The Expanding Universe of Securitization

2000/12/12

Analysts: Joanne Rose, New York (1) 212-438-6601;
Patrice Jordan, New York (1) 212-438-2501;
Joseph F Sheridan, New York (1) 212-438-2605;
Kurt Sampson, London (44) 20-7826-3535;
Barry Hancock, London (44) 20-7847-7202;
Alain Carron, Paris (33) 1-4420-6664;
Clayton Hunt, New York (1) 212-438-2492;
Calvin R Wong, Hong Kong (852) 2533-3501;
Fabienne Michaux, Melbourne (61) 3-9631-2050;
Rosario Buendia, New York (1) 212-438-2410

As the structured finance business spreads across the globe, the market is expected to experience numerous developments and innovations in the coming years. Nations throughout the world are easing the way for securitization, usually by encouraging home ownership, which they hope will lead to the development of an RMBS market. Following that, other consumer assets, such as personal loans and auto loans, are generally securitized. Indicating growing sophistication among issuers and investors, CMBS and other, more complex instruments, including pools of corporate bank loans, are embraced.

Asset securitization is one of the most significant financial innovations in the global capital markets, substantially enhancing the management of assets and liabilities by individuals and corporations, said Joanne W. Rose, executive managing director of Standard & Poor's Structured Finance Ratings group in New York. "Structured finance is a very robust market and it is broadening both in terms of asset classes and the use of securitization techniques in other forms of financing. Most exciting is the growth occurring outside the U.S. and the developments that are different from U.S. structures," Ms. Rose said.

Issuance of private-label (non-agency-guaranteed) RMBS reached US$92 billion in the U.S. in 1999, up from just US$250 million at the market's beginning in 1977. ABS have grown at a breathtaking rate in the U.S., from a little more than US$1 billion in 1985 to a projected US$215 billion in 2000. And CMBS grew from a mere US$5 billion in 1990 to almost US$80 billion in 1999. Global securitization topped US$1.1 trillion in 1999, but issuance in 2000 will be moderately smaller due to the significant increases in interest rates during the first six months of the year.

"What started as true sales of large pools of homogeneous assets-primarily consumer assets-has spread to allow the technology to be used for more diverse, unique asset types," said Patrice Jordan, managing director of global asset-backed securities in Standard & Poor's Structured Finance Ratings group in New York. "Today's securitizations are an expanding universe where the 1970s U.S. definition has morphed into a variety of instruments known as securitizations that differ greatly in terms of asset types and structures."

Securitization involves the use of legal structures to separate a pool of assets from the general credit of the assets' originator. Basically, the structure segregates the assets from the effects of an insolvency of one or more parties to the transaction. In these types of financings, also known as structured financings, investors do not generally have recourse to the transaction's sponsor. Instead, the deal depends on the performance of a defined pool of assets. In comparison, corporate financings provide investors with recourse to the corporation's balance sheet.

The U.S. is the largest, most sophisticated securitization arena, having been around for 30 years, and other nations are well on their way to realizing the true potential of this market. Regardless of the stages at which individual nations find themselves, the global securitization business is broadening and deepening year by year.

Europe Provides Best Growth Opportunity
"Europe is the best growth opportunity outside the U.S. today because the major financial institutions in Europe are starting to embrace securitization in a meaningful way," said Kurt Sampson, managing director of Standard & Poor's Europe Structured Finance Ratings group in London. "These banks have been originating assets for years, pursuing the idea that bigger is better. Now they are facing challenges, among which are trying to improve both their returns on equity and shareholder value, and these initiatives are driving the securitization market."

There are two major ways that banks can improve their returns on equity: increase the margin on the loans they are holding, or move assets off their balance sheets. It would be difficult to increase the interest on outstanding loans, but it is relatively easy to sell assets and return to the bank a significant portion of the funds that were previously tied up due to regulatory capital requirements. In fact, European banks are holding enormous quantities of loans on their balance sheets-residential mortgages, auto loans, personal loans, trade receivables, and credit cards, to name a few-which gives them large potential pools of assets to securitize.

Also spurring securitization among European banks are the frenzied pace of mergers and acquisitions (M&A) among financial institutions, and the advent of the euro, which has eased the way for institutions to invest in assets from a wider variety of sources. Worldwide announced M&A volume in 1999 surged to a record US$3.1 trillion, up from more than US$2.6 trillion a year earlier, according to Barry Hancock, managing director in Standard & Poor's Financial Institutions Ratings group in London. In Europe, M&A doubled to US$1.2 trillion in 1999, up from US$591 billion one year earlier.

European banks are also anticipating the changes that could be wrought by the BIS proposal from the Basel Committee on Banking Supervision, which would encourage securitization by standardizing the amount of regulatory capital required by banks based on the risk weightings of various holdings.

Mark Bowles, a director at Bank Austria/Creditanstalt in London, primarily invests in European ABS. "Although we used to purchase U.S. securities, the vast majority of our current purchases are European ABS. We now feel the European market has reached a position where we can concentrate on our local area," he said. "And now with the euro, it's an advantage for us. We have no problems going into Italian or Portuguese deals, for example, whereas a couple of years ago we might have had problems."

Passage of Laws Aids Securitization
Not only has the euro prompted growth, there have been a variety of new laws passed in France, Germany, Italy, Spain, Portugal, Finland, and Luxembourg, among others, that have eased the way for securitization.

France has benefited from the passage of two important laws. Since an initial law allowing the establishment of "fond communs de créances" (FCCs) and authorizing the sale of MBS more than a decade ago, the country has updated it to accommodate the growing sophistication of its structured finance market, said Alain Carron, director of Standard & Poor's Europe Structured Finance Ratings group in Paris. With its most recent change, in 1998, the French Ministry of Economics and Finance allowed issuers to create transactions similar to the credit card master trusts and commercial paper conduits used in the U.S. The FCC is a French statutory securitization vehicle similar to special-purpose entities (SPEs) in the U.S.

Yet despite the French government's efforts, this market's potential has remained largely untapped, Mr. Carron noted. Cumulative residential mortgage securitizations total about euro (Eur) 10 billion, and only one approximately Eur1 billion securitization of loans to local authorities was completed, by Credit Foncier de France.

Last year, the government passed a law authorizing "obligations foncière," securities modeled on the German "Pfandbriefe," itself a type of structured financing that has been around for more than a century, Mr. Carron said. Obligations foncières are debt instruments collateralized by residential and commercial mortgage loans, as well as loans to public-sector entities. Under the new legislation, SPEs called "sociétés de crédit foncier" will be established as wholly owned subsidiaries of banks and other financial institutions, and the activities of these sociétés will be limited to the origination and purchase of mortgage and local authority debt, and the issuance of the obligations foncières.

Based on the overwhelming success of the Pfandbriefe, it is expected that obligations foncières will also be embraced by the capital markets. As of the first quarter of 2000, French banking authorities had granted licenses to three "sociétés de crédit foncier." They are Compagnie de Financement Foncier, Dexia Municipal Agency, and Crédit Foncier et Communal d'Alsace et de Lorraine-Société de Crédit Foncier.

Residential Mortgage Securitizations Kick Off in U.K.
The U.K. was the first European country to debut a modern securitization-in this case, a transaction backed by residential mortgages-in 1987, according to Karen Naylor, a director in Standard & Poor's Europe Structured Finance Ratings group in London. The market took off because mortgage lending companies realized they could use the structured finance market to obtain funds and, thus, generate new business.

When a recession hit in the early 1990s, the securitization market all but faded away but it picked up again when it was over. The first to return to the market were subprime lenders.

Kensington Mortgage Co. PLC is a repeat subprime RMBS issuer in Europe with its series of Residential Mortgage Securities transactions. "We were a low-cost originator without financial backing from a huge organization so we got into securitization as an alternative to retail funding," said Tim Cooley, the head of structured finance at Kensington. "We generally come to market three times a year-once every four months-and as our volumes have increased, so have the sizes of our deals."

Kensington began by issuing notes denominated in British pounds sterling but subsequent transactions have been denominated in euros and U.S. dollars. "More and more issuers are coming to market in sterling in this country-our competitors, for example-so there is the danger that the market will get oversaturated. Also, it widens our investor base," said Mr. Cooley.

Gradually, high street banks began to see the benefits of securitization and they, too, entered the fray in earnest in about 1997. "The market here is becoming very competitive," said Ms. Naylor, "with lending institutions offering attractive retail deposit rates. At the same time, new market entrants aren't traditional branch-based originators but Internet-based banks that are offering very competitively priced mortgage products."

Abbey National PLC, Bank of Scotland, and Northern Rock PLC are just a few of the market's regular issuers. Abbey National Treasury Services was an experienced investor in ABS and MBS, according to Chris Fielding, its head of treasury advisory services, so its expertise in those areas helped it to view securitization as a tool for both balance sheet management and funding diversification. "We have a massive stock of assets-£60 billion mortgages, which we regarded as illiquid-and part of the exercise was to prove that there was liquidity in that market," Mr. Fielding said.

Other markets where residential securitizations have taken off include Germany, the Netherlands, and France. In Germany, due to the importance of banking confidentiality, issuers have adapted existing laws to allow for the securitization of pools of mortgages using synthetic structures, where a bank securitizes a reference pool of securities. The actual assets remain on the issuer's balance sheet and it uses the proceeds from the transaction to buy a pool of 'AAA' rated bonds to act as collateral but the losses on the mortgages are allocated to the bondholders. "The real drivers of this type of structure are capital relief and returns on equity," Ms. Naylor said, "and, at the same time, it helps ensure confidentiality."

Other Consumer Assets Become Popular
Other types of consumer assets-primarily personal loans-are gaining importance in Europe as countries in the region develop cultures that are gradually becoming more dependent on and comfortable with the use of credit. This "credit culture" is not nearly as widespread in Europe as it is in the U.S., but the European market is heating up, spurred by entrance of several American companies, including MBNA International Bank, as well as units of Capital One and Household Finance Corp..

MBNA International Bank, a subsidiary of MBNA America Bank N.A., is a fully licensed U.K. bank. Established in 1993, it completed its first securitization 18 months later-£207 million (US$312.36 million) of ABS. As of mid-2000, it has sold 11 credit card securitizations plus one consumer loan securitization, all denominated in British pounds sterling, totaling more than £3 billion. Its most recent transaction was denominated in euros.

"We view the European market as having significant opportunities for MBNA in the long term," said Vernon H.C. Wright, vice chairman and chief corporate finance officer. "The U.K. is part of the EU so it's very easy for MBNA International to branch into various European countries. The question is, what is the right timing? Obviously, that has to do with the development of the consumer market and the utilization of credit cards or other types of consumer loans."

The entrance of new competitors into the European consumer lending market shook it up. Barclays Bank PLC, through its Barclaycard business unit, issued Gracechurch Card Funding (No.1) PLC worth US$1 billion. When it hit the market in November 1999, it was the first securitization of consumer credit cards by a U.K clearing bank, and it also ranked as one of the largest European credit card backed securitizations.

The mix of assets finding their way to the market is dependent on the entities issuing the securities. At this point, the majority of the issuers are large financial institutions, rather than specialty finance companies, which could bring different types of assets and credit qualities to the market.

The specialty finance company hasn't really arrived in Europe quite yet, according to Jack Caouette, vice chairman of bond insurer MBIA Insurance Co., but it's on the horizon. "In time in Europe, it's logical that this will happen; but I think it's going to be some time."

Asset-Backed Commercial Paper Conduits Increase
As of third-quarter 2000, total asset-backed commercial paper (ABCP) in European-based conduits was US$71.6 billion, an increase of 12% from the end of 1999. Today, there are more than 44 conduits based in Europe-which was about 10% of the size of the U.S. market, although this recent growth has pushed that up to around 13%, said Perry Inglis, a director in Standard & Poor's Europe Structured Finance Ratings group in London.

A number of German banks have set up ABCP conduits, including Deutsche Bank AG, Westdeutsche Landesbank Girozentrale, Bayerische Hypo- und Vereinsbank AG, and Commerzbank AG. These conduits have been set up by a number of U.K. banks as well, including National Westminster Bank PLC, Barclays Bank PLC, and Bank of Scotland. Spain's Banco Santander Central Hispano has sponsored a conduit, too, and there are also several French bank-sponsored conduits. Other recent country entrants have included Belgium, Denmark, and the Netherlands.

ABCP programs are SPEs used primarily to finance the acquisition of consumer or commercial receivable pools or securities with the proceeds of commercial paper notes. Commercial paper usually has a maximum maturity of less than one year.

Assets typically funded in the conduits include trade receivables, auto and other consumer loans, and mortgages, along with a range of more esoteric assets, such as rolling stock, auto rentals, and whole businesses, he added. "The majority of ABCP is issued by conduits, and a conduit is a way of providing short-term financing for assets that may or may not be short term," explained Mr. Inglis. "It's a very flexible financing tool for funding a wide range of asset types."

Conduits may be set up for a variety of reasons. Many program administrators have provided a cost-competitive funding alternative to banking clients, while others have capitalized on arbitrage opportunities by purchasing longer term securities and funding the acquisitions with shorter term notes. Investment banks will often establish one or possibly more than one conduit for arbitrage opportunities, and these vehicles now account for more than 60% of total European issuance. Asset sellers, in many cases, have removed the assets from their balance sheets and freed up capital for other uses.

Many asset originators like commercial paper conduits because they offer confidentiality. When a conduit issues ABCP, the investor doesn't necessarily know what types of assets are in the conduit, nor which companies originated them. "This is important for many sellers as they do not want the underlying relationships with their customers to be impacted in any way by the securitization," said Mr. Inglis.

Investors are often drawn to the ABCP market by attractive yields and the risk-reward trade-off associated with highly rated securities.

Traditionally, European-based conduits have funded themselves in the U.S. market but, with the advent of the euro, there is a slow but definite trend to issue European commercial paper matching the currency of the underlying assets. This negates the need for hedging and, therefore, reduces the funding costs still further for a company selling its assets into a conduit.

During the past decade, the shift in U.S. savings from bank deposits to higher yielding money market mutual funds has created enormous demand for high quality, short-term paper. "This demand has far outpaced the growth in the corporate commercial paper supply, creating an extremely favorable environment for ABCP program administrators to grow their businesses," said Joseph Sheridan, managing director of Standard & Poor's North America Structured Finance group.

ABCP has risen to 48% of dealer-placed U.S. commercial paper from 6% during the past 10 years. "At the end of 1999, the market passed the half trillion dollar mark. There were 55 new ABCP programs established in 1999, and the number of programs selling paper in the U.S. is rapidly approaching 250," Mr. Sheridan said.

Commercial Mortgages Spur Innovations
All of the changes taking place in the European financial institutions sector-increased M&A activity, the common currency, and the new emphasis on shareholder value and returns on equity-are impacting the ways in which commercial property is being financed.

The initial approach to CMBS in Europe involved the securitization of commercial properties-either single properties or pools of properties located in the same country-by the properties' owners. Several transactions have been completed in the U.K. involving securitizations of large single properties, including Canary Wharf Finance PLC, Morgan Stanley Mortgage Finance (Broadgate) PLC, and Trafford Centre Finance Ltd.

"The private bank market-the customary funding source for European borrowers-really can't handle these large amounts of debt without having to syndicate the loans, which is cumbersome. The securitization market can offer flexibility to these property owners that large loan syndicates cannot," said Clayton Hunt, Jr., director of international CMBS in Standard & Poor's Real Estate Finance group in New York.

In the past several months, the European CMBS market has seen two distinct innovations: the securitization of a pool of commercial properties spread throughout Europe, and the origination of commercial mortgages with the intention of eventually securitizing them. Calling it a watershed event, Mr. Hunt pointed to Europa One Ltd., a Eur1.35 billion transaction from Frankfurt's Rheinische Hypothekenbank AG, known as Rheinhyp. The first Pan-European multi-jurisdictional CMBS issued, it consisted of assets or loans the bank had booked in five countries on the Continent.

As with some German residential mortgage securitizations, this, too, depended on a synthetic structure. "There were a few structural changes on the loan administration and servicing side, but from an accounting perspective, it was not really difficult. From the time we discovered that we would go the synthetic route to the time we finalized the structure, it took us six months," said George Ruchti, head of structured finance and portfolio management at Rheinhyp in Frankfurt. When it came to selling the bonds, "we attracted a lot of interest from the insurance industry throughout Europe-certainly not limited to Germany-and a small number of banks, as well," he added.

As a result of the success of this particular offering, other banks are interested in securitizing their commercial loans, according to Mr. Hunt. "I think it's likely we'll see a tremendous amount of activity coming out of Germany. There's talk that we could eventually see Eur10 billion of securitizations a year from German banks' commercial loan portfolios alone. I think that's optimistic but it shows that people are energized by the growth of this marketplace," Mr. Hunt said.

The second innovation in Europe resembles activity in the commercial real estate sector that has been common in the U.S. for about five years-the origination of commercial mortgages with the express intent of securitizing them. Essentially, a company establishes an SPE that originates the loans, warehouses them, pools them, and uses them as collateral to issue CMBS. In particular, Morgan Stanley & Co. Inc. has been extremely active in the development of the U.K. market.

In addition to the U.K., Italy is a major player in the European CMBS market as a result of some legislation passed recently that allows banks to write off their nonperforming loans in return for tax relief. One example is Island Finance (ICR4) S.p.A., sponsored by Banco di Sicilia S.p.A., which sold Eur420 million of asset-backed notes in March 2000.

Hybrid Securitizations Are High Profile
Despite the growing importance of transactions backed by consumer assets and commercial real estate, the European market has become known for its unique deals, which include securitizations of revenues generated by U.K. pub contracts, U.K. motorway service areas, French champagne inventories, and the international Formula One car racing organization. Even the Italian government's delinquent social security contributions have been securitized. These creative offerings, known as hybrid securitizations or even whole business securitizations, carry elements of both corporate and securitized bonds.

Despite their high profiles, these types of transactions are not the basis of the European structured finance market, emphasized Mr. Sampson of Standard & Poor's. While they make headlines, they cannot usually be replicated and they do not contribute to the growth or liquidity of the market. "Where do I expect to see real growth? Traditional assets, like residential mortgages, consumer loans, and commercial real estate," he said.

Asian Markets Operate Independently
Unlike Europe, where a new law in one country encourages the passage of a similar law in another country so that banks and other corporations throughout the region can maintain a competitive advantage, Asia-Pacific is not a homogeneous region when it comes to securitization. Rather, there are pockets of activity in nations that function independently, according to Calvin Wong, the Hong Kong-based managing director of Standard & Poor's Asia-Pacific Structured Finance Ratings group.

"Japan is a market unto itself, and the Australia-New Zealand region is a market unto itself," he explained, "and there's not much interplay between them, although there are a few examples of ways the region could become more integrated."

Mr. Wong pointed to the efforts of Australian investment bankers to structure transactions in Korea and Singapore that would be sold in Europe. For example, Macquarie Bank Ltd. is trying to initiate residential mortgage securitizations in China, he said, and a unit of Societe Generale had securitized a pool of corporate leases in Korea via its Hong Kong and Tokyo operations.

"Eventually we may see Japanese assets sold into Australian commercial paper conduits, or Asian assets sold into Aussie conduits. Or maybe, at some point, we could see Aussie and Japanese investors buying Japanese securities. But those things haven't happened yet," Mr. Wong said.

Australia Is Region's Most Active Market
Australia is the Australasian region's most active market, as well as its oldest. It is also a fairly conservative arena, according to Fabienne Michaux, director of Standard & Poor's Asia Structured Finance Ratings group in Melbourne. Until 1997, nearly all its transactions were backed by residential mortgages and all of those RMBS deals carried 100% mortgage insurance, supporting 'AAA' ratings.

Issuance of structured financings backed by Australasian assets set a new record in 1999, Ms. Michaux said. Standard & Poor's assigned ratings to 56 transactions totaling almost A$33 billion (US$19.49 billion) by program size, and A$25.7 billion (US$15.18 billion) by actual securities issued, in 1999. These new issues brought to A$69.9 billion (US$41.28 billion) the amount of total securities outstanding as of Dec. 31, 1999, with a total issuance capacity of A$108.4 billion (US$64.02 billion). Of the securities issued in 1999, 62.4% were RMBS, 28.5% were ABCP, 8.1% were ABS, and, for the first time, 0.6% were CMBS.

Residential mortgages have continued to dominate the issuance landscape in 2000, and there has also been significant activity in the ABCP sector, as well. While term ABS have been limited to three transactions, it is encouraging to note that the diversified asset types finding their way into ABCP conduits are expanding to include small business loans, margin loans, and auto and equipment contracts, along with the traditional trade receivables pools, residential mortgages and repackaged RMBS, and corporate loans and bonds. While only one CMBS transaction closed through the mid-third-quarter 2000, several others are in the pipeline and at least one is expected to close before year-end.

Issuers Move Offshore

But Australia is a relatively small country so its limited population, combined with its isolation from other capital markets, has encouraged it to move in new directions in recent years. Because of the limited appetites of domestic investors, issuers have begun offering their structured financings to global markets.

There were nine cross-border issues totaling A$8.9 billion (US$5.26 billion) in 1999, up from five in 1998. Seven issues were placed in Europe and sold globally-that is, into both the European and U.S. markets.

In the future, it seems that some Aussie issuers will be stepping into the U.S. market, a trend that is already emerging, with four of the seven offshore issues tapping into the U.S. markets, as of the mid-fourth-quarter 2000, through global offerings. What's more, there are many more issues expected over the coming year.

"The main reason we haven't seen more offshore issues this year is the spreads on the cross-currency swaps," Ms. Michaux said. "And, for the smaller issuers and those with limited balance sheet or warehouse capacity, the weakening performance of the Australian dollar against the U.S. dollar means that significantly more Australian dollar-denominated assets are needed to support U.S. dollar offerings."

Concurrently, domestic investors are becoming willing to move down the credit spectrum to securitizations rated as low as 'BBB', and they are branching out into securities backed by consumer assets, including retail credit cards and auto loans, as well as commercial mortgages. Also, at the short end, Standard & Poor's is seeing more 'A-2' rated conduits coming to market. Furthermore, in the past year, the first 'A-3' rated conduit was launched by ANZ Investment Bank. As investors begin to take on additional risk, their internal organizations are changing as they hire credit analysts to focus specifically on structured finance paper.

RMBS Grow Increasingly Sophisticated

Probably due to its emphasis on RMBS, Australia's residential mortgage origination business has become quite sophisticated, noted Paul Burke, a managing director at Chase Manhattan Bank in Hong Kong. "Instead of having the banks fund mortgages on their balance sheets, the banks set up vehicles that generate the mortgages and securitize them directly," he said, pointing to Macquarie Bank's Puma vehicle as one example.

The Australian RMBS sector experienced several firsts in the past year. For instance, The Home Loan Co. Ltd., the captive finance arm of AV Jennings Homes Ltd. series 1999-1 HLC securitized loans with 100% loan-to-value ratios, meaning that the amount of the loan was equal to 100% of the home's value. In place of the customary 100% primary mortgage insurance, investors relied on a combination of subordination, equity, and excess spread for repayment of principal and interest.

Citibank Ltd.'s Compass Master Trust Series 1999-1 was the first to incorporate a master trust structure that contained innovative payment allocation mechanisms. And the first Australian subprime deal was issued. Liberty Funding Pty. Ltd. issued notes backed by A$100 million (US$59.060 million) of loans to borrowers who generally do not meet prime lenders' underwriting criteria. Investors were comforted, in part, by partial mortgage insurance on some of the loans, as well as 10% subordination and excess spread.

Other Assets See Increased Interest

The emergence of several ABS transactions in Australia over the past year signals the market's growing acceptance of securities other than 'AAA' rated, mortgage-insured RMBS. For example, St. George Bank Ltd.'s Crusade Auto Trust No. 1 of 1999 involved auto and equipment receivables.

A very active investor class in Australian structured financings is the local ABCP. At the end of first-quarter 2000, the Australasian ABCP market was composed of 54 conduits that had financing commitments of more than A$50 billion, and A$21 billion was outstanding. The number of asset sellers in the Australasian ABCP market stood at 258.

Australia saw its first three CMBS transactions in 1999, and the first one in 2000 closed in July. Macquarie Office Trust, totaling A$224 million (US$131.6 million), is a publicly listed property trust whose corporate and legal structure resemble a U.S. REIT. The most common form of funding for these trusts is often unsecured bank loans but the amount of money that can be raised is limited so they have begun exploring securitization as a means of raising large amounts of cash that is, in effect, secured by their properties, according to Mr. Hunt of Standard & Poor's.

Japan Focuses on ABS
Unlike Australia, where the emphasis is on RMBS, the focus in Japan has been on ABS. The most frequently securitized assets in Japan are consumer-related, according to Geoff Durno, chief underwriting officer at bond insurer Financial Security Assurance Inc. in Singapore. For example, unsecured personal loans, including those known as shopping loans, have been securitized.

"In the U.S., everyone has credit cards, but Japan is a cash economy," Mr. Durno pointed out. "One means of personal finance is a loan that is received as cash dispensed from an ATM. Consumers use their bank cards to draw down on an approved credit card line."

Japanese investors, who previously focused on high-quality corporate and government bonds, are beginning to develop a taste for securitizations, possibly motivated by the transactions' higher yields-including RMBS and CMBS, as well as ABS transactions. For example, about 90% of the investors in Nikko Salomon Smith Barney's J-CMBS deal were Japanese, said Michael C. Jaeger, vice president of the investment bank's real estate structured finance group in the fixed-income division in Tokyo.

Market Approaches RMBS and CMBS

Insurance and nonbank finance companies are viewing RMBS as a possible exit strategy from the mortgage lending business, while the country's major banks, particularly trust banks, are seeking direct securitization experience. For instance, MTBC Housing Loan Corp., from originator Mitsubishi Trust & Banking Corp. in July, was the first Japanese securitization rated by Standard & Poor's backed by residential mortgages.

What's more, relevant laws are expected to be revised to allow Government Housing Loan Corp. (GHLC), a quasi-governmental organization that carries nearly 40% of the residential mortgage market in Japan, to securitize its newly originated mortgages. This could encourage other mortgage originators to approach the RMBS market.

The growth of the CMBS market is taking place on two fronts, as well-performing and nonperforming commercial real estate loans-and Standard & Poor's has rated both types of transactions. Examples of these include International Credit Recovery - Japan One Ltd., sponsored by Morgan Stanley Realty Inc., which was backed by nonperforming commercial mortgages, and J-CMBS-1 Ltd. from Salomon Smith Barney (Japan) Ltd. which was secured by performing commercial mortgages.

As more issuers and investors get comfortable with these sectors, the international finance community is also doing its best to help the markets develop. Investment banks are providing their structuring expertise in conjunction with others, such as credit rating services and bond insurers, to help establish national standards for securitization.

"The first stage of our J-CMBS deal involved working with local professionals to establish global underwriting standards here in Japan," Mr. Jaeger explained. "The second stage was developing a collateral package that provides both protection to investors and facilitates global liquidity in the secondary market. This groundbreaking transparency helped us educate investors about the risks and benefits of the transaction."

In Japan, CMBS issues are not typically secured by mortgages. Instead, they benefit from an assignment of beneficial interests in the trust that holds the commercial real estate. "Obtaining both a mortgage over the assets and assignment of these beneficial interests provides superior security over the collateral," Mr. Hunt said.

In the area of real estate equity finance, Japanese corporations and property owners are actively pursuing securitization as a way to alleviate the effects of the country's economic recession and to increase property valuations, according to George von Liphart, managing director of GMAC Commercial Mortgage Japan, K.K., in Tokyo. This situation parallels that of the U.S. in the early 1990s, when the commercial bank lenders encouraged the formation of REITs by their largest borrowers to increase liquidity in the real estate markets. "There is increasing conviction in Japanese financial circles that securitization vehicles of all types are the wave of the future," Mr. von Liphart said.

Identifying True Securitizations

Despite the country's relatively high level of activity, its legal infrastructure for securitization is still developing. Structured financings have existed in Japan for several years but the early transactions were not true securitizations because investors still had recourse to the sellers of the assets, or there was some type of credit enhancement in addition to the collateral itself. Investors were likely to buy a transaction because they were comfortable with the name of the assets' originator rather than the structure of the transaction.

Two years ago, the government passed two new laws intended to encourage securitization but, according to legal experts, the laws did not provide for all outstanding concerns. "While the Japanese securitization laws help greatly, they can't override other laws already in place," explained Petrina Dawson, senior managing director and general counsel in Standard & Poor's Structured Finance Ratings group.

The Law Regarding Securitization of Specified Assets by Special Purpose Company, commonly called the Special-Purpose Company (SPC) Law, allows SPCs to be created under Japanese laws. But the administrative burden and the cost of setting up the SPC remains fairly high, making it more sensible from tax, economic, and administrative perspectives to set up SPCs in places such as the Cayman Islands.

The second law, the Law Regarding Special Rules of the Civil Code Relating to the Perfection of Assignment of Receivables, commonly called the Special Perfection Law, made it possible to enforce a true sale of assets against third-party creditors of the seller without obligor notification. Notification is still required to enforce a sale against the obligors themselves and to comply with usury laws.

In addition, notification is still required to perfect such an assignment vis-à-vis the obligors themselves. Notification can be an expensive and time-consuming process, and lenders are usually unwilling to notify unless absolutely necessary because of business considerations. As a result, securitizations of such assets are still subject to setoff risk. Setoff allows obligors to net their loan repayments against monies owned to them by the lender, such as borrower funds deposited with the bank. This risk, which is difficult to quantify because it can change over time, must be covered by additional credit support.

For similar reasons, it continues to be difficult for domestic banks to securitize pools of their corporate loans and bonds. Called collateralized loan obligations (CLOs), these securitizations allow banks to move large amounts of assets off their balance sheets in order to achieve regulatory capital relief. But Japanese law may still require that all loan and bond borrowers be notified that their obligations will be sold to an SPC. Moreover, setoff risk associated with CLOs is even more difficult to quantify because of the possible existence of derivatives exposures.

Other Asian Markets Try to Bounce Back
Asia-Pacific's troubles began in October 1997, with Thailand's devaluation of its monetary unit, the baht, and its closure of 56 Thai finance companies with burgeoning foreign currency debt and problem credits. Offshore securitization became more expensive as nonlocal investors and bond insurers pulled out of Asian markets, local investment in debt securities was underdeveloped, and regional banks were unable to meet corporations' funding needs as they had in the past due to high default rates among their own customers. To make matters worse, swaps between U.S. dollars and Asian currencies became difficult to obtain, if not impossible, explained Diane Lam, a director in Standard & Poor's Asia Structured Finance Ratings group in Hong Kong.

Today, the domestic bond markets in Hong Kong, Singapore, and Korea are taking off due to plentiful local liquidity, according to Mr. Wong of Standard & Poor's. Domestic banks are making corporate loans and, at the same time, regional investment banks are selling both corporate and structured bonds, which are being purchased by domestic investors. Korea, in particular, has active ABS, RMBS, and CMBS markets.

But as with Japan's early structured transactions, these may not be considered true securitizations and "name buying" is fairly common. Therefore, it's best for investors to approach securitizations outside Japan and Australia on a country-by-country basis because some have more developed securitization infrastructures than others. "The Asian markets have the potential to develop securitization markets but reaching that goal is dependent upon each sovereign's ability to work out its own legal and regulatory issues," Mr. Wong said.

The passage of two laws in Korea and the upgrade of Korea's sovereign rating in 1999 have encouraged cross-border transactions. Two notable offerings last year were structured as CLOs. Industrial Bank of Korea issued notes via Peak Funding Ltd., and Export Import Securitisation B.V. was issued by Export-Import Bank of Korea, or Kexim. (For more information on the importance of the sovereign's rating, see Latin America Pursues Different Tactics.)

Nations Encourage RMBS and CLOs

Hong Kong, which had an active residential mortgage business before 1997, has reinvigorated its local RMBS market, and taken some steps to develop a CMBS market, too. There's speculation that Hong Kong Mortgage Corp. (HKMC), a government-sponsored entity, will eventually securitize its residential mortgages for the first time, thereby reopening the country's securitization market.

In Singapore, where there is significant interest in securitization, the first rated asset-backed deal premiered this year. It was a CLO-type of asset-backed commercial structure sponsored by DBS Bank. In addition, the Monetary Authority of Singapore has released its guidelines on securitization of bank assets. Such transactions have been issued in Singapore dollars and placed domestically. Furthermore, Standard & Poor's has developed preliminary criteria for rating Singapore RMBS.

Before the Asian crisis, there were two offshore ABS deals out of Thailand. The country has an established residential mortgage system, and government officials there are considering creating a legal and regulatory framework that could facilitate RMBS deals. However, complex legal, regulatory, tax, political, and business issues make it unlikely this will be accomplished soon.

In other Asian countries, including Indonesia, Malaysia, and the Philippines, securitization is a possibility but some of the factors essential to market development are missing. Key elements include positive regulatory environments, proper legal frameworks, capital markets infrastructures, receptive investor bases, and prepared originators with high asset volumes.

Developing New Possibilities

To date, the bulk of the commercial assets in Asia have been securitized by banks, while consumer assets, such as auto loans, have been securitized by the region's nonbank finance companies. But as its economic recovery continues, it's possible that regional banks will begin extending consumer credit in the form of credit cards and auto loans with a view to eventually securitizing their holdings, according to Chase Manhattan Bank's Mr. Burke.

"There will be a handful of non-Japanese Asian deals done in the international capital markets but they will be unique transactions. Those markets will continue to develop as local markets with locally distributed securities," he said, "until some issuers in each market catch on to the idea of financing consumer credit, growing it off balance sheet, then accessing the international capital markets with securitizations."

In this way, with regular issuers, well-understood securities, well-defined origination standards, and willing, well-educated investors, Asian nations will be able to develop a sustainable structured finance market.

Latin America Pursues Different Tactics
Since its inception less than a decade ago, the securitization market in Latin America has matured differently than in other regions. In addition to underdeveloped local bond markets and highly regulated operating environments, it has had to cope with a most onerous challenge-low-rated sovereigns. On average, Latin sovereign ratings are lower than those of European and Asian countries. Therefore, structures were developed to mitigate sovereign risk, the most worrisome risk in the region, according to Rosario Buendia, managing director of Standard & Poor's Latin America Structured Finance Ratings group in New York.

The sovereign's rating is important because it indicates, in part, the likelihood that actions by the sovereign government could directly or indirectly affect the ability of the obligor to make timely payments to bondholders. To partly mitigate sovereign risk, securitizations of future flow receivables were developed to decrease a government's ability to interfere with payments to investors.

For instance, a government can directly interfere with a transaction by enacting foreign exchange controls or a foreign debt moratorium. Indirect sovereign risk, also called country risk or economic risk, happens when a government takes steps that are not specifically intended to modify a transaction but those actions still affect bond performance, including currency devaluations, interest rate changes, labor market conditions, taxation, regulation, and infrastructure.

The First Stage: Future Flows
The best way to mitigate the risk of potential direct sovereign actions was to build a structure that would minimize the possibility of accessing the transaction's cash flows. Known as future flow deals, these were cross-border offerings denominated in hard currencies, mainly U.S. dollars. Instead of depending on the performance of an existing pool of assets to generate cash flows that are used to repay bondholders, future flow deals rely on a company's capacity to supply a particular product, service, or commodity, and its continued ability to find international buyers for these assets.

The most logical issuers of future flow transactions are large, well-run, internationally recognized companies, typically those that are exporters of some type of commodity or natural resource. In general, companies in this situation receive hard currencies in return for their products. Notable future flow issuers include YPF S.A. in Argentina, whose bonds were secured by future flows of crude oil, and ALCOA Aluminio S.A. in Brazil, secured by future exports of primary aluminum sales.

The Second Stage: Local Markets
But as local markets grow through the passage of necessary legislation and regulations and the development of local investor bases due to the privatization of nations' pension systems, companies in some countries have been able to reach the second stage of Latin American securitization: the issuance of structured financings in local markets in locally denominated currencies.

This is an attractive option for smaller companies looking to raise amounts as low as the equivalent of US$5 million-companies that may not have the same access to international markets or corporate bank loans as do larger organizations. The assets that are securitized at this stage are typically consumer assets-residential mortgages, auto loans, personal loans.

"Argentina is in the advanced reaches of stage two. We expect, in the near future, that Mexico, Chile, and Peru will enter this stage, as well," said Ms. Buendia. "Brazil has the potential to attain this level in the years to come but, currently, it doesn't have the proper set of conditions to make securitization viable at this stage."

The Third Stage: Global Issues in Local Currencies
The third stage is the most difficult to attain: issuing local currency-denominated structured financings in the international capital markets internationally. It is the most difficult because it requires that investors must be comfortable taking on the sovereign risk involved in Latin American transactions derived from the fact that both the companies issuing the securities and their assets are located in the region. Currently, only Chile and Uruguay and, to a limited extent, Argentina, would be in a position to ascend to this level.

Governments Encourage Securitization
In some cases, governments are doing their best to encourage securitization. The oldest securitization market in Latin America is in Argentina, where it has been developing since a key law was enacted in 1995 and important tax amendments implemented since 1997, according to Jose Ramon Tora, a director in Standard & Poor's Latin America group in New York. There have been more than 100 transactions issued in the local market.

In Mexico, the pension system was reformed in 1997. So today, with the regulatory framework strengthened and domestic long-term savings increasing, Mexico's local capital market is deepening, Mr. Tora added.

Although Peru is not a big player in the international securitization markets, particularly when compared to larger countries such as Argentina, Brazil, and Mexico, it's setting a good example by reforming its legal, taxation, and regulatory efforts to encourage local structured financings. Comisión Nacional Supervisora de Empresas y Valores (CONASEV), a government agency that regulates the country's capital markets, is an active proponent of securitization, according to its general manager, Dr. Gustavo Beramendi.

"The actions taken by CONASEV have been aimed at promoting the processes of securitization of assets in the domestic market," he said. "A characteristic of Peruvian securities market is the increasing needs for instruments on the part of the institutional investors. The private pension funds and the mutual funds showed an important growth after their creation at the beginning of the present decade and they came to be the main national demanders of securities."

CONASEV is currently working on two fronts. It is reviewing all tax frameworks that govern the action of securities market participants, especially in relation to securitizations, "in order to propose additional actions that will make this alternative of financing attractive," Dr. Beramendi said. It is also examining the development of the U.S. residential mortgage market with a view to making the Peruvian market reflective of the same transparent environment.

Bond Insurance and Political Risk Insurance Gain Groun
d In addition to government support, some issuers have received support from a new source: external enhancement from third parties, such as bond insurance and political risk insurance, which impact both stage one and stage three issuers. "A Latin American trend that started in 1995 provides transactions with additional enhancement to make them stronger, less risky," Ms. Buendia explained. "Because of the difficulties the market faced in 1998-1999, issuers and bankers saw these types of insurance as ways to move forward and attract investors."

Bond insurer MBIA Inc. provided full guarantees to several securitizations. Other entities ranging from Asset Guaranty Insurance Co. to the World Bank, the World Bank's Multilateral Investment Guarantee Agency, or MIGA, the Overseas Private Investment Corp. (OPIC), and the Inter-American Development Bank (IADB) have also provided partial guarantees. These guarantees have become so popular among investors that, in 1999, there were no international securitizations sold without external credit enhancement except some classes of certain issues from Pemex Finance Ltd., Ms. Buendia said.

By Lisa A. Tibbitts