China’s first margin loan ABS divides market
Guotai Junan’s Rmb500m ($80.6m) ABS has set a new landmark in China's securitization market, which has welcomed a raft of new asset classes this year. But while the opening up of a new funding channel for Chinese brokers has excited some market participants, others are worried it could deepen the country’s margin financing troubles.
The Chinese broker was in the market last week soliciting interest for what was the first ABS in China to be backed by margin loans. Guotai Junan was looking to free up Rmb500m of margin loans from its balance sheet in a deal that was split into a Rmb475m 4.9% senior tranche and a Rmb25m junior subordinated piece, which the broker is retaining.
Unlike most ABS in China, the transaction consists of a dynamic asset pool due to the short-term nature of margin loans. Before a rule change in July, margin loans in the country only had a maximum maturity of six months. Brokers are now able to roll over the loans beyond that to their discretion.
Both tranches in the Guotai Junan ABS have a maturity of 14 months.
Some market participants hailed the deal as a silver lining for Chinese brokerage firms, which have been left reeling from the fall from grace for Chinese equities over the past couple of months.
After hitting a record high of 5,178 in June, the Shanghai Stock Exchange Composite Index has gone on to fall 24%. It was quoted at 3,928 on August 10.
In a bid to curb the fall, last month a group of 21 Chinese securities firm were called upon to pump 15% of their net assets into a pool totalling Rmb120bn to buy A-share ETFs (exchange-traded funds) to support the market.
The China Securities Regulatory Commission (CSRC) also intervened by suspending all primary listings, as well as secondary trading for a multitude of stocks.
“It [the suspension] was made with good intentions in mind although the brokers were hit very hard by this because one of their primary sources of income was cut,” a Shanghai based capital markets lawyer said. “It’s also important to understand that their stocks were also routed by the drop, so they probably came out worse than most.”
The lawyer said that the Guotai Junan deal had therefore provided an alternative funding channel for brokers at a time when more conventional options might seem prohibitively dilutive or costly.
“It’s not that all their financing avenues have dried up, but they will definitely have to pay up compared to whatever they had been paying earlier,” the lawyer said. “The ABS market, on the other hand, not only offers them an alternative but, at a yield of 4.9%, a very cheap alternative.”
But not everyone shared his enthusiasm about a new securitization market fuelled by Chinese margin loans. One Hong Kong-based structured finance ratings analyst was surprised the deal was even given the go-ahead by regulators, particularly given the scrutiny that margin lending in China has come under this year.
China had one of the best performing stock markets in the world in the first half of 2015, with the Shanghai Stock Exchange Composite Index shooting up 44.1% to its record in June. A large part of that performance, however, was powered by retail investors backed by margin financing.
Things soon started to unravel when some market participants began to question whether the bull run had any legs left — and whether investors had enough capacity to repay their margin loans once the market turned sour.
That was especially concerning given how much margin lending has grown over the past year. At the height of the lending binge, the Shanghai Stock Exchange had outstanding balance of margin debt of Rmb1.48tr on June 19, a year-on-year increase of 560%.
“I wouldn’t be comfortable rating an ABS backed by margin loans,” the ratings analyst said. “There hasn’t been much on a global basis and there are good reasons why even some of the more aggressive securitization bankers have been unwilling to venture into this.”
The senior tranche of the Guotai Junan ABS is rated AAA by domestic agency Shanghai Brilliance Credit Rating & Investor Service.
Good or bad?
The main reason why critics say using margin loans as collateral is not a good idea is that it can be hard to deduce the potential default rate of the asset pool based on historical data — a common technique used in more conventional ABS.
Instead, the default rate will be more closely linked to the volatility of the stock market, which is susceptible to huge swings. This is especially true for the Chinese equities market, where retail investors make up the bulk of the daily trading volume.
“There are a few areas of concern here. One is the stock investors’ ability to repay the margin loans and the other is what the brokers are doing with the proceeds from the margin loan-backed ABS,” the analyst said.
He worried that stock investors in China are already in a highly-leveraged mode. And if brokers are freeing up space on their balance sheets to continue that lending spree, the situation could snowball into a crisis.
While a banker close to the deal agreed that such a situation would indeed be worrying, he explained that this could only happen if the analyst’s underlying assumptions about margin lending trends were correct. “It could be a problem if margin financing increases, but the opposite is happening right now,” he said.
Compared to its June high, the outstanding balance of margin debt on the Shanghai Stock Exchange had fallen drastically by 41.8% to Rmb861bn as of August 10.
That drop was thanks mostly to actions by the CSRC, which has been tightening its grip on margin financing. Zhang Yujun, assistant chairman of the CSRC, recently urged brokers to prohibit malicious short selling and stop providing cash for umbrella trusts.
Under current rules, investors are only allowed a maximum leverage of up to two times when buying stocks with cash collateral.
But by setting up a trust plan and a securities account for that plan, investors can borrow as much as five times their margin. Moreover, other investors are also able to add to the pool by opening sub-accounts in the trust without having to register new securities account of their own.
Keeping high standards
With the authorities keeping a close watch on margin financing, a Beijing based lawyer said margin loan-backed ABS should be able to grow into a viable asset class without fear of a systemic breakdown.
This is especially true if the Guotai Junan transaction is going to be the reference for the rest of the industry.
The asset pool comes with a 5% exposure limit, which prevents any individual loan from taking up more than that stipulated amount in the portfolio. In addition, the borrowers of the margin loans in the asset pool must have a collateral maintenance ratio above 150%.
These two measures ensure that the asset pool is diversified and the loans are strong, the lawyer said.
“As long as the standards are kept high, I think having a margin loan-backed ABS sector will be good since it provides product diversification for the market as well as funding diversification for the brokers themselves,” he said.
Guotai Junan’s deal was only made possible last month when the CSRC allowed margin loans to be used as a collateral for securitization.