Non-performing Bank Asset backed Securitie

                                                                 Hu Xiaoyin

At the most recent National People’s Congress and political consultative conference, the topic of bank asset-backed securities was a once again a focus. For banks, this financial innovation allows for the structuring and packaging of bad assets that secure loans.This would allow enhanced fluidity and permit the optimization of asset structure for banks.For the industry, more advanced standardization of the capital market can be realized.

Under the current legal system however, commercial banks are restricted from utilizing asset-backed securities and instead resort to a framework of various “quasi asset-backed securities”, which are insufficient to meet the demands of increasing competition as well as regulatory capital requirements. Facing this dilemma, the establishment of legislation on asset-backed securities is needed right away because it would benefit the local banking industry and relieve the severe problem of capital fluidity for banks.

On 24th May, 2004, the well-known Standard & Poor’s Rating Service published its estimate of bad assets held by mainland Chinese banks, stating that almost 40% of PRC banks’ overall loan portfolios in 2003 contained bad assets.Not being allowed to dispose of or restructure bad assets through asset-backed securities hinders local banks against competition from foreign banks, impairs international business, and impacts banks’ international credit standings.Moreover, substantive bad assets put the integral operation of the PRC banking industry at risk, and are one of pivotal obstacles remaining for the enforcement of the four national commercial bank’s comprehensive reform targets.

Restructuring and disposing of bad assets through asset-backed securities can be accomplished over time, but there still exist some inevitable challenges.For example, when disposing of a bank’s bad assets in such fashion, pricing is quite difficult.To strip the bad assets off the bank’s system is the first step in the process. In establishing the price for the bad assets, a crucial element is whether the “real sell” can be achieved and the securitization can be favorably enforced. A balance is needed because if priced too high, the cost of the asset-backed securities will increase, which would bring down the chance of success of disposal through this method.If priced too low, the losses taken on the commercial bank assets will be so grave as to incur more severe losses to commercial bank.

At present, there are three popular categories for pricing of bad assets: (1) face value method: namely, transferring assets based on the book value plus some discount; (2) Price by agreement: namely, the assignee of the bad assets and the receiver establish the value through negotiation; and (3) auction: namely, establishing the final transfer price via competitive bid.

These three price-making categories are all based on the evaluation of the bad assets’ value and risks contained therein. Evaluating these risks, though, can be a challenge.A lack of reliable credit rating and evaluation services, coupled with distortion from the management of debtor companies, makes getting reliable data a burden.This slows the slows the process of purging bad assets from the banking system which in turn impacts the efficiency of the use of asset-backed securities.

Another challenge to the process of disposal through the use of asset-backed securities is the capital of the organizations that do so.In 1999, four state property management companies were established for the purpose of disposing of 1.4 trillion in bad assets from the PRC’s four largest commercial banks.They have been able to use leverage to accomplish some of their tasks, but are still undercapitalized for purposes of handling the volume of bad debt.

Still another challenge is the lack of the supply of abundant, steady long-term capital.

As a financing method, asset-backed securities require steady sources of capital.Typically, the primary investors in such asset-backed securities in other countries are not individuals, but institutional investors such as pension funds, commercial banks, mutual funds, insurance companies, etc. However, in China, few institutional investors can participate in securities investment, foreign institutional investors are few because of the lack of accurate information as described above.

Also problematic for the industry is the sub-standard service of agents.Asset backed securities are complicated and involve investment banks, accounting firms, asset evaluation services, rating organizations, etc. While investment banks are comparatively similar, credit rating and evaluation agencies in China are well below the standards required internationally. Many lack transparence and the standard of neutrality.Also, the many various organizations do not employ uniform rating standards so that investors can make informed decisions.

Room for Improvement

Although the above-described problems present some challenges to effective implementation of asset-backed securities, there are ways to overcome these obstacles:

Increase Credit – The liquidation of assets backed securities relies on future cash flows produced by the securitized assets.Bad assets lack steady cash flow, which may make exposes investors to some risk. In order to attract investors, it is necessary to enhance the assets securities’ credit level. This can be accomplished through guarantees, excess mortgages, financial department’s pledge, second-level and priority-level securities design, etc.

Standardize the Evaluation and Ratings Systems – Nationwide evaluation entities should be established, who follow the same methods and who employ transparency in their evaluation.Such findings could, and perhaps should, be guaranteed by the government, as well.The reason for this is that having the ability to correctly evaluate impaired assets in a standardized fashion will allow international investors to have confidence in their decisions.That will help resolve the banking industry’s bad debt problem that much quicker.

Creditor Rights – Securing creditor rights is important because debt recovery requires sufficient service, as well as supporting legislation and practical application.If the right to recover is not set forth in a legal and practical framework, then the costs and efforts associated with recovery can become prohibitive, diminishing the perceived value of the securities from the start.

Accelerating the Process

Trying to be dependent on national capital sources to support programs of asset-backed securities is not a good way to improve the situation, nor does it leave a lasting impression on the international financial community. However, the current gradual opening of the bank industry during the WTO transition period is a good time to introduce foreign capital sources.If capital can come in with confidence, then the scope and pace of bad asset disposal can increase. They key is to have the legislation and means in place for capital sources to be confident in their decisions.

One way of doing so is through tying the sale of bank’s bad credit rights in with foreign investor’s contracts to purchase and operate state-owned enterprises. Another more practical and effective method is to cooperatively joint venture with foreign companies that already have experience in disposing of bank’s bad assets.To that end, the Ministry of Foreign Trade and Economic Cooperation (MOFTEC) has already formally ratified the establishment of such joint ventures.HuaRong company was the first, and RongSheng asset management, established with Morgan Stanley bidding group and GaoSheng company, have also been established. MOFTEC’s allowance of the establishment of such sino-foreign joint venture companies represents the government’s efforts to resolve the problem of the disposal of impaired assets. Other legislation has begun to be enacted, as well.In 2004 the first asset-backed securities program of a domestic commercial bank was signed.It recognized that the bank in question had made substantive progress in the asset-backed securities innovation.

Enhancing the Market

In order for securitized assets to gain favor, attract investors and ensure the final goal of satisfactorily managing impaired assets, it is essential that secured assets be more liquid.Therefore, a sound secondary market should be established to provide more avenues for investors to cash out of their investments.

As the primary investors in the secondary market, the government should support special organizations of investors through policy, and encourage their development.It is in the government’s interest to cultivate customers to take over and manage poorly performing assets so that the burden of bad debt becomes more quickly relieved.Such methods of support can include tax preference, relaxation of regulatory controls, opening of market access, etc. Also, individual investors are a potent supplement to investor organizations and should be granted the same benefits.Trust management companies could also be more utilized and encouraged absorb and guide individual idle capital.

Reliance on Governmental Support

Legislation that supports all of this is important.Asset-backed securities have complexity, but also are systematic. For it to work across the country, national legislation to help standardize its operation is needed in order for investors to feel comfortable.

Since the disposal banks’ impaired assets will to a great extent be influenced by policy, the government should exert its active function in three areas related to asset disposal: (1) the government should infuse capital into bank and asset management companies, reset bank’s capital levels, and enforce stock-resolved measures; (2) enact flow control measures in order to prevent recurrences during the process of asset disposal; and (3) enact legislation toward further reformation of the bank industry (including continuing education programs for financial professionals).This will help prevent such situations from reoccurring, and would also help banks adapt in a post-WTO environment.