Source: China Finance by Zhang Zi’ai
Asset securitization, dubbed as the “Alchemy” in the financial world, has been very popular in the capital market since the first batch of mortgage-backed securities were issued and guaranteed by GNMA (Government National Mortgage Association) of the United States in 1970. As a newly invented financing tool, it has been tapped upon by many countries. In 1990, RTC (Resolution Trust Corporation) of the United States set the first example of NPLs (NPL securitization) to effectively deal with the NPL owned by deposit and lending institutions. NPLs was applied to dispose of the NPL owned by over 1000 institutions in liquidity crisis. In the following 6 years, RTC launched over 20 NPLs projects, each with a scale of more than USD 14 billion. The total book value of these projects reached USD 458 billion, accounting for 98% of the total transferred asset value.
Inspired by the success of RTC in NPLs, other countries followed its example with ever improving and constantly innovated NPLs techniques. Japan and ROK after the Asian Financial Crisis and explored diverse ways of NPL disposal and financial restructuring through NPLs. NPLs witnessed fast development in Asia. At that time, Japan was mired by NPL accumulated since the burst of real estate bubble in 1990s which was the largest in the Asian market. The first NPLs project in Asia was introduced by Japan in October 1999. It was the first time that Japanese government dealt with NPL in the banking sector with innovated tools in the capital market. However, the world-class investment banks such as Morgan Stanley and Goldman Sachs dominated the whole process of NPLs in Japan and played crucial roles including NPLBS (NPL-backed securities) investors, sponsors, underlying assets service providers, managers and underwriters. They arranged for the offering of securities and provided financing support. Since the first issuance of NPL-backed securities in the end of 1999, Japan had become the largest NPLs market in Asia. KAMCO, the Korean Asset Management Corporation, came up with a KRW 320 billion NPLs project backed by the NPL from 5 local banks in June 1999. It was followed up by a USD 45 billion NPLs project issued by KAMCO in the international financial market in August 2000. Incomplete statistics have shown that 20% of Korea’s total NPL has been disposed of through NPLs. Moreover, India, Taiwan (China) and Malaysia have put in place exclusive acts for NPLs to further boost the NPLs business of financial institutions.
The four major AMCs incorporated in late 1990s in China have also attempted NPLs for NPL disposition. NPLs have been included in the business scope of AMCs approved by the CBRC and the “Regulations on AMCs”. However, Chinese AMCs have not been engaged with NPLs business in a large scale due to the restrictions of the legal and regulatory eco-system. Fortunately, the exploration of the Chinese AMCs on NPLs never stopped and there were some successful cases which offered lots of precious experiences. Currently, the NPL portfolios and NPL ratio of the commercial banks are on constant rise. Drawing upon the experiences acquired from other countries, NPLs could serve as an effective tool for NPL disposal in commercial banks and facilitate the AMCs’ effort in resolving financial risks. NPLs in China is very promising.
AMCs tried their hands at NPLs.
l Structured Trust product: quasi-NPLs product
AMCs in China had tried their hands on NPLs since the establishment. In 2001, China Huarong signed an agreement for special consultancy over an NPLs project with KAMCO, which specified the plan of the NPLs project and submitted it to relative authorities for approval. However, the plan was rejected due to various reasons. In spite of this little setback, Chinese AMCs carried on with multiple innovative ways to undertake NPLs business. In June 2003, China Huarong found another way around for NPLs-----structured trust product, which was carried out in the following steps. The AMC picked certain NPL portfolios and put them in an asset pool. The asset pool was then entrusted with to a trust company to set up an asset trust with certain maturity in order to get all the beneficiary rights. The AMC categorized the beneficiary rights as priority ones and subordinated ones according to the cash flow that are expected to be generated by different assets. The priority ones were sold to the investors with a fixed interest, while the subordinated ones were held by the AMC. The ones held by the AMC was actually a kind of guarantee to the priority beneficiary rights transferred by the AMC. Thus the structured trust enhanced the credit of the transferred beneficiary rights. Since the trust company had no experience in NPL management, most of the time the trust company would assign the AMC to provide NPL management services for the entrusted assets.
Structured trust makes it possible for cash recovery in advance by transferring the priority beneficiary rights. The illiquid NPL is thus transformed into a liquid trust product. After Huarong’s successful attempt, the other 3 AMCs also took part on the structured trust business to deal with their NPL portfolios. Since 2005, COAMC has launched such projects in Guangzhou, Beijing, Tianjin, Liaoning and Wuhan. The trust structures are now better designed. Its launch and offering are now more efficient. COAMC raised RMB 1.8 billion after the structured trust projects in Guangzhou, Beijing, Tianjin and Nanjing went public, making its structured trust projects the largest ones in China.
Dealing with NPL portfolios with structured trust is an innovation made by the AMCs to avoid the complicated approval procedures. It simplifies the transaction and makes it more flexible. It is similar with NPLs, since it applies the basic principles of NPLs and trust, the risk isolation mechanism of the underlying assets, cash flow packaging, investment contracts backed by particular assets, off-balance sheet operation, and credit enhancement by combining the priority and subordinated beneficiary rights etc. Therefore the insiders of the business take it as a “quasi-NPLs”. The fundamental difference is that NPLs is carried out by selling securities to investors, which shall be subjected to the “Securities Law” and other relevant regulations. However, in a structured trust transaction, the transferred item is the priority beneficiary rights instead of securities. The transfer is done through contracts, which shall be subjected to the “Contract Law” and “Trust Law”.
l “Phoenix” and “TECO”: typical NPLs products
China’s first NPLs project was an NPL disposition project carried out by China Cinda and the Deutsche Bank (DB) on January 23rd, 2003. The project combined NPLs techniques and structured asset portfolio, with an NPL debt balance of RMB 25.152 billion. Cinda and DB applied NPLs model and sold the securities in the international markets mainly to the investors from the U.S. and Southeast Asia.
“Phoenix” and “TECO” were the two NPLs projects carried out solely by Chinese AMCs. In October 2006, CBRC announced the pilot NPLs projects. COAMC and Cinda were chosen to be the first AMCs to test the water of NPLs. In December 2006, “TECO 2006-1” (3 years, RMB 700 million) and “Phoenix 2006-1” (5 years, RMB 3 billion) priority asset-backed securities were introduced by COAMC and Cinda respectively as the local fixed-income NPLs projects. The securities were sold to the investors in the national inter-bank bond market. Major Chinese commercial banks, fund companies, financial companies etc. all subscribed for the securities. Business insiders agree that “TECO 2006-1”, based on the NPL in Liaoning province, is the first typical NPLs carried out purely by a Chinese AMC. In June 2008, the principal and interest of the “TECO 2006-1” were paid in full ahead of schedule.
Differentiated from the standardized NAPS in the U.S., the Chinese NPLs still has its own characteristics. In the U.S., NPLs is done mostly by setting up Special Purpose Vehicles (SPV) as the intermediaries between the issuer and the investors for “bankruptcy isolation” purpose. The SPV serves as the core of the whole NPLs transaction. However, there was no legal basis for setting up SPVs in China at that time. The “Corporation Law” said nothing about SPVs. Thus “Phoenix” and “TECO” were carried out as trust products.
Chinese commercial banks have also attempted NPLs for NPL disposal. ICBC, Credit Suisse First Boston (CSFB), Citic Securities (CITICS) and Zhongchengxin (CCX) signed the agreements to securitize the RMB 2.6 billion NPL portfolios owned by Ningbo ICBC branch.
l The significance of NPLs attempts.
AMCs’ attempts on NPLs with the incomplete legal framework and insufficient relevant policies are of great significance despite of the relatively small scale compared with other means of NPL disposal and higher disposition cost. First and foremost, by drawing on the foreign experience, NPLs serves as another tool for NPL disposal. Traditionally, Chinese AMCs deal with its NPL portfolios though “DPL”, which refers to “discount”, “packaging” and “litigation”. These disposal methods do not require the complicated techniques as NPLs, “the alchemy of the financial world”, does. On the other hand, our staff learned a lot from the operation of NPLs, which prepared them for the future investment banking businesses. And investment banking will be one major section of our business when COAMC becomes a comprehensive financial group after the market-oriented transformation. NPL is an investment banking business by nature. So now we are more capable of conducting such business. Third, securitization makes it possible to get the cash back in advance, enhance the liquidity of the NPL, and disperse risks. The long-term loans held by the AMC are turned into liquid cash or bonds, which makes the liquidity management easier. Last but not least, NPLs speeds up the NPL disposal and makes it more efficient. NPLs is a way to dispose of a bunch of NPL portfolios at one time, so you don’t have to deal with each one of them separately. This undoubtedly makes the NPL disposal more efficient.
The Grand Prospect of NPLs Securitization
1) The fast growth of NPLs desiderates asset securitization
In 2008, in order to respond to the U.S. subprime mortgage crisis, our government launched the 4 trillion yuan stimulus package, along with massive bank credit. By the end of the second quarter of 2014, the loans of commercial banks in China have reached 64 trillion yuan. Though the massive fiscal and monetary stimulus boosted the short-term growth of China’s economy, it leads to high-leveraged enterprises and local governments and sets up potential financial risks. With China’s macro-economy enters “New Normal”, and the economic growth slows down, China’s economy would enter into a painful phase of restructuring and deleveraging. The trend of double drops of NPLs balance and percentage has reversed, by the end of the third quarter of 2014, NPLs balance of commercial banks in China has risen for 13 consecutive months, and the NPLs percentage of the whole banking industry has reached 1.16%, in some provinces, for example Zhejiang province, the percentage is over 2%. Moreover, with the uncertain future of the real estate market, the NPLs of commercial banks are more likely to increase, and the accumulation of NPLs will inevitably bring financial risks. The government is less likely to intervene in commercial banks and strip massive NPLs. Therefore, in the coming years, as the international standard market approach to dispose NPLs, asset securitization will be widely used by commercial banks in China, which will bring a new phase of fast growth of asset securitization in China.
2) NPLs securitization dissolves the liquidity risks of AMCs
After the commercial transformation, AMCs have become wholly market-driven financial enterprises, and will definitely face problems like financing capability and liquidity risks. Before the commercial transformation, AMCs could apply for relending from PBOC and issue MOF guaranteed bonds to state-owned commercial banks when they purchase policy NPLs. But after the commercial transformation, AMCs should use their own fund and finance from financial institutions when they purchase NPLs in the market. Once the amount of NPLs purchased by AMCs is too huge and the disposal of NPLs requires a certain period, this will put pressure on AMCs’ liquidity. NPLs securitization is the best approach for AMCs to revitalize stock assets, finance and dissolve the liquidity risks.
3) NPLs securitization will further improve tools of investment market
In recent years, though capital market has achieved fast development and provides more and more investment products, it still falls short of the increasing social capital, especially those products which have high security level, high liquidity level and high return level. Large amounts of capital such as pension fund and insurance fund remain untapped in bank accounts. It is reported that only 10% of local pension fund is invested in national debt, the rest is deposited in banks at a rather low annual rate, which is not a good way to preserve and increase the value of the pension fund. At the same time, the main investors of asset securitization business abroad are institutional investors, including pension fund, insurance fund, commercial banks, mutual fund and foreign institutional investors. As a innovative financial instrument, NPLs-backed securities enriches the security market, increases options in the security market, satisfies investors’ need to diversify investment instruments, improves the market structure and the operating efficiency of the security market, which optimizes the allocation of resources.
4) NPLs securitization will remain the core business of AMCs
NPLs securitization is not the patent of AMCs. Theoretically and practically, many NPLs securitization businesses are launched and implemented by commercial banks. But as an innovative financing tool, asset securitization only liquidates the NPLs; it does not dispose the NPLs. The payment of principal and interest relies on the disposal of the NPLs. AMCs are professional in disposing financial NPLs and have strong disposal capability through years’ practice, and are bound to be provider of NPLs securitization. Therefore, for commercial banks and AMCs, it is their best choice to entrust AMCs to dispose NPLs after securitization.
NPLs securitization requires improvement of laws and regulations
Basically, the development of asset securitization in China is policy driven. In Report on Monetary Policy Implementation 2012, PBOC put forward the idea to proactively promote the mortgage-backed securitization. The Opinions on Promoting the Reform and Opening up and Stable Development of Capital Market by the State Council in 2004 first proposed to proactively explore and develop asset securitization products. With the deregulation comes the exploration of asset securitization theoretically and practically. By the end of December, 2005, National Development Bank and China Construction Bank successfully issued two asset-backed securities successively.
Asset securitization is not only the product of optimized allocation of economic resources in a market economy, but also a financial innovation which reflects the advantage of combined systems with the improvement of the legal system. Internationally, many countries rolled out regulations on asset securitization respectively in order to facilitate the securitization business. The success of disposing NPLs through asset securitization in the U.S. benefited from sound regulations on asset securitization, sophisticated capital market and proper government support. In France, Italy, Japan and Taiwan, they all legislate on asset securitization and the types of legislative rules are diversified, some countries have special laws, for example in Taiwan they promulgate Regulations on Financial Asset Securitization.
Therefore, China should consider the characteristics of its financial market and the requirements of asset securitization, promulgates laws and accounting rules on asset securitization as soon as possible, and amend, supplement and improve current laws and rules which stand in the way of asset securitization to provide legal protection for the further development of asset securitization businesses. At the same time, we should improve regulation on asset securitization, reduce examination and approval procedures to standardize the issuance of asset-backed securities and involve more institutions in the business.
