ABS: Foreign names seek deals in comfort zone

Supply of asset-backed securities (ABS) is growing in China. But most international banks, investors and originators are sticking to the segment of the market they know best — auto loan ABS. To get these foreign players out of their comfort zone, China needs to introduce more diversity in the market, bankers say. Noah Sin reports.

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China’s securitization market is booming.

ABS issuance hit Rmb1.47tr ($217.2bn) in 2017, up from just Rmb28.14bn in 2012, according to a report that Moody’s published in April. There were Rmb1.85tr of outstanding ABS notes at the end of last year, compared with Rmb32.1bn five years earlier. The market will continue to expand in the coming years, and it will be an increasingly important driver for economic growth, according to analysts at the credit rating agency.

Growth at this rate would have seemed inconceivable just two decades ago, says Alexander Batchvarov, head of interna­tional structured finance research at Bank of America Merrill Lynch.

“When I visited China and Asia for the first time on business in 1998, I thought we were never going to see an ABS market in this region,” the London-based banker tells GlobalRMB. “Loan-to-deposit ratios were as low as 30%. Banks were happy to lend very cheaply.”

Typically, banks’ lending criteria become stricter when this ratio hits 80%, says Batchvarov. Yet in China, the path to development took another twist: accord­ing to the Nomura Research Institute, the global financial crisis – which originated in the securitization market – prompted the central bank to halt a pilot ABS programme which had been running since 2005. It was not until 2012 that the market took off again.

The restart was inevitable, Batchvarov says, because the asset class is a necessary component of China’s capital market toolkit as the economy shifts from an export-led to a consumption-led model.

“You cannot do that without more supply of credit domestically, and it can’t all be done by banks,” he says. “Chinese authorities want to continue the lending cautiously without indefinitely expanding banks’ balance sheet. ABS can help them to do that.”

COMFORT ZONE

For international banks, however, the op­portunities within this market are limited, with the result that they are largely con­fined to doing auto loan ABS, leaving the rest of the field to the Chinese banks.

To begin with, these international lend­ers have a small market share in China, partly because of the restrictions on foreign majority ownership in financial institu­tions, which China only began to dismantle recently. Their one clear advantage lies with serving foreign players in this market.

Their challenge is most obvious with ABS underwriting. In the past 12 months, Standard Chartered (China) was the biggest foreign underwriter, closing Rmb6.8bn of deals, Wind data shows. But the bank only ranks 38th in the underwriter league table, with a tiny market share of 0.41%. China Merchants Securities (CMS), the market leader, sold Rmb253.6bn of ABS or 15.29% of all deals.

Foreign banks performed much better in auto ABS underwriting in the same period. The Rmb6.8bn of deals managed by StanChart were all auto ABS, but that was enough to give it a 6.23% market share. The bank still ranks behind CMS, but this time it is in fifth place in the league table, just ahead of state-owned China Merchants Bank.

As Chinese consumers grow richer, demand for cars, including foreign ones, is increasing. The onshore subsidiaries and joint ventures of foreign carmakers, from BMW and Hyundai to Mercedes-Benz and Volkswagen, have readily available cash­flows on their books.

“That’s mainly being driven by the wider economic backdrop,” says one China DCM head at a Japanese bank. “More and more Chinese consumers are borrowing to pur­chase new cars.”

The market is promising. S&P estimates that auto ABS accounts for 10%-15% of annual funding needs in the auto finance sector, compared with 18% in the US.

The downside is that auto loans repre­sent only a small part of the overall ABS market.

Of the Rmb2tr in outstanding ABS notes in China as of August 21, only 4% are auto loan ABS notes, according to Wind. Resi­dential mortgage-backed securities (RMBS) is largest piece of the market, with a share of 22.90%, followed by ABS with accounts receivables and micro loans as underlying, which make up 13% and 11% of all ABS outstanding.

The DCM banker argues that interna­tional banks are smart to stick with auto ABS, even if in reality they have little choice in the matter.

“I notice that there is growth in other asset classes, such as RMBS, but we are staying in auto loans for very strategic reasons,” he says. “These assets have a lot of commonality with auto loans overseas. People have to make 20% down-payments. We consider them very conservative assets. We are comfortable with our business model.”

BUY-SIDE WOES

Similarly, foreign investors are attracted to autos because they are familiar with the originators, say bankers. The launch of Bond Connect in July 2017, which made access to onshore fixed income easier, has spurred interest in ABS among offshore investors, says the DCM banker.

“Because of Bond Connect, people are increasingly looking at this asset class,” he says. “We have had conversations with various offshore investors, from banks to asset managers, about investing in this market.”

But foreign investors represent a rela­tively small portion of the buyers of these products. Less than 10% of Ford Automo­tive Finance (China)’s Rmb4bn offer last August, the first foreign ABS sold through the bond link, was taken by offshore accounts.

On average, other foreign auto names fare no better than Ford in the ABS market. But taking into account only Bond Connect flows may underplay the level of foreign participation, according to Andy Lai, head of securitization for Asia Pacific at BNP Paribas.

“The level of offshore investor involve­ment is not massive, they take less than about 10% of the deal size,” he says. “But if you count the onshore subsidiaries of offshore investors, then their share could be between 20% and 40%.”

The onshore arms of foreign banks often provide support for foreign name origi­nations. For instance, Japanese banks are keen investors of ABS sold by Japanese car manufacturers, as shown by the Rmb4.5bn trade originated by Dongfeng Nissan Auto Finance in July.

Foreign buyers should not be blamed for their narrow scope. That responsibility falls squarely on the supply side, Batch­varov argues.

“In China, the majority of ABS transac­tions only have senior tranches,” he says. “We need to see the development of mez­zanine tranches. In most other markets, you would have banks buying the senior tranches, and asset managers taking the lower tranches.”

Aaron Lei, senior director for structured finance ratings at S&P, makes a similar observation. International experience shows that a more diverse market, in terms of credit quality, can entice a broader base of investors.

“In global securitization markets, weaker issuers or riskier assets are typi­cally associated with higher credit spreads in their notes than those with better risk profiles, hence creating differentiation of notes pricing,” he says. “In China, as most securitization issuers are industry leaders and collateralized assets are prime ones, such price differentiation is naturally limited.”

Batchvarov reckons foreign investors’ critical approach to investing, in par­ticular, will be a valuable addition to the Chinese market.

“They would also look at how the underlying assets are different in China from other jurisdictions,” he says. “They would ask: what are the pros and cons of buying these ABS in China relative to other geographies?”

UNDERLYING LESSONS

Regulators, too, need to consider case stud­ies from other markets, as they prepare to allow more credit differentiation in the market while ensuring that systemic risk is contained, in accordance with the policies of president Xi Jinping.

The key to pulling off this balancing act is to keep an eye on what really matters in securitization, the underlying assets, Batchvarov argues.

“People tend to focus on the regulation of the securitization product itself, but this is incorrect,” he says. “ABS is just an instrument. Regulators, who want to con­trol risk, are not focused only on that. They are interested in controlling the lending criteria — what determines the quality of the asset.”

This is a fundamental principle that US bankers, investors and regulators chose to forget in the run-up to the subprime mort­gage crisis that spawned a global recession in 2008.

Chinese regulators should learn this lesson and keep their eyes on the ball, says Lei.

“We have to bear in mind that the prod­ucts really affected during 2008 and 2009 period were mostly related to subprime mortgages,” he says. “The market learned in a hard way that no structuring tech­niques could fully compensate the risk of irresponsible lending, and proper loan underwriting and risk pricing should be key considerations for deal investment.”

BOX

WHY BOTHER WITH ABS?

Before and after ABS deals come to the market, originators have to pay up.

ABS deal-making is expensive, from structuring the deal to servicing the pool of assets throughout the lifetime of the transaction.

Fortunately for originators, there are ways to get around these roadblocks, says BNP’s Lai.

“The way you amortise the expenses and achieve a lower all-in cost is by making the deal bigger,” he says. “You will also get better publicity if you manage to close a jumbo deal.”

SAIC-GMAC Automotive Finance, General Motors’ joint venture in China, did just that in June, sealing a Rmb10bn deal. ABS can also offer value for money when borrowers come to the market repeatedly, according to S&P’s Lei. Most of the foreign names sell more than one auto ABS deal per year in China.

Besides, other financing channels are not always less expensive if you take a closer look at the hidden costs, as BAML’s Batchvarov points out.

“If you do a bilateral bank loan, for instance, there is a commitment fee paid to the bank,” he says. “Also, the company is the entity that is legally obliged to repay. While in securitization there is no recourse of the bondholders to the issuer.”