China NPL securitization: Pass the parcel

Bank of China brought an end to eight years of inactivity last May by selling RMB301 million ($46 million) in bonds backed by non-performing loans (NPLs). China Merchants Bank soon followed suit, raising RMB233 million. There was no shortage of demand among domestic institutional investors, even though the yields on the senior secured tranches are lower than interest rates on bank deposits. As the first NPL securitizations since 2008, it was a pilot project Beijing didn’t want to go wrong.

By the end of 2016, the six banks awarded quotas to issue asset-backed securities (ABS) with NPLs as the underlying asset had raised RMB15.6 billion through over a dozen transactions. More are expected in 2017, given the overall quota is RMB50 billion and reports that a number of smaller banks will be able to participate as well.

The return of NPL securitizations reflects the severity of China’s bad debt problem, which different sources put between $1 trillion and $3 trillion. The initiative was announced last year, with the government also revealing plans for regional asset management corporations (AMCs) and debt-for-equity swaps. Whether it is rolling NPLs into products sold to third-party investors, transferring them to AMCs for resolution or sale to third-party investors, or converting them into equity, these measures enable banks to move bad debts off their books.

The securitization idea was mainly driven by the central bank and the commercial banks don’t want to allow a default of these products – Eddie Hui

The rationale of NPL securitizations is sound – as it is with debt-for-equity swaps – but much rests on transaction design, and whether the political considerations that have characterized these initiatives in their early stages can give way to more sustainable, long-term thinking. 

“China wants a multi-pronged approach because the volume of NPLs it needs to resolve is too large for any one solution to be the entire solution,” says Ben Fanger, founder of China distressed debt investor ShoreVest Capital Partners. “There have been a few transactions but many participants assumed that there was an implicit guarantee by the government that these would not lose money. Future transactions will require the buyers to look more to the underlying assets, which can be difficult without a lot of detail.”

Securitization in practice

The difficulty in assessing whether or not securitizations can go mainstream is that a pilot project doesn’t necessarily take place in realistic conditions. For example, when China embarked on its first securitization experiment between 2005 and 2008, Orient and Cinda – two of the national AMCs tasked with absorbing bad debts from the big state-owned banks – and China Construction Bank issued RMB13.4 billion in bonds backed by NPLs with an original principal balance (OPB) of nearly RMB80 billion. About 60% of the total was senior secured.

However, each transaction was heavily over-collateralized – essentially ensuring investors in the senior tranche were guaranteed a return – and the subordinated tranches were retained by the issuers. Fitch Ratings observed that Xinyuan 2008, which was issued by Cinda, comprised RMB2 billion in senior bonds and RMB2.8 billion in subordinated bonds based on an OPB of RMB15 billion. The plan was to collect RMB5.1 billion over four years and RMB3.1 billion within 18 months. When Xinyuan 2008 was liquidated in 2010, RMB2.2 billion had been collected, which was enough to pay off the senior tranche.

According to industry sources, in the most recent transactions, the issuers have not held onto all of the subordinated tranches: they were bought by private investors, with the likes of banks and AMCs picking up the senior debt. But as in the previous cycle, the senior tranche was structured so that it would sell.

“The securitization idea was mainly driven by the central bank and the commercial banks don’t want to allow a default of these products. If you don’t allow defaults, you have to price the products very conservatively. And if that is the case the banks have to make provisions on those loans. If the banks have enough money to make provisions they wouldn’t move the loans off balance sheet, so I don’t think this will become a mainstream method for resolving NPLs,” says Eddie Hui, managing partner in the absolute returns division at PAG.

Fitch’s initial concerns around the latest NPL securitizations focused on cash-flow uncertainty. Would it receive detailed loan-by-loan collateral information, servicer business plans, loan purchase price information, and historical workout and performance data for the issuer and servicer relevant to the securitized asset pool? The National Association of Financial Market Institutional Investors, a self-regulatory organization set up under the central bank, is supposed to offer reassurance in this area: it issued guidelines last year on asset valuation and the disclosure of due diligence procedures.

Resolution issues

However, a more fundamental question involves the ability to resolve NPLs once securitized. “You’ve got a bank that has made all these poorly performing loans and now they are going to securitize them, and they are going to be the guys who collect them. There are many reasons why a state-owned bank isn’t going to collect money from a private company or a state-owned enterprise, everyone gets that. Securitization doesn’t change anything,” says Ted Osborn, a partner at PwC who focuses on restructuring and NPLs. “Insurance companies and banks will be encouraged to buy these securities but they won’t go overboard.”

China’s banks have engaged in various initiatives over the years to shift NPLs off their balance sheets in order to meet capital adequacy requirements set by regulators. In the past, underperforming loans have been classified as investments, which carry a lower risk weighting, and partnerships have been established with trust companies to package up NPLs for sale to retail investors or simply warehouse them. Similarly, joint ventures with the AMCs have emerged where the primary purpose is to move bad debts off balance sheet rather than to resolve them.

Securitizations could therefore pose a problem because they serve as a means of allowing banks to delay addressing NPLs. This view is not shared by all. “If the banks didn’t shift them there’s a danger they would just sit on the balance sheet for a rainy day, but when you expose those portfolios to other stakeholders then you have a different imperative,” one industry participant notes. Nevertheless, he professes some sympathy with the argument that responsibility for collection is left in the hands of the originating bank, it might not be the most efficient means to resolution.

A paper published by the IMF also flagged up a number of disadvantages to securitizations. It warned that these transactions can make debts harder to restructure, particularly in the absence of an unclear insolvency framework in China; that they may transfer risk outside the regulated financial sector to entities less able to absorb losses; that there isn’t a sizeable domestic institutional investor base willing to buy these products; and that a viable securitization market requires strong supporting legislation.

In this context, NPL securitizations will remain a work in progress not only until political considerations become less acute and market forces are allowed to prevail, but also until there is sufficient infrastructure in place to accommodate these transactions. And this is only possible with the introduction of broader reforms to corporate restructuring in China.

A more sophisticated and better enforced bankruptcy law – improvements have been made but most investors highlight the need for more – is a significant measure but not the only one. The IMF also advocates stronger regulatory oversight of banks to ensure proper recognition and workout of NPLs, a clear plan for addressing the country’s bad debt problem that includes multiple stakeholders, and an improved distressed debt market with more timely access to information.

Swapping in

Furthermore, a change in attitude is required: the financial system should not be used to prop up nonviable companies. This is particularly relevant to debt-for-equity swaps, where there is a risk that transactions are motivated by the political expediency of keeping large state-owned employers in operation rather than for commercial reasons. Even if there is a commercial rationale, banks are not natural company owners. They often lack the expertise to run or restructure businesses and there is a potential moral hazard if they continue lending to companies they control, adding to the debt pile.

Debt-for-equity swaps were employed in the late 1990s and early 2000s to remove souring loans to state-owned enterprises from bank balance sheets. They ended up with the AMCs. The next generation of swaps are intended to be brokered by banks and feature third-party investors. However, several deals completed last year saw debt sold to investors at face value before being converted into equity, with the target company obliged to buy back the equity at a later date if certain performance targets aren’t met.

It is unclear whether the new investors – some of whom are retail players who bought into wealth management products – will have sufficient influence over companies to the point of bringing about a restructuring. It also remains to be seen what sort of appetite there is for these transactions among institutions such as banks, which would likely only be interested in large positions where there is clear upside over a limited time period.

“We’ve been told by banks that they only want to do debt-for-equity swaps with healthy customers because they see it as a way of getting equity and making money through an IPO. They aren’t going to take debt and exchange it for equity in a zombie company – but those are the companies really being targeted for this,” says PwC’s Osborn. “Debt for equity swaps will happen and maybe there will be one or two good ones, but taking off as a way to solve the NPL crisis? Never.” 

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• Topics
• Greater China
• Restructuring
• Credit/Special Situations
• China
• Distress
• PAG
• ShoreVest Capital Partners