Securitization Can Work in China

Can securitization work in China?

Securitization was invented in the 1970s to resolve a U.S. systemic financial crisis. It can work anywhere, provided that (i) the legal system supports the market’s custom and practice; and (ii) the system of risk measures reflects true security risk and value.

Twenty years ago, securitization could not work in China. The law did not expressly allow asset purchases and sales. But in the last two decades, China’s central government has shown considerable will to foster securitization. Beginning in the late 1990s, quasi-securitization became possible when the four asset management companies, Huarong, Cinda, Great Wall and Orient, were formed to acquire and resolve state-owned commercial banks’ nonperforming loans (NPLs). The laws for this were codified in the Corporate Assets Special Management Scheme promulgated by the CSRC in 2003. China’s Trust Law followed in 2001, creating a legal basis for investors and securitizing firms to engage in U.S.-style securitization. In 2005, the PBOC and CBRC piloted an asset securitization system under the framework of Credit Assets Securitization Scheme. Over four years, CNY 66.785 BN insecurities backed by loans or mortgages were issued, and a repo market emerged.

The pilot stalled in the Global Financial Crisis (GFC) but was revived in May 2012 when the PBOC, MOF and CBRC issued Notice on Matters Concerning Further Expansion of Credit Assets Securitization Pilot. Final rules were promulgated March 2013 by China’s financial institution regulators PBOC, CSRC, CBRC and CIRC. China came full circle on securitization when central bank Governor Zhou Xiaochuan called for an orderly roll out of securitization in August 2013.

In the surface, China’s “single trust” securitization resembles the U.S. model whereby-

  1. Borrower identifies a pool of assets on balance sheet, to be conveyed to a Trust Company.
  2. Trust Company structures notes or certificates backed by the asset cash flows with a target credit quality and maturity.
  3. The notes/certificates are rated by licensed rating agencies and sold to investors.
  4. Sale proceeds are used to purchase the assets:
         a) Borrower receives cash proceeds. The assets are no longer under Borrower’s control.
         b) Because of (a) Investors are entitled to their share of all the cash flows coming from the assets.
         c)  Borrower on the verge of default cannot claim the assets back, and
         d) Investors cannot go back to the Borrower (or the Trust Company) for more money if the assets stop paying.

Chinese trust companies also sell “collective trusts.” Such transactions are also referred to as 信托(证券化), but these are not true securitizations. Instead of Step 1, loans are made to borrowers directly and conveyed to a trust company, which issues loan-backed notes. A recent example of a collective trust proved a test case for the industry. Credit Equals Gold No. 1 (诚至金开1号) was backed by a loan from ICBC Bank to Zhenfu Energy Group (振富能源集团) in Shanxi Province in 2010, which was later used as collateral for a structured note issued by China Credit Trust. Before the note came due in January 2014, Zhenfu’s capacity to repay the principal amount due was in doubt.

(Contrary to speculations in Zero Hedge and other Western media, Credit Equals Gold No. 1 did not test the Chinese financial system by defaulting. What happened next is content for another blog.)

This case example brings out an inner difference between the Chinese and U.S. market models. In the U.S., the credit risk of assets going into the trust is measured, not always accurately but always strategically. In China, the credit risk of assets going into the trust is at best haphazardly measured. China’s market lacks an authentic credit risk measurement paradigm.

In conversations with Chinese domestic market practitioners, I sense a deep anxiety on this point, accompanied by suspicion that U.S. style valuation may not be viable in China. But, securitization only works if the system of risk measures reflects true security risk and value. China needs credit risk measures—on the assets going in, and on the securities coming out. Ratings alone may not be enough, as the Global Financial Crisis (GFC) showed.

What is securitization, exactly?

Director of the Center for China in the World Economy, Li Daokui, has called securitization of commercial bank assets a “breakthrough point for China’s financial reform.” If securitization is just debt finance, what’s the big deal? The big deal is a paradigm shift. Securitization is based on a bottom-up model of enterprise value. It has disruptive, possibly revolutionary implications for how to nurture an economy.

The traditional corporate finance model is based on an incomplete description of “company financial anatomy” that focuses on the balance sheet (body) and capital (blood) and disadvantages the growing sector of the economy because it leaves out intangibles (lymphatic system), a precious source of energy for enterprise growth and competitive defense. Growing firms have a permanent need for “working capital” for liquidity and growth. Without reliable access, they are naturally more vulnerable and riskier than well-capitalized, established firms, which have less need for external financing.

There is no good direct measure of intangible enterprise value, but one indirect measure is the quality of the firm’s receivables: loans made by a firm to its own clients. Receivables are micro-capital that can be pooled, valued and used as a borrowing base instead of the whole balance sheet. By tapping this form of capital, securitization taps into the firm’s hidden energy system and sees a micro-picture of the firm’s current credit health, which is often much stronger than how it looks using the traditional tools of corporate credit analysis. This is not a paradox but the result of using a model of enterprise value that focuses on the internal capital formation process.

Will China pioneer its own style of securitization market?

Yes. Although I believe the microstructure of the two markets will be similar, Chinese securitization will take its own course and distinguish itself from the U.S. model in these three ways:

  1. The mix of assets will be different based on local credit conditions. The emphasis will be on SME, real estate and infrastructure credits, followed by consumer credit.
  2. There will be more experimentation with alternative distribution channels including organized exchanges, like the Alibaba deal.
  3. Because China is attempting to merge the shadow banking and securitization markets, overall investment performance may be more volatile initially than in the first 20 years of U.S. securitization market history. However, China has policy tools the U.S. does not have, not to mention a strong incentive to bring securitization into a comprehensive risk measurement framework—to avert U.S.-style crisis.

Author’s Note: on February 28, 2014, it was announced that a newly created department for corporate bonds within CSRC would regulate China’s securitization market.

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