Three years ago, Alexander Batchvarov left Hong Kong and his post as head of Asian securitization research with Merrill Lynch because there was not enough activity in the ex-Japan Asia markets to justify his continued presence.
On a return visit to the SAR, the highly respected analyst gives FinanceAsia his views on how the climate for issuance has changed and where he sees the market going in the future.
FA: You left Hong Kong three years ago. At that time, how did you assess the non-Japan Asian securitization market?
One of the reasons I left was because I did not expect much development in structured finance. I thought the market needed anywhere between two and five years to be ready for securitization.
The key issues at that time were a lack of an adequate legal structure: securitization is very legally intensive and if you don't have the proper laws in place and the proper regulatory framework, you simply can't do it.
The second issue was the availability of suitable assets and the willingness of banks to securitize them.
The third issue was whether the market was ready for domestic securitization, which in my opinion it was not as that time. Investors were probably not in place and the cross-border market was difficult to develop for a number of reasons: sovereign ceiling issues and a number of downgrades, availability of swaps and willingness of foreign investors to buy Asian structured finance paper. With the Asian crisis, and especially after the Russian default, the attitude to emerging markets became very negative and at the time it became very difficult to place the paper.
Put all these factors together and we had a situation that was unfavorable to the development of the Asian market.
In the three years that have passed since then, do you think anything fundamental has changed to alter your perception?
Actually, quite a few of these aspects have changed although it has not gone right across the board. Probably the most dramatic and important change has happened in Korea, where a securitization law has been passed. Secondly, a number of banks needed to raise funds and securitization was one way to do that.
Korea also has the right assets that have been made available for securitization. The swap market is now more active and you can probably get swaps for three to five year maturities, maybe even longer. Korea is also back in the investment grade range and you can find the investor base willing to take the risk on Korea.
Another significant development has been the return of the monoline insurers and the cross-border transactions that have been done from Korea this year have been wrapped by monolines. There are investors willing to take exposure and if the deals are wrapped, that's even better.
What about developments outside of Korea?
Singapore is also interesting. Several securitizations have been executed there. Although it's arguable whether these were true sale transactions - the way they were structured with recourse to the originators puts them more into the straight corporate type of deal - at least the techniques were applied. There is an indication that there might be more deals to come from Singapore.
In particular, I think changes to the regulatory framework with regard to banks and the requirement that banks must focus on their core activities may lead banks to securitize more real estate, of which they seem to have quite a bit of.
Hong Kong has always been in a good position for securitization because it has the legal and regulatory framework. It has a common law jurisdiction so there is no need for a specific law. It has done deals in several asset classes and is probably the most developed market in that sense: real estate and consumer assets.
The establishment of the Hong Kong Mortgage Corporation was an important development. There are indications that it's gearing up to do another deal that will use a master trust structure with segmented pools, from which they will issue mortgage-backed securities that will be sold on the market.
These are the most exciting developments but the situation is less encouraging for pretty much all of the other ex-Japan Asian countries, where they lack the comprehensive legal framework required.
However, I do know that Malaysia has developed a law recently and the interest from potential issuers is a good sign but generally in the other countries, there's not been enough consistent activity to suggest a market is emerging.
I think one thing that has delayed the development of the market in the region is the huge liquidity in the banking systems. This liquidity makes them unwilling to sell assets especially performing assets like mortgages and consumer loans.
They are not pressured to find alternative funding sources. In fact, banks face problems finding opportunities to do credit work, to extend loans, which is their primary business.
Apart from Korea, Singapore and Hong Kong, it's difficult to find swaps, especially in the long-term and that makes cross-border issuance difficult.
There have been moves towards passing laws in Taiwan and the Philippines, where the government is strongly pressing forward to get a law passed before the end of the year. How do you view those developments?
Whether they pass a law isn't the real issue: it's whether the law is workable. The main issue is about the assets themselves and the ability to transfer them. So my question would be, in addition to these laws, do these countries have the right framework to allow a true sale into the special purpose vehicle (SPV)? In some countries, the securitization laws effectively define the conditions for true sale.
A further issue is that even if there is a law, is there the willingness from banks and other originators to sell assets. We have seen for example in Japan, there has been enormous progress in the last few years in getting the correct regulatory and legal structures in place, but many banks just don't want to sell the assets. They want to keep them on the balance sheets.
How do you view the non-performing loan (NPL) situation in relation to securitization?
One thing that has always concerned me is the illusion that securitization can be the solution to the NPL problem. It was regarded as such in Japan and in other countries in Southeast Asia.
There are two key issues that will determine the effectiveness of tackling this problem. One is the framework for insolvency, bankruptcy and disclosure. If the laws are not in place with a proper precedent in going through the insolvency process, then how can you rely on NPLs generating the cash needed for the securitization deal?
The second issue is the availability of specialist servicers. In order to securitize NPLs effectively, what you need is a party that can take the loans and get the collection process going. If we draw parallels with other countries, in Italy a special law was passed that allows the banks to amortize the losses incurred through the sale of NPLs over a five-year period.
As a simple example, let's say the bank has $100 book value of NPLs and decides to sell the loans at $30. If the bank sells the deal today it faces an immediate loss of $70. That is a very difficult decision for a bank to take because it has to write-off a substantial amount of the book value.
With the Italian law, they don't have to take that loss immediately. It allows the banks to amortize that $70 loss over five years, which is $14 a year. That will not have such a dramatic effect on their profit and losses.
Another issue is how the banks deal with the loss that inevitably follows the sale of NPLs. Will the regulators and tax authorities give the issuer some relief and preferential treatment? If that is not in place, banks will be reluctant to sell these loans at such an immediate loss so the regulators need to give banks some kind of encouragement and preferential treatment.
It's an interesting point, because it does seem that in some countries, there is still a lot of naivety about what securitization can do. NPLs will not just disappear and a lot of hard work still needs to go into servicing them. Kamco should probably serve as a good example of an asset management company that has used securitization effectively in conjunction with good recovery of bad loans.
In the case of Italy, there were several private entities established that specialized in servicing the loans and that has worked reasonably well. If you want to securitize these loans, you have to persuade investors that there is a qualified servicer who can derive value from the loan portfolios.
You also have to persuade the rating agencies to rate these bonds, which shows them that the proper procedures are in place with respect to insolvency and bankruptcy so that the loans can be liquidated, and that the cash flows will be sufficient for the deal to pay the interest and principal. This is where the capabilities of the servicer and the legal framework for bankruptcy foreclosure play a crucial role.
Using Italy again as an example, in some cases it may take 10 years to foreclose on a defaulted loan so imagine trying to extrapolate cash flows. In other countries such as Holland or the UK, it may take between 12 months and 24 months. In Hong Kong it is also very easy to foreclose on a mortgage.
Given that there is a lot of liquidity in the Asian banking system at the moment so getting funding is not quite so difficult, what benefits can banks, and other issuers, derive from doing a securitization at this time?
I am glad you raised that point because traditionally people associate securitization with banks but that doesn't have to be the case. Corporates, especially those that are highly indebted and are finding it difficult to access funds on an unsecured basis, could benefit substantially from securitization.
One of the biggest developments in Europe over the last 12 months has been the entry of the telecom sector to the market, securitizing their receivables and in the future this may extend to their real estate holdings.
Additionally for corporates, it provides off balance sheet funding, longer-term funding on a stand-alone basis, and these are clear benefits. Another aspect of securitization that is not fully appreciated relates to synthetic transactions.
You don't always have to securitize on a cash basis and sell the assets. If banks want to get rid of specific risks, they can do this by doing a synthetic transaction. This has additional benefits in that you do not have to transfer assets, you don't need a sale and purchase agreement and all the legal work associated with perfecting a true sale.
You can also transfer the risk through a credit default swap and by doing this you can also circumvent the sovereign ceiling issue. Synthetic securitization could be helpful for small banks or larger banks that want to transfer specific risks faster and more cheaply.
Commercial property companies can also benefit. Singapore is trying to introduce a REIT structure, as is Korea and Hong Kong and this could be a very significant development.
Why do you think this is important?
This effectively distributes the ownership of commercial real estate to a much broader base. Secondly it provides an alternative funding source for many property management companies. Thirdly, it frees the banks from their substantial property holdings.
We know that in Hong Kong there is a regulation that limits a banks exposure to property holdings to 40%, which I think was relaxed and this may be a solution to that.
It also provides transparency in terms of pricing for the property market. There may be some people who oppose that, but overall it may be a fairly good thing for the market in the long-term.
As a final thought, where do you see the market being three years from now?
One thing we haven't mentioned is that although there's a lot of liquidity in the banking system, the return on equity of that is not very substantial at the moment. One thing I hope will develop is that banks will invest in the international ABS market.
I hope banks will find ways to transfer risk through synthetic structures themselves on a cross-border basis. The Korean banks are ready to do that and I hear that some of them are interested in doing this.
I hope corporates get into this sector and I think the telecos will become the first to do this. I also expect to see substantial development in the real estate sector, from banks securitizing their real estate to the REIT market developing in the region.
I would also like to mention China because this is a country ripe for securitization. It has the assets - consumer real estate, mortgages - what it doesn't have yet is the proper framework. If it gets this, that will give huge impetus to the development of the market because China has the domestic investor base, it just needs the right structure to be able to channel the assets to investors.