The crash brought on by the subprime lending crisis in the US in 2008 caused markets around the world to reconsider financial derivatives, and the business of securitizing non-performing assets (NPAs) was also suspended for a time in China. However, with the increasing pressures felt as a result of the weakening Chinese economy, the rate of NPAs has continued to rise for several consecutive quarters and the market has searched high and low for a means to dispose of such assets. The market has therefore taken a second look at NPA securitization.
The issuance of the Guidelines for Information Disclosures Relating to Non-Performing Loan Asset Backed Securities (Draft for Comment) in 2016 is a harbinger of the imminent restart of non-performing loan securitization. Many NPAs are mainly caused by a short-term cash flow shortage, and if a significant quantity of funds can be committed, the NPAs have a good chance to become quality assets.
In financing terms, the advantages of asset securitization are obvious.
First, the financing costs are low. Disposing of NPAs requires a large cash flow, while management of the same requires large costs. In asset securitization, the use costs of the financing proceeds are relatively low; compared to bank loans, relatively high interest rates can be avoided; and compared to equity financing, the financing costs can be reduced while the enterprise's organizational structure is maintained. Additionally, the limit imposed by the credit rating of the NPAs themselves may be overcome through credit enhancement, to issue securities of a higher rating.
Second, an asset portfolio can reduce the risks of a single NPA. According to investment portfolio theory, combining negatively correlated securities can cause the risks of the securities portfolio to be less than the risks of any one type of security held, without reducing their anticipated return rate. The credit rating of NPAs is relatively poor and the risks of default are relatively high, but during securitization, if assets of different risk levels are combined into an asset pool, they can mutually offset the risks of single assets, thereby increasing the stability of the level of the returns of the entire asset pool.
Finally, risk remoteness eliminates the risks of the payment of the returns associated with the financed party. The major highlight in the design of an asset securitization structure is the establishment of a special purpose vehicle (SPV). The financed party removes the underlying assets from its hands by transferring the same to the SPV through a "genuine sale", and the SPV uses these as security to issue the securities.
Such a financing structure arrangement ensures that the asset securitization financing takes the specific assets rather than the entire credit standing of the financed party as the payment guarantee and credit basis. Accordingly, the repayment of the principal and payment of interest to investors is entirely unaffected by the financial position of the financed party itself, reducing the investors' and the financed party's credit risks. Since the risk of bankruptcy is eliminated, there is no need to provide relevant compensation to investors, thus reducing the financed party's financing costs.
The restart of NPA securitization also presents new opportunities for enterprises and the market. First, it can enhance an enterprise's capacity to defend against risks. Securitization allows different types of NPAs to enter one asset pool to achieve risk hedging; and, through accelerated transfer, separation and centralized disposal of the NPAs by the capital market, the percentage of non-performing loans is directly reduced.
Securitization can additionally allow rapid removal of NPAs from the balance sheet, sanitization of the on-balance-sheet assets, digestion of the accumulated risks from the sliding economy, optimization of the asset-to-liability structure and strengthening of business operation capabilities, risk management capabilities and core competitiveness. Additionally, the market-based and mass disposal method has a scaling effect, reducing the economic and time costs of disposing of NPAs and enhancing disposal efficiency.
Second, securitization also helps reduce the quantity of an enterprise's NPAs. With the weakening economy, the possibility that an enterprise can rapidly dispose of NPAs within a short timeframe decreases; and, generally, NPA projects can achieve relatively high returns only when the economy is doing quite well. However, holding assets for a relatively long period of time signifies that the management or disposal risks are relatively high. Through NPA securitization, an enterprise can sell the NPAs quickly and use the sale proceeds to invest in, or develop, a new project, increasing liquidity and helping it adjust its business structure.
Third, NPA securitization can increase capital sources. Asset securitization can provide enterprises with a new means of financing, effectively allowing enterprises to break their current over-reliance on bank borrowing. Securitization can also expand enterprises' revenue sources. Through NPA securitization, an enterprise generally can revitalize existing funds, without in general increasing liabilities, and secure a low-cost fund source, increasing asset liquidity.
Asset management companies specializing in the disposal of NPAs are presented with even greater opportunities. Traditionally, asset management companies have adopted a profit model where they make their money on the spread. The weakening in enterprises' performance capacity and China's reform of market-based interest rates have greatly squeezed their profitability space. Through NPA securitization, asset management companies can earn asset management fees, handling fees and other such intermediary service fee income, satisfying capital regulatory and leverage regulatory requirements. Asset management companies can also take advantage of this opportunity to expand the scale of their main NPA business to achieve a transformation in their profit model; additionally they can obtain experience in structured financing, securities issuance, etc., laying the foundations for their future operations.
Finally, NPA securitization can increase the diversity of underlying assets in the securitization market and increase the number of credit ranking and return rate tiers, further expanding the scale of the asset securitization market. Additionally, as compared to the increasing wealth and demand of people and the vast sums of idle private funds, the investment products currently available in capital markets remain insufficient.
In an environment where stock market risks are relatively large, non-performing loan securitization products can provide new investment products for the capital markets, open investment channels and increase product choice. While helping enterprises in effectively resolving non-performing loans, such products can satisfy different investors' risk appetites and their ever diversifying investment demands.
Author: Lü Liqiu, Gu Fang
Lü Liqiu is a partner in the Beijing office of Guantao Law Firm. She can be contacted on +86 10 6657 8066 or by email at llq@guantao.com
Gu Fang is an associate in the Beijing office of Guantao Law Firm. He can be contacted on +86 10 6657 8066 or by email at gufang@guantao.com