Disposal and Securitization of Non-Performing Loans in China

1
Disposal and Securitization of Non-Performing
Loans in China

• Carson Wen
• April 2005

2
Overview

• NPL Portfolios
• Methods and Alternatives for Disposal
• NPL Disposal in China
• NPL Securitization
• Deciding on the Structure

3
Overview - Major Banks

• 4 state-owned commercial banks ("SOCBs")
• Industrial and Commercial Bank of China ("ICBC")
• Bank of China ("BOC")
• China Construction Bank ("CCB")
• Agricultural Bank of China ("ABC")

4
Overview - Major Banks

• 3 government-run non-profit policy banks
• State Development Bank ("SDB")
• Import and Export Bank of China
• Agricultural Development Bank of China
• 11 joint-stock commercial banks

5
NPL Portfolios of Major Commercial Banks
As of Dec. 31,2004 RMB 100 mil.
Outstanding Balance Share in Total Loans
NPLs 17176 13.21
By Five-category Classification
Substandard 3075 2.36
Doubtful 8899 6.84
Loss 5202 4.00
By Institutions
SOCBs 15751 15.62
JSCBs 1425 5.01
Note The major commercial banks include SOCBs
and joint-stock commercial banks (JSCBs).
6
Overview - AMCs

• Establishment of Asset Management Corporations in
  1999
• Cinda - China Construction Bank/China
  Development Bank
• China Great Wall - Agricultural Bank of China
• China Huarong - Industrial and Commercial Bank of
  China
• Orient - Bank of China
• Must recover NPLs they took over in 10 years

7
NPL Portfolios of 4 AMCs

• When the AMCs were created in 1999
• RMB 1.4 trillion (US 169 billion) in NPLs were
  transferred to the 4 AMCs
• Capital source of transfer

8
NPL Portfolios of 4 AMCs

• As of end-December 2004
• Total resolved NPLs - RMB 675.06 billion
• Collection in cash - RMB 137 billion
• Cash recovery ratio - 20.29

9
Disposal Progress of AMCs in 2004(Totally)
Unit RMB billion
10
Disposal Progress of AMCs in 2004(Respectively)
11
NPL Securitization in China - Factors Affecting
the Market

• Onshore vs. offshore investing entity
• Remedies and foreclosure laws
• Bankruptcy laws and creditor rights
• Foreign investor rights and ownership
• Execution

• Court enforcement
• Fees to transfer assets
• Employee liabilities
• Repatriation of capital
• Taxation
• Processing time
• Land-use rights
• Political issues

12
Draft PRC Enterprise Bankruptcy and
Reorganization Law

• Anticipated enactment in 2005
• Would be universal
• Would apply to all enterprises
• Except individuals (consumers) and possibly
  financial institutions
• Phase in period for SOEs
• No prior government approvals needed
• Modelled on international standards and procedures

13
NPL Disposal - Strategies for Ultimate Resolution

• Retain, Work Out and Recover on NPLs
• Direct Sales
• Servicing Transfers
• Joint Ventures
• Securitization

14
NPL Disposal - Direct Sales

• Most efficient alternative for the AMCs and banks
  to move NPLs out of balance sheet
• Most adopted by the AMCs and banks in China for
  the present
• Pricing is dependent on the agreement between
  seller and buyer as to the likely amount of
  recoveries from NPL assets

15
New Promulgation re Foreign Capital Involved NPL
Disposal

• Effective from 1 January 2005
• Decree (2004) 119, promulgated by State
  Administration of Foreign Exchange ("SAFE")
• Set up rules for direct sale of NPLs to foreign
  investors
• Disposal related issues process, documents,
  guaranty, FIE, etc.

16
New Promulgation re Foreign Capital Involved NPL
Disposal (con'd)
Disposal Process re Foreign Exchange Issues
17
Re-disposal for Foreign Buyers

• Resale
• Set up JV with seller
• Servicing transfer
• Debt-equity swap
• Debt collection through lawyers

18
NPL Disposal Morgan Stanley - Huarong AMC (2001)
19
NPL Disposal Goldman Sachs - Huarong AMC
20
NPL Disposal CCB - Morgan Stanley (2003)

• The State Council has not approved the structure
  yet.

21
NPL Disposal CCB - Morgan Stanley (2004)
22
Sale of NPLs vs. Securitization

• Sale of NPLs
• More difficult to price
• High risk
• Illiquid investments
• Very few investors

23
Sale of NPLs vs. Securitization

• NPL backed securities (securitization)
• Rated securities
• Risk dependent on rating
• Transparent pricing
• Larger pool of investors
• Securitization can be done by loan originator or
  purchaser of loan

24
Securitization

• Process by which cash generating assets (e.g.
  loans or NPLs) are converted into securities sold
  to investors
• The assets are transferred in a "true sale" to a
  special purpose vehicle (SPV) that issues the
  securities
• The securities are paid from the cash flow on the
  assets rather than from the originator (e.g. NPL
  owner)

25
Advantages of Securitization

• Improves balance sheet
• Swap of lower quality asset (e.g. NPLs) for
  higher quality asset (e.g. cash)
• Improves funding
• Diversification of funding sources
• Lower cost of funds
• Transfers credit risk of receivables (e.g. NPLs)
  to a third party

26
Disadvantages of Securitization

• Transferability of assets may create issues
• Must obtain "true sale" opinion from a law firm
• Must obtain "true sale" treatment from an
  accounting firm
• Is the asset owner (e.g. NPL owner) authorized to
  transfer the assets?
• Does the owner want to transfer the assets?
• Security for repayment remedies - do rights
  transfer with the assets?
• Increased due diligence
• High level of legal complexity

27
Basic NPL Securitization Structure
28
Special Purpose Vehicle (SPV)

• Restricted charter
• Created for the sole purpose of holding the NPLs
• Limited powers
• Limited activities
• Designed as "bankruptcy remote"

29
NPL Securitization - Factors for a Healthy Market

• Sound regulatory system
• Sound legal system, especially in bankruptcy and
  foreclosure, contract and security laws
• Ability to track legal title and ownership of NPL
  assets
• Quality due diligence

30
NPL Securitization - Factors for a Healthy Market

• Quality valuation of collateral and cash flows
• Not appraisals
• Sound cash flow vs. asset-value methodologies
• First-rate servicing, collection and workout
  capabilities

31
NPL Securitization in China - Factors Affecting
the Market

• Onshore vs. offshore investing entity
• Remedies and foreclosure laws
• Bankruptcy laws and creditor rights

• Court enforcement
• Fees to transfer assets
• Employee liabilities
• Repatriation of capital

32
NPL Securitization in China - Factors Affecting
the Market

• Foreign investor rights and ownership
• Execution

• Taxation
• Processing time
• Land-use rights
• Political issues

33
NPL Securitization in China - Legal Problems
with Onshore SPV

• Companies are supposed to have "active business"
• SPV is intended to be passive ownership vehicle
• Prohibition on inter-company lending
• Valid transfers require notice to obligors
• Rules against "debt collection" companies,
  exception for banks and AMCs
• Foreign exchange control
• Repatriate proceeds from disposal of NPLs after
  the termination of SPV or by way of dividends

34
NPL Securitization in China - Legal Problems
with Onshore SPV (cond)

• Difficulty for SPV to issue "bonds" (company law)
  
• Net assetsRMB 60,000,000 (limited liability
  company)
• RMB 30,000,000 (company limited by shares)
• Total amount of issued bonds shall not be over
  40 of the company's total net assets
• The average net profit of the latest three years
  shall be sufficient to pay 1-year's interests of
  the issued bonds

35
NPL Securitization in China - Legal Problems
with Offshore SPV

• Foreign exchange control
• SAFE approval required for the repatriation of
  proceeds from disposal of NPLs
• Foreign debt registration
• Transfer of NPLs to offshore SPV raises foreign
  debt registration issue
• Who is responsible for the registration?
• Foreign investment prohibition
• Foreign investment industrial policy will affect
  the restructure of NPLs portfolio
• Other issues

36
NPL SecuritizationDeutsche Bank - Cinda AMC
(2003)
37
NPL Securitization in China - Trust Structure

• Special Purpose Trust ("SPT") -viable structure
  for the present
• Bankruptcy remoteness
• Huarong trust structure - start of asset
  securitization in PRC
• Quasi-securitization

38
NPL Securitization Huarong Trust Structure
(2003)
39
ICBC Trust Structure (2004)
40
Asset Securitization Proposed by CCB -
Unconsolidated Model
Note The proposal has been approved by PBC, yet
to be approved by the State Council.
41
Asset Securitization Proposed by CCB -
Consolidated Model
Note Five proposals have been turned down by PBC.
42
Asset Securitization Proposed by SDB

• Note
• Phase I The SPV will earn profit if the interest
  received from mortgaged loan exceeds the interest
  of financial bonds paid to investors.
• Phase II The securitization may be scheduled
  years later.
• It is reported that the PBC might not approve the
  proposal because it focuses on Phase I aiming to
  earn profit through assets held by the SPV and
  does not reflect the propose of securitization to
  release financial risks.

43
Trust Investment Corporations ("TICs")

• Financial institution, under supervision and
  control of People's Bank of China ("PBC")
• Need PBC's approval to eagaged in inter-bank
  borrowing
• Prohibited from
• Drawing deposits
• Issuing bonds
• Borrowing external debts
• Providing guaranties with the trust property

44
Trust Investment Corporations ("TICs")

• Only TICs can operate the business of capital
  trust
• Limited capability of operation and disposal of
  trust capital in a collective management
• Capital trust contracts accepted by TICs 200
  pieces
• Value of each contract RMB50,000

45
Trust Structure - Issues

• Issue of trust certificates
• Who can be trustees and issuers?
• TIC issues
• Circulation of certificates of beneficiary rights
• The certificates are not securities
• Private raising
• Non-standardized certificates
• No existing market available for trading

46
Trust Structure - Issues

• Limited investors
• Accounting
• Moved out of originator's balance sheet?
• Taxation
• Trust registration and alteration of the mortgage
  registration

47
Administrative Measures of Asset Securitization
(Draft)

• Expect to launch in first quarter of 2005
• Give answers to issues relating to securitization
• Status of TICs acting as SPV
• Tax, accounting
• Issue and circulation of securitized products

48
Administrative Measures of Asset Securitization
(Draft)

• The proposal should reflect the purpose of
  securitization - release financial risks
• Allow securitized products issued and circulated
  among inter-bank bond market
• Listing and circulation of securitized product
  are subject to PBC's approval

49
PRC Inter-bank Bond Market

• Participants - Institutions only
• Commercial banks and their branches
• Non-bank financial institutions with legal status
  
• Non-financial institutions with legal status,
  through settlement agencies
• Branches of foreign banks that are approved to
  operate RMB business

50
PRC Inter-bank Bond Market

• Trading products
• Government securities
• Central bank notes
• Policy financial bonds
• Enterprise bonds

• Trading types
• Buying back
• Trading of current bonds

51
Synthetic Securitization

• Synthetic securitization may provide a more
  attractive alternative to disposing of NPLs than
  outright sales or conventional "true sale"
  securitization

52
Synthetic Securitization

• Securitization of NPLs in China has thus far
  focused on conventional securitization
• However, there are substantial legal, regulatory
  and practical obstacles, principally caused by
  the requirement to transfer NPL assets
• Synthetic securitization does not involve asset
  transfers and thus avoids many of these obstacles
• Synthetic structures are gaining increasing
  acceptance in Asia

53
Synthetic Securitization Structure
54
Synthetic Securitization - Advantages

• No asset transfer (true sale issues, loan
  consents, relationship issues, due diligence,
  costs)
• Greater diversity of asset pool
• Assets which are not readily transferable,
  involve ongoing commitments to lend or guarantee
• Relative simplicity to true sale securitization
• Lower transaction costs
• Documentation - ISDA Credit Derivative
  Documentation

55
Synthetic Securitization - Disadvantages

• New concept in the NPL market
• No synthetic NPL deals yet - education of market
• But synthetic structures (in non-NPL deals) are
  gaining wide acceptance in Asia
• Pricing and valuation techniques need to be
  developed
• No transfer of actual NPLs occurs
• NPL owner is subject to counterparty risk under
  credit default swap
• Some NPL owners (e.g. many banks) may want true
  sale treatment of NPL transfers - regulatory
  treatment unclear

56
Deciding on the StructureFactors to Consider

• NPL acquisition price
• Secured vs. unsecuredServicer/AMC abilities
• Location of NPL owner (structure, taxation, asset
  transfer, valuation)
• Location of NPL borrowers (creditor rights,
  enforcement, remedies)

• Size of NPL pool
• Availability of ratingAvailability of credit
  enhancement
• Availability of additional collateral
• Identity of potential investors
• Capital market factors

57
Our PRC Connections

• Close relationships with the State Development
  Bank and the Great Wall AMC
• Working with the 4 AMCs to find solutions to
  disposal of NPLs

58
The Company We Keep
59
Our Expertise and Experience

• Lawyers in Hong Kong, Beijing, New York and other
  US cities working as a team in NPL transactions
• Expertise in NPL workouts, sales and
  securitization
• Resources of 700 plus lawyer international firm,
  including lawyers specializing in China practice,
  securitization, capital markets, creditors rights
  and bankruptcy law

60
Our Expertise and Experience

• Representative clients include
• Bank of America
• Nomura
• Resolution Trust Corporation (US)
• Washington Mutual
• Industrial Bank of Japan (now Mizuho)

61
US Offices

• San Francisco
• 333 Bush Street
• San Francisco, CA  94104
• 2878
• Phone [phone]
• Fax [phone]
• Silicon Valley
• 275 Middlefield Road
• Menlo Park, CA 94025-3506
• Phone [phone]
• Fax [phone]
• 2775 Sand Hill Road
• Menlo Park, CA  94025
• Phone [phone]
• Fax [phone]
• Los Angeles
• 601 South Figueroa Street
• 40th Floor
• Los Angeles, CA  90017-5758

San Diego 4350 La Jolla Village Drive 7th
Floor San Diego, CA  92122-1246 Phone 1 (858)
450-8400 Fax [phone] Seattle 701
Fifth Avenue Suite 6100 Seattle,
WA  98104-7098 Phone [phone] Fax 1
[phone] Portland 200 SW Market
Street Suite 1750 Portland, OR  97201-5718 Phone
1 [phone] Fax [phone] Anchorage 5
10 L Street Suite 500 Anchorage,
AK  99501-1959 Phone [phone] Fax 1
[phone]
New York 120 West 45th Street New York,
NY  10036-4041 Phone [phone] Fax 1
[phone] Washington D.C. 1666 K Street,
NW Suite 300 Washington, DC  20006-1228 Phone 1
[phone] Fax [phone] Madison One
East Main Street Suite 201 Madison,
WI  53703-5118 Phone [phone] Fax 1
[phone]
62
Asian Offices

• Hong Kong
• 35th Fl., One Exchange
• Square
• 8 Connaught Place
• Central, Hong Kong
• Phone [phone]
• Fax [phone]
• Beijing
• Units 01-02, Level 14
• China World Tower I
• 1 Jian Guo Men Wai Ave
• Beijing
• 100004 China
• Phone [phone]
• Fax [phone]

Singapore 50 Raffles Place 17-04 Singapore
Land Tower Singapore  048623 Phone (011)
65-6538-1756 Fax [phone]
63
James C. Olson 333 Bush Street San Francisco, CA
U.S.A. Telephone [phone] jolson_at_hewm.com C
arson Wen One Exchange Square 8 Connaught
Place Hong Kong Telephone [phone] cwen_at_he
wm.com
Susan C. Yu 1 Jin Guo Men Wai Avenue Beijing Tele
phone [phone] syu_at_hewm.com Michael P.
Phillips One Exchange Square 8 Connaught
Place Hong Kong Telephone [phone] mphillip
s_at_hewm.com
64
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