.. The securitization was listed in Shanghai Stock Exchange.

Chart 2: ChinaUnicom’s Securitization Structure[12]

Arranger: CICC

CDMA

 Lessee:

CUCL

Originator:

CNHL

SAMP

Institutional Investors

Trustee Bank: BOC

Rating Agency:

CCXI

Credit Enhancer:

BOC

Fees

Income Rights

Proceeds

Income Rights

Proceeds

Third Party Guarantee

Rating

Account

Management

Since the introduction of CDMA network by China Unicom, the CUCL leased the CDMA network lessee, paying increasing leasing fees to the CNHL in returns of CDMA network capacity. After the leasing fees were paid quarterly which constituted into a pool of asset, the CNHL could undertake CDMA securitization and the capital received by the CNHL would be used to repay the loans for constructing CDMA hardware. The five issuances use the same structure as chart 2 shows.

2.2 China Development Bank

The CDB’s securitization can be seen as a typical CLO, which is the first credit securitization inChina. In addition, the CDB’s securitization was issued in China National Intra-Bank Bond Market, rather than in a stock exchange. The total amount of issuance is RMB 5.72 billion and raised RMB 5.74 billion in total, as Table 5 shows.

Table 5: Securitization Issuance of CDB (RMB)

  Tranch A Tranch B Tranch C
Issuance Date 04/25/2006 04/25/2006 04/25/2006
Method of Issuance Public Offering Public Offering Private Placement
Amount (Bn) 4.3 1 0.44
Interest (%) 2.98 3.46 N/A
  Basis Interest (%) 2.25 2.25 N/A
  Interest Gap (%) 0.73 1.21 N/A
Maturity Date 06/30/2009 12/31/2009 12/31/2009
Credit Rating AAA A N/A

Chart 3:  Securitization Structure of CDB[13]

Payment

Arranger: CDB

Originator:

 CDB

Institutional Investors

Borrowers

Servicer:

CDB

Trust Bank:

BOC

Clearing Institution

Credit Rating:

CCXI

Trust:

CCTIC

Consignees

Issuance Agreement

Trust

Agreement

Consignee

 Agreement

Security

Capital Raised

Rating

Payment of

 Interest

& Principal

Payment

Transfer

In this particular deal, the CDB did not use any external credit enhancers, instead the Bank enhanced the pool of assets through subordination of assets (three tranches), and therefore the domestic rating agency the CCXI was able to grant credit rating accordingly. On top of that, the CBD played multi roles here. Apart from being an arranger and originator, CDB also plays the role of servicer after the securitization was issued.

2.3 China Construction Bank

The securitization issued by the CCB can be seen as a typical MBS, which primarily due to the increase of personal mortgages caused by the rising housing market. In addition, the issuance of CCB’s securitization is the first CMBS inChina, although many aspects of CCB’s securitization are similar with CDB, such as both of them were issued in the National Intra-Bank Bond Market, and CCB’s securitization was also divided into different tranches, as Table 6 shows.

Table 6: Securitization Issuance of CCB (RMB)

  Tranch A Tranch B Tranch C Tranch D (equity)
Issuance Date 12/15/2005 12/15/2005 12/15/2005 12/15/2005
Amount (Bn) 2.7 0.2 0.05 0.09
Interest (%) Floating Floating Floating N/A
  Basis Interest 7-day Repo Rate 7-day Repo Rate 7-day Repo Rate N/A
  Interest Gap 1.10 1.70 2.80 N/A
Maturity Date 11/26/2037 11/26/2037 11/26/3027 11/26/2037
Credit Rating AAA A BBB N/A

Chart 4: CCB’s Securitization Structure

 

Arranger: HSBC

Originator:

CCB

CCB

 & Other Investors

Borrowers

Servicer:

CCB

 

Trust Bank:

Clearing Institution

Credit Rating:

CCXI

Trust:

CITIC

Consignees

Issuance Agreement

Trust

Agreement

Consignee

 Agreement

Security

Capital Raised

Rating

Payment of

 Interest

& Principal

Payment

Transfer

The CCB deal shares many common features with the CDB deal with two prominent exceptions. First, the CCB case structured more aligned with international practice. Second, the CCB played multi functional roles here, acting as servicer, originator and investors in the same time.

The use of SPV inChinais generally classified as two types. One is ruled by the banking regulators, as in the cases of the CCB and CBD; the other one is governed by the CSRC to use SAMP in securitization, witnessed by China Unicom. The distinction of Chinese deals structure is that SPV is established and operated by a third party, not by originators, and the later is popular in the West. This could restrain the extent of adverse selection and moral hazards for the originator, which are one the fundamental causes of the recent subprime credit crises. In addition, the creation of SPV in China can be viewed as government initiative, since all the securitizations need to be approved by a regulatory body, but the role of government is only limited to assessment rather than establishment by itself. Since securitization inChinais still in the experiment stage and Chinese government remain cautious about full impacts from securitization. So the Chinese government is willing to adopt both approaches to see which one works better and more suitable to the Chinese financial market. In the long run, those two sets of rules will combine into one integrative framework to suit all Chinese market participants.

3. Informal Securitization

When we talk about the securitization inChina, we could not let go the informal securitization principally undertaken by Chinese banks. According to a recent report, in 2011 alone, the Chinese banks issued wealth management products (WMPs) with a total value of RMB16.99 trillion, an increase of over 100% over 2010. We don’t know the exact percentage yet, but we are pretty sure that credit-backed wealth management products (CWMPs) will make up a large part. We refer CWMPs to informal securitization, as they share similar features as asset securitization (please refer to Chart 5 below). Chinese will pack some loans into CWMPs and promote them as good investment opportunities to Chinese investors.

Chart 5: Structure of Informal Securitization inChina

Borrowers

Banks

 

CWMP

Investors

Interests&

Principal before

Interests&

Principal after

Loan Transferred

Sales Proceeds

Servicing

Interests&

Principal

Sales Proceeds

As said above, informal securitization has exponential growth, however this is still a grey area for Chinese supervisors and so far no comprehensive legal framework is in place. Regulators have focused most of their attention on directing specific aspects of transactions. Credit-backed investment products are frequently marketed as substitutes for bank deposits, and investors commonly believe there is an implicit commitment from banks to repay investors upon the products’ maturity.

The principal drivers behind are banks’ need to free space on banks’ balance sheets and retain customers’ loyalty. InChina, banks commonly use CWMPs to deal with regulation on loan quotas and regulations on capital, liquidity, concentration and sectoral exposures. In the past, the primary driver was to seek a loophole to deal with loan quotas. After 2010, banks are more focused on alluring customers to keep money with them. This convergence of interests between banks eager to adjust loan balances and investors keen on higher-yielding investments has fuelled the rapid rise in volume recently.

WithChina’s equity and property markets languishing and real savings rates now in negative territory, investors are avid for alternative, higher-yielding investments. Although broadly similar, informal securitization inChinadiffers considerably from traditional securitizations in some critical aspects: asset pools are usually very heavily concentrated; no tranching structure exists based on credit risk; and the roles of loan originator, product distributor, custodian, and loan manager are frequently commingled, and in practice sometimes all played by a single bank.

4. Perspectives

InChina, there are huge amounts of corporate assets that generate stable streams of cash flows, such as toll roads, power plants and water disposal systems. Since the owners of these assets are normally actively seeking low-cost funding for expansion, corporate ABS backed by such assets is thought to be the most promising sector for securitization inChina.

However, before reaping the fruits, clearly there are still obstacles involved in the Chinese securitization, such as less understanding of securitization products by the investors, or regulation limitations. On top of that, other issues should be tacked likewise, including the following:

· It is not clear whether the current accounting and tax measures will still apply to future transactions after the pilot projects.

· Regulators expect to release certain credit risk from the banking system through securitization. However, in practice, most securitization products originated by banks were bought by other banks. As a result, the risk is still left within the banking system.

· It is questionable whether products supplied by a limited number of financial institutions would support the securitization market effectively, even if PBOC opened up securitization issuances in the interbank market.

With those issues in mind, we could remain cautious optimistic aboutChina’s securitization market.

References

  1. BCBS (December 2010): Basel III: International framework for liquidity risk measurement, standards and monitoring
  2. Alfredo Martin-Oliver, Jesús Saurina (November 2007): Why do banks securitize assets?
  3. Michael Simkovic:  Competition and Crisis in Mortgage Securitization
  4. Michael Simkovic, Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal, Vol. 83, p. 253, 2009
  5. OCC (November 1997): Asset Securitization Comptroller’s Handbook.
  6. Tarun Sabarwal (December 29, 2005): Common Structures of Asset-Backed Securities and Their Risks
  7. IIF ( June 2010): Reviving Securitization Safely: A Staff Discussion Note
  8. Fitch Rating (July 14, 2010):ChinaSpecial Report, Chinese Banks Informal Securitisation Increasingly Distorting Credit Data
  9. Fitch RatingsChinaSpecial Report (July 2010): Chinese Banks Informal Securitization Increasingly Distorting Credit Data
  10. Hong Yanrong: Restarting Securitization Markets and theDevelopment WayofChina
  11. IMF (October 2009), Global Financial Stability Report: Navigating the Financial Challenges Ahead
  12. BIS (2005): Securitization inAsiaand the Pacific: implications for liquidity and credit risks
  13. Amato, J D andE Remolona(December, 2003): The credit spread puzzle, BIS Quarterly Review
  14. Mimi HU (2008): Developing Securitization Laws inChina
  15. Paul Browne and Jane Newman: Securitization in the People’s Republic ofChina, moving forward, but challenges still remain
  16. BIS Quarterly Review (December 2003) The credit spread puzzle

[1] The Securities Industry and Financial Markets Association (SIFMA): http://www.sifma.org/issues/capital-markets/securitization/housing-finance-and-securitization/overview/.

[2] Dodd Frank Act: Subtitle D—Improvements to the Asset-Backed Securitization Process, Sec 941 regulation of credit risk retention.

[3] Basel Committee of Banking Supervision (June 2006): International Convergence of Capital Measurement and Capital Standards: a Revised Framework – Comprehensive Version, para 539, page 120.

[4] Id, para 540, page 120.

[6] Asset Securitization Comptroller’s Handbook: page 22, para 1.

[7] Basel III requires that banks should hold at least 10.5% capital for 100% risk-weighted assets after 2019, however bear in mind that banks possess large portion of low risk assets, so the equity percentage is significantly lower than 10.5%.

[8] Basel Committee of Banking Supervision: Consultative Document Assets Securitization, January 2001, para 12-13, page 3.

[9] China United Telecommunications Group (China Unicom) is aChina state-owned telecommunication operator, which established in 1994 by the Ministries of Electronic Industry, of Electric Power and of Railways.

[10] China New Horizon Limited (CNHL) is a subsidiary of China Unicom.

[11] China Unicom Corporation Limited (CUCL) is also a subsidiary of China Unicom.

[12] In this securitization structure, CICC refers to China International Capital Corporation, SAMP refers to Special Asset Management Plan, BOC refers to Bank of China, and CCXI refers to China ChengXin International Corporation. The threshold for investment is RMB1 million.

[13] In this transaction, CCTIC refers to China Credit Trust Co. Ltd, borrowers are a pool of assets of  51 loans  worth RMB4.17bn, most of which were performing.

About wilbertouyang

I am a Chinese, just moved from China to the States. I am now working for the banking compliance field, especially keen on new basel accord, liquidity risk, corporate governance, etc.
This entry was posted in China, financing, securitization, Uncategorized. Bookmark the permalink.

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