China asset-backed notes: it’s time to stand alone
Too many Chinese investors focus on the originator more than the asset pool. That undermines one of the crucial purposes of securitization.
What is securitization for?
Critics might answer that its purpose is simply to make banks money. There is a grain of truth to this, since banks wouldn’t bother with a market that offered no upside. But regular ABS issuers are stingy. There are some ancillary benefits of managing a company’s securitization, as well as the potential for profit on banks’ trading books, but securitization is hardly a big money-spinner.
The other obvious answer is that securitization is just another funding tool, offering originators an all-in cost of funding that should be at least as attractive as other financing options, if not much cheaper. Again, this is not far off but it ignores the crucial advantages for investors and originators that securitization offers.
Let’s stick with a textbook-style definition. Securitization is the process of transforming assets — anything from mortgages or auto loans to future receivables on airline tickets — into securities.
It allows investors to get direct exposure to the cash flows generated by a pool of assets, rather than taking credit risk on an individual company. This has a crucial advantage: estimating cash flows from well-defined asset pools should be much easier than figuring out likely cash flows from corporations, which tend to be well-trained in the dark arts of obfuscation and puffery.
There is also a clear benefit for originators. By separating the credit risk of a pool of assets from the credit risk of a company, corporations can raise money without increasing their debt levels. Since securitization is typically structured as a sale of assets, it keeps a company’s balance sheet intact.
This is, at least, the theory. But some originators and investors prefer a more fuzzy world, where corporate risk and asset risk are combined in a sometimes muddled way, turning securitization into a dual-recourse structure that adheres better to the philosophy of covered bonds. This is the case in parts of China’s securitization market, where shortfall guarantees are a typical way of blurring the lines between asset and corporate exposure.
China’s securitization market, like the rest of the country’s capital markets, is regulated by a set of different, sometimes competing regulators. The market is generally split into three main categories: credit ABS, typically originated by financial institutions and sold on the interbank market; exchange ABS, usually securitized corporate assets, this time sold on the exchange bond market; and asset-backed notes, another financing option for corporations but this time on the interbank market.
Bankers say credit ABS rarely has a shortfall guarantee nowadays, reflecting the increasing sophistication of China’s banks when it comes both to their own funding options and to the wider development of the market.
Exchange ABS is much more likely to rely on shortfall guarantees and other forms of originator protection. There is some logic to this: exchange ABS deals often securitize future payments. Bankers defend the practice of the guarantees by arguing they are designed to show an originator’s commitment to the product — and the likelihood that those future assets will remain high quality — rather than provide a credit wrap.
What about asset-backed notes? These are usually not all that different to credit ABS, typically securitizing a pool of assets — albeit sometimes revolving assets — that should need little help from a shortfall guarantee. But investors demand more. Companies too often give it to them.
A reliance on guarantees in one part of China's ABS market may not be a large problem in the grand scheme of things. Bankers say they are working hard to develop the ABN market, including convincing investors and originators about shortfall guarantees. But at the moment, it represents a weakness in China’s securitization market.
One of the great strengths of securitization is also one of its great dangers: there is so much room for innovation. Securitization can be used for almost any type of asset. Tranching can create very specific risk exposures. Over-collateralisation can provide reassuring credit enhancement.
These are all great benefits when handled carefully. But the focus should never shift from the main part of securitization: the asset pool. That should be the key consideration for investors in China’s ABN market. The more they keep their eyes fixed on the credit risk of originators, the longer it will take for the market to fulfil its full potential.
Does that really matter? Perhaps more than you might think. The primary function of securitization for originators — removing risk from their balance sheets, allowing them to fund while freeing up capacity — is also a great boost for the wider financial system.
Securitization can be a great tool for spreading risk throughout different parts of the financial system, particularly on those deals — like ABNs — that can be sold to foreign investors through the Bond Connect scheme. But that doesn't happen by magic.
Bankers and originators should work together to make sure Chinese securitization continues to move forward. If they don't, the regulators just might force their hand.
This piece was first published online in Asiamoney on December 8.