As the reform and opening of China's financial sector continues, China's bankers and their regulators have become keenly interested in the potential of securitisation as a tool to help achieve their objectives of capital relief, risk transfer and balance sheet optimisation for commercial banks.
The four large state-owned commercial banks are under increased pressure to deal with their massive portfolios of non-performing loans (NPLs). The same pressure is weighing heavily on the four asset management companies (AMCs), which received a substantial infusion of pre-1996 NPLs from the banks in 2000 and have only six years left to dispose of the bulk of these aging assets. The banks have also built up valuable portfolios of residential mortgages, auto loans and credit card receivables in the major Chinese cities.
However, as with other innovative financing techniques on offer from foreign jurisdictions, the financial institutions' regulator (until recently the People's Bank of China or PBOC, now the newly-established China Banking Regulatory Commission or CBRC) tends to adopt a cautious approach. So, while it is reported that regulations to facilitate at least certain types of securitisations have been in the works for some time, it is likely that one or two banks will be permitted to engage in small-scale "experiments" before any kind of general clearance is given.
So far, interest has mainly focussed on conventional securitisations of the type familiar in the US or other Asian jurisdictions, that is an outright transfer of a pool of mortgage loans to a special purpose vehicle (SPV) that issues securities on the basis of a rating attached to the deal. However, such transactions face a number of substantial legal, regulatory and practical obstacles in China. We will briefly describe some key issues below, with illustrations from a recent pioneering transaction, namely the successful portfolio sales of NPLs to foreign investors by China Huarong Asset Management Corporation, one of the AMCs. Finally, we will consider an experimental alternative - representing a possible way forward - developed by the trust and investment companies.
Loan sales and mortgage transfers
There are no legal restrictions on transfers of loan rights in China, and China's Contract Law has clarified that only notice to the borrower, rather than consent, is required. However, there are a number of other policy and practical obstacles to outright loan sales which could stand in the way of future securitisation transactions.
First, the regulator's most critical policy concern is that allowing true sales of loans could do more harm than good to the banks, if strict controls are not exercised over what assets are sold and what levels of discounts permitted. This is partly a general policy concern about the leakage of state assets into private hands at an undervalue. In the case of NPLs, there is also a very practical concern about the effect of a substantial write-down on the banks' balance sheets, given their already slim capital reserves. (It is telling that the 2000 transfer of pre-1996 NPLs to the AMCs was priced at book value.)
The AMCs, the statutory purpose of which are to dispose of NPLs, were specifically authorised not only to sell loans (including to foreigners) but also to take responsibility for determining a price other than book value without requiring further approvals. These vital regulations were passed during the early stages of the Huarong transaction. Until similar policy decisions are taken by the CBRC with respect to the banks, it is not clear that any similar transaction could be done involving a portfolio of either non-performing or performing loans of a state-owned commercial bank.
This concern works in reverse when it comes to new and attractive assets such as residential mortgages. Since these are perceived as being among the banks' best assets, bankers and regulators alike may be reluctant to remove them from the banks' balance sheets at any price.
Transfers of legal title to mortgages pose a considerable practical difficulty. Registration with the local land and/or building registry is required in order to complete the transfer. While this registration is theoretically possible under relevant regulations, it is enormously difficult in practice and subject to almost universal confusion at the level of local registry offices throughout China. This is partly because the sale of mortgage loans is entirely new to China. Another factor is that local authorities have a material incentive to steer the parties toward the creation of a new mortgage, for which they can charge substantial appraisal and processing fees. The AMCs themselves were in practice unable to register their title to the mortgages transferred from the banks in 2000. Instead, they obtained a special waiver from the Supreme People's Court. This waiver has not yet been extended to any other transfer, nor has the status of an unregistered transferee (other than an AMC) been clarified.
To SPV or not to SPV
The Huarong transaction involved the establishment of an onshore joint venture company, jointly invested by Huarong and the foreign investor, to own and deal with the NPLs transferred by Huarong. In fact, the transaction's most significant delay was incurred due to difficult regulatory issues encountered in the course of obtaining necessary government approvals and registrations for this special purpose vehicle.
The main reason for the unusual complexity of the approval process was that the transaction involved foreign investment and participation in an entirely new type of business. This business is especially sensitive for the foreign investment authorities because it clearly relates to financial matters, but the CBRC has not yet decided whether or not to regulate it. Obtaining the necessary ‘business scope' for an onshore SPV could well be an issue not only for foreign investors but also for many private sector domestic investors.
There are several other ways in which the optimal SPV for such a transaction conflicts with the rather rigid structures imposed by PRC company law:
- Because a PRC company must operate an active business, a pure holding company which contracts out all of its asset management functions to a separate servicer is difficult to achieve.
- For the same reason, as well as a legal prohibition on providing debt collection services to others, the establishment of a specialised servicing entity remains problematic. This is mainly an issue for investors who want their own servicer. There seems to be no problem with servicing by the originating banks or the selling AMCs.
- Without special legislation, such a company may not be able to achieve complete flow-through of cash collections. This is particularly an issue for foreign investors since distributions to them must be scrutinised by the State Administration of Foreign Exchange (SAFE) to ensure they fall into a recognised category of entitlements governed by special SAFE rules, being either after-tax dividends or specially approved "reductions of registered capital".
- There are also many restrictions under a PRC law on such a company actually securitising. Limited liability companies in China do not have share capital and transfers of equity are cumbersome. These particular joint ventures were prohibited from any kind of third party borrowing. In any case, generally under PRC law, lending can only legally be carried out by financial institutions. Issuing debt securities in China is still extremely difficult. The only recognised form is the corporate bond. Much like equity securities before recent reforms, corporate bond issuance is still subject to central planning approval via quotas allocated to provincial governments, and is therefore feasible only for the largest state-owned issuers.
Of course, from a corporate law point of view it would be far easier to use an offshore SPV. This would be fine in cases where the receivables themselves are already offshore, or at least where they are denominated in foreign currency. However, the vast majority of China's bank loans are naturally denominated in Renminbi. Again, in the absence of enabling regulations, special SAFE approval would have to be obtained in order to enable an offshore transferee to acquire and hold RMB loan obligations, and of course to convert cash flows from such loans and remit them offshore. Such approvals have been issued in the past on an ad hoc basis, but as yet there is no basis for such approvals to be issued for routine transactions.
The ability to obtain a reliable credit rating for securities backed by the underlying assets is a vital component of securitisation in developed markets. As with other parts of the financial sector, this is a work in progress in China. No credit rating agency, however sophisticated, would have an easy time assessing the risks of the pre-1996 NPLs held by the AMCs, or even the newer portfolios held by the banks. This is partly due to gaps in the legal infrastructure - the absence of basic legislation in the areas of property and bankruptcy. This combined with rapid and only partially-absorbed reforms has led to continuing uneven lending and collection practices by banks, registration practices by local authorities and enforcement practices by the courts. No one has much of a track record to go by. So it will be of interest to foreign investors and credit rating agencies to see the ratings issued by the domestic appraisal and credit rating agencies who have reportedly been retained by Huarong to rate a portfolio of its NPLs.
The future: actual or synthetic?
It may be that many of the issues mentioned above will be resolved by regulation so that conventional securitisations become feasible for the banks. Early indications from PBOC were that true sales would be the preferred means for the banks to transfer the credit risk of the receivables to investors. On the other hand, if these difficulties are not resolved, it is clear that in the meantime the easiest type of transaction to carry through would be one where the loans remain on the banks' balance sheets. In this case, China may jump straight to the kind of synthetic securitisations which have evolved in developed civil law jurisdictions, such as Germany, where true sales of mortgage loans are problematic and no special legislation has been passed to solve these problems.
Some early steps along this road are being pioneered by China's trust and investment companies (TICs). Recently the TICs have begun enthusiastic marketing of a useful new vehicle, the collective capital trust plan, to the banks for this purpose. The TICs are exclusively authorised to set up such trust plans, which pool investment funds entrusted by a number of individual investors (currently up to 200, with a minimum investment per "settlor" of RMB 50,000) for designated investment purposes, under the management of the trustee. This area was opened to the TICs in June 2002. So far the highest profile plans have been in the area of urban infrastructure, like the fund established to lend to the Chaoyang District Government in Beijing for construction in the Central Business District.
Recently a trust plan has been established by the Xinhua TIC to acquire interests in residential mortgage loans owned by Shenzhen Commercial Bank. The exact structure employed is not clear, but it does seem that the Bank required that the loans remain on its balance sheet. In return, investors were invited to rely on the Bank's guarantee of their return. The Bank also offered holders of trust plan certificates credit on the basis of a pledge of the trust plan certificates.
The successful completion of this transaction has given rise to speculation that this may provide a way forward for similar deals between banks and AMCs and the TICs. Huarong in particular has announced its intention to attempt a similar transaction with one of the TICs. At the same time, banks and AMCs are looking for alternative routes to achieve the same results without being forced to rely on the TICs to structure their relations with investors. So far trust plans are limited to a relatively small scale, and TICs are not authorised to issue bonds or securities, both factors which may limit the development of this vehicle.
Actual or synthetic, the future of securitisations in China should be an interesting space to watch.