- April 9, 2018 Financial Markets
Asset-Backed Securities: A Niche, Not A Cure-All
When, in May 2016, Beijing first allowed banks to package nonperforming loans (NPLs) into asset-backed securities (ABS), it was greeted as an important new tool for helping banks clean-up their balance sheets. After almost two years, however, the issuance of NPL ABS remain relatively thin. In fact, the total value of bad loans packaged into ABS in the whole of 2017 was less than that in 2016. However, while ABS have yet to evolve into a mainstream tool for dealing with bad loans, they seem to have acquired a niche role: ABS are primarily being used by banks to dispose of bad retail loans (that is, loans to individuals), particularly delinquent credit card debt.
Banks initially used ABS as a tool with which they could dispose of bad corporate loans, which account for the lion’s share of China’s bad debt. Of the first ten NPL ABS issued (a period spanning from May to November in 2016), seven were backed by loans to companies. However, things have since turned on their head. Since December 2016, only three newly issued NPL ABS have been backed with corporate loans. The rest—20 in total—have been backed by retail loans. That includes home mortgages, small business loans, consumer loans, ‘micro’ loans, and combinations thereof. But the most important subset has been delinquent credit card debt, which has been the underlying asset for 12 ABS since December 2016.  Over that period, credit card debt represented 42.8% of the face value (that is outstanding principal and unpaid interest) of all NPLs packaged into ABS. Other types of retail loans made up a further 44.2% of all NPLs.
Changing the Mix
Note: Other retails loans include small business loans, consumer loans, ‘micro’ loans, and combinations thereof, that also include mortgages.
Source: NPL ABS filings.
Bad loans made to individuals are large in absolute volume, but nonetheless represent a minority share of total delinquent loans in China’s banking system. At the end of 2016, outstanding NPLs made to individual borrowers totaled 572.8 billion yuan, or about 38% of all NPLs at commercial banks. However, at a time when banks have an increasing range of options for disposing corporate loans (see here), retail loans are tougher to get rid of.
Traditionally, China’s banks have disposed of nonperforming loans by selling them en masse, and at a discount, to asset management corporations (AMCs), otherwise known as ‘bad banks’. However, in 2012, the China Banking Regulatory Commission (CBRC) and Ministry of Finance jointly issued rules barring banks from including loans made to individuals in any mass transfer of loans to the AMCs. The banking regulator didn’t explicitly say why it imposed the restriction, but the change came at a time that Beijing was actively moving toward protecting individuals’ private information. The change meant that banks had to deal with dead-beat retail borrowers themselves—until, that is, Beijing authorized the issuance of NPL-backed securities, which allow banks to move retail loans off their balance sheet.
A Little Context
NPL ABS are widely used globally to dispose of bad loans. They are currently being used by Italian banks; they were instrumental in cleaning up the South Korean banking system after the Asian Financial Crisis; and they were deployed in the United States after the Savings and Loans Crisis of the 1980s. China briefly experimented with NPL-backed ABS a decade ago, when two asset management corporations sold two batches in 2006, and China Construction Bank and another AMC each sold one in 2008.
When Beijing relaunched NPL ABS in 2016, it initially allowed only six banks to issue them. In 2017 it added an additional 12 banks to the list. In 2016, 51.0 billion yuan worth of NPLs were packaged into ABS, followed by 48.8 billion yuan in 2017, a fraction of the total 1.5 trillion yuan worth of NPLs outstanding at commercial banks at the end of 2017.
More ABS, But Fewer NPLs
Number of NPL ABS issued, versus face value of NPLs packaged into ABS
Source: NPL ABS prospectuses
Securitizing NPLs and packaging them into ABS enables banks to sell large volumes of bad debts that they might otherwise struggle to move off their books, allowing them to earn back at least a portion of the face value of the original loans. Generally speaking, the market for distressed debt is fairly small. Only a niche class of investor is typically willing to acquire bad loans and go through the legal trauma involved in seizing borrowers’ collateral and extracting payment from third parties that guaranteed the original loans. Securitization can turn a distressed asset into a triple A-rated investment, vastly expanding the pool of potential investors and making it easier for banks to dispose of their NPLs.
They do that by dividing the securities into traches. China’s NPL ABS all have two tranches: a senior tranche, which carries the triple A-rating (thus far the senior tranche of every Chinese NPL ABS has been rated triple-A), and a subordinate tranche that isn’t rated and typically accounts for between 20% and 30% of the ABS issuance. The investment grade rating on the senior tranche reflects the expectation that enough value will be extracted from the bad loans to ensure that investors will unquestionably be paid everything they’re owed. That’s made possible by the subordinate tranche. Holders of the senior tranche get paid first. Whatever is left over goes to the holders of the subordinate tranche. If the cash recovery from the bad loans is better than expected, then the holders of the subordinate tranche can do very well. If it’s worse than expected, they might end up with nothing.
Regulations require that for each ABS they sell, China’s banks must hold a portion of the subordinate tranche that is equivalent to at least 5% of the total value of the ABS’ issuance value. In other countries, asset managers or private equity outfits with a high tolerance for risk might also invest in the subordinate tranche. In China, AMCs—the bad banks—are filling that role. Shanghai State-Owned Assets Operation Co., one of Shanghai’s two local AMCs, invested 172 million yuan in the subordinate tranche of an NPL ABS issued by China Merchants Bank in September 2016, which was equivalent to 26.3% of the total issuance value of the ABS, and 70.8% of the subordinate tranche. In November of that year, the AMCinvested 132 million yuan in the subordinated tranche of an NPL ABS issued by Bank of Communications, equivalent to 8.3% of the total issuance value of the ABS, and 30.7% of the subordinate tranche. (According to Shanghai Securities News, NPL ABS subordinate tranches are almost entirely acquired by AMCs.)
China’s NPL ABS are also rated so highly because they are packed with far more NPLs than is likely necessary to pay investors what they’ve been promised. On average, the forecast cash recovery on China’s NPL ABS is 140% of the value at which the ABS are sold, giving them plenty of space to ensure that investors are repaid their principal and interest. (The yield on NPL ABS has ranged from 3% in May 2016 to as high as 6% in recent months. So far, no NPL ABS has been sold where the senior tranche has had a maturity of longer than four years. Most mature after less than two and a half years.)
Paying-Off the Credit Card
These days, China’s banks have a wide range of options available to them to dispose of corporate NPLs. The banks can simply sell them to AMCs; they can use their own in-house expertise to resolve them; they can tap the vibrant secondary market to sell directly to investors via financial asset exchanges and Taobao; and, of course, they can use securitization.
But according to a report published by Lianhe Credit Rating Agency at the end of 2016, “the cost expended [on packaging corporate NPLs into ABS] in terms of time and labor are relatively high.” The report correctly predicted that in the future there would be relatively few corporate NPL-backed ABS.
In particular, the due diligence process required to produce NPL ABS is highly involved. According to the prospectus for an ABS backed with corporate NPLs from Huaxia Bank, due diligence involved examining the collateral posted against the loans (a process that often involves visiting physical assets like land, buildings, and machinery to verify the collateral’s condition), looking into the soundness of the debtors’ management teams, interviewing any third-parties that had guaranteed the loans, and then reviewing whether any existing legal proceedings might complicate any claim on the loans. Moreover, pursuing repayment of certain corporate loans might present political barriers if local authorities decide that a borrower is too important to have its assets seized or be forced into liquidation.
Meanwhile, far less due diligence is required for retail loans, making it cheaper for banks to package them into ABS. Moreover, mortgage loans and small business loans are typically backed by residential property. The appeal of homes—apartments and villas—as collateral is that they are easier to appraise and sell than the industrial land, factories, office space, plant, and inventory that companies generally post as collateral. A price can be easily determined and they shouldn’t have any trouble attracting a buyer, particularly if sold at a discount. That said, with China’s economy having slowed considerably in recent years, with the potential to slow further, designing NPL ABS can be difficult.
“Disposing of NPLs has some cyclical characteristics, and with the domestic economy currently completing an economic cycle, there is a lack of data on the recovery of NPLs, and because of this, appraising, price setting, rating, and structuring ABS is particularly difficult,” the China Central Depository & Clearing Co. said in its 2017 annual ABS report.
While packaging delinquent credit card debt into ABS doesn’t solve all of these problems, it does somewhat simplify the process. Rather than vet each individual borrower—an impossible proposition, given that credit card-backed ABS typically pool together tens of thousands of borrowers (other types of NPL ABS are usually packaged with loans to hundreds, and sometimes only dozens, of debtors)—credit card debtors are assessed as a group.
The credit rating agencies tasked with estimating the rate of return don’t interview each credit card holder but base their forecast on data provided by the issuing bank on the amount of cash it has been able to extract from delinquent credit card debtors in the past. (It’s worth noting that the amount of cash recovered from bad credit card debt is lower than for other types of loans. Credit card debt is unsecured—that is, it’s not backed by collateral—and so banks have no recourse if it can’t get debtors to pay. The average cash recovery rate on ABS backed by delinquent credit card debt is 12.7%, compared with 29.3% for corporate debt, and 46.4% for mortgage loans.)
The securitization of credit card debt isn’t unusual. In the United States, banks partially fund their credit card lending business by packaging it into ABS. China has recently started securitizing ordinary credit card debt. In 2017, China’s banks issued 65.3 billion yuan worth of ABS backed by ordinary credit card debt—that’s a 366.2% jump from just 10.7 billion yuan the year before. But while the securitization of credit card debt isn’t unusual, the securitization of badcredit card debt is. According to the People’s Bank of China, China is the first country to securitize delinquent credit card debt.
A Growing Slice of an Expanding Pie
Share of ABS backed by credit card debt and NPLs, relative to total ABS issuance
Source: China Central Depository & Clearing Co.
Although constituting only a small portion of China’s commercial banks’ total NPLs, delinquent credit card debt is growing, in part because credit cards are becoming increasingly important to banks’ business, but also because they have a marginally higher rate of delinquency relative to other loans. The NPL ratio for credit card debt rose from 1.19% at the end of 2011 to 1.90% at the end of 2016. Over that period, the NPL ratio at commercial banks for all types of debt rose from 1.0% to 1.74%. Meanwhile, credit cards went from accounting for 2.38% of all NPLs at commercial banks to 4.97%.
Worse Than Average
NPL ratio for personal credit cards, versus commercial banks’ total NPL ratio
Credit cards represent a very small slice of overall NPLs, but the relatively thin issuance of ABS has consequently had a significant impact on restraining the growth of delinquent credit card debt. In 2016, China Merchants Banks packaged 2.8 billion yuan worth of delinquent credit card debt into an ABS, equivalent to 65.4% of the bank’s 4.3 billion yuan worth of outstanding credit card NPLs at the end of 2015. That same year China Construction Bank packaged 2.1 billion yuan worth of credit card NPLs into an ABS, equivalent to 48.3% of the 4.3 billion yuan worth of outstanding credit card NPLs at the end of 2015. (Not all banks disclose data on credit card delinquencies.)
China is also experimenting with an alternative version of ABS—called ‘asset beneficiary rights transfers’—albeit with limited success. This alternative vehicle takes an idea that was originally pioneered by banks as a way to get around rules that prohibited them from disguising loans as ‘investment assets’ by extending credit through trust companies. By using that technique, banks could lend more than they were otherwise permitted by holding trust products on their books instead of loans. When the CBRC cracked down on the practice, banks starting investing in trust beneficiary rights instead, which gave them the right to the income stream being generated by the trust product (that is, the interest payments from the loans underlying the trust) without having to own the trust product outright.
The ‘asset beneficiary rights transfers’ being used for NPLs throws that process into reverse. Rather than buying the beneficiary rights, the banks are selling them to investors. In other words, ‘asset beneficiary rights transfers’ allow investors to purchase the income generated by the disposal and resolution of bad loans. However, ownership of the underlying NPLs continues to reside with the issuing bank.
That’s the main way in which asset beneficiary rights differ from ABS. With ABS, banks sell ownership of their NPLs to a special purpose investment vehicle (SPIV) like a trust and so no longer have to record them on their balance sheet. That improves their NPL ratio and reduces the reserves they must hold against losses on the NPLs. Banks don’t enjoy any such benefits when transferring asset beneficiary rights. The upside of asset beneficiary rights is that banks get paid in advance of disposing of their bad loans. Moreover, they’re cheaper and easier to issue than ABS, but because less effort goes into the due diligence, only institutional investors are allowed to buy them.
The first asset beneficiary rights package backed by NPLs was sold in September 2016 by the Bank of Jiangsu, soon after the CBRC issued Document 82 which spelt out guidelines approving the practice.In total there have been 26 such products issued according to data from the Banking Industry Credit Asset Registration & Exchange Co., compared with 33 NPL ABS since May 2016. However, the average face value of assets transferred in each product is a little over 500 million yuan, far smaller than ABS, which average 3 billion yuan. After initial enthusiasm in 2016, when 17 products were issued with underlying assets worth nearly 9 billion yuan, things have cooled somewhat. In 2017 only eight were issued, with assets worth 3.7 billion yuan. So far, the product has primarily been the domain of small banks. All but four of the 16 banks that have issued asset beneficiary rights backed by NPLs have been city or rural commercial banks.
Small Banks Doing Small Volumes
Face value of NPLs sold as asset beneficiary rights, versus number of beneficiary rights products sold
Source: Banking Industry Credit Asset Registration & Exchange Co.
Perhaps a more interesting variation to watch is the ‘investment beneficiary rights’ being issued by some local AMCs.Like the asset beneficiary rights sold by banks, investment beneficiary rights provide investors with a return generated from the cash recovered from a pool of bad loans over which the AMC retains ownership. However, they differ from banks’ asset beneficiary rights transfers in that AMCs list these products on financial asset exchanges, making them tradable. Rules governing the listing of investment products on such exchanges dictate that no given product can have more than 200 investors—so the AMCs often divide them up into multiple products. Those individual products sometimes raise only a few million yuan each—making them more accessible to small, retail investors—that together can fund a significantly larger pool of bad loans.
In October 2017, Zheshang Asset Management raised 60 million yuan by issuing an investment beneficiary rights product with an annual yield of 6.2%, due to mature in 18 months. The product was backed by NPLs that Zheshang Asset Management had bought from the Tianjin branch of China Merchants Bank in March 2016. At the time the AMC acquired NPLs with a face value of 119.8 billion yuan, but by mid-2017 it had already resolved a big chunk of those NPLs such that only 62.1 billion yuan was still outstanding. Those residual NPLs served as the assets underlying the investment beneficiary rights. Investors were limited to a minimum investment of 250,000 yuan. The product was marketed on the Zhejiang Financial Assets Exchange, where it is now freely traded like a bond or other security.
There’s not enough data available to tell just how widespread a practice this is. Typically, details of these products are posted on an exchange while they’re being marketed, and then taken down once the subscription period is over. So far, at least Zheshang Asset Management and Anhui Goho Asset Management have issued such products, with Goho selling its first investment beneficiary rights at least as early as the second half of 2015.
Still, selling investment beneficiary rights has its limitations. On one hand they’re a way for AMCs to fund their business—every product they sell frees up funds to buy more NPLs. At the same time, however, by leaving the NPLs on the AMCs’ balance sheets, investment beneficiary rights also limit the ability of AMCs to buy more NPLs. The volume of NPLs that AMCs can hold is proportional to their capital. Given that most AMCs are operating with relatively thin capital levels, they typically favor businesses that don’t require much capital (see here, under the subheading ‘The fast-in-fast-out approach’). Investment beneficiary rights consume AMCs’ capital while sharing with investors any financial gain they extract from the NPLs, thereby making it a fairly inefficient use of their limited capital.
China’s NPL ABS market—and its variations—is still in its early days and has yet to make a significant dent in China’s NPL levels. That may change as investors become more familiar with the product or if other avenues through which banks currently dispose of loans become less welcoming. But regardless of the current degree of progress, developments in the NPL ABS market show a willingness by both the banks and regulators to experiment with new ways of dealing with bad loans.
 Data on NPL ABS is from prospectuses posted on Chinamoney.com.
 This data comes from the People’s Bank of China’s ‘2017 Financial Stability Report.’ The figure includes business loans made to individuals.
 ‘政协委员赵宇梓：建议赋予商业银行更多核销自主权’ (‘CPPCC Member Zhao Yuzi: Suggests that Commercial Banks Be Given More Autonomy to Write-offs Loans’), Zhang Han, Finance China, March 2, 2017. http://finance.china.com.cn//news/special/2017lianghuifinance/20170303/4122163.shtml
 For references to China’s 2012 privacy crackdown please see: ‘Dun & Bradstreet Probes Alleged Privacy Violations,’ Dinny McMahon, Wall Street Journal, March 19, 2012. https://www.wsj.com/articles/SB10001424052702303506404577448113933841708; ‘Beijing Dims the Lights on Data for Investors,’ Dinny McMahon, Wall Street Journal, June 6, 2012. https://www.wsj.com/articles/SB10001424052702304636404577290953326061744.
 Shanghai Brilliance Credit Rating and Investor Services Co.’s credit rating reports on Shanghai State-owned Asset Management Co., from August 1, 2017.
 ‘银行：不良资产证券化内热外冷’ (‘Bank: NPL ABS are Hot Internally but Cold Externally’), Wei Qian, Shanghai Securities News, August 11, 2017, http://company.cnstock.com/company/scp_gsxw/201708/4114869.htm.
 Figure is based on average implied cash recovery rated, calculated by dividing the forecast cash collection amount disclosed in each ABS prospectus, by the issuance value of the ABS.
 ‘2016年不良资产支持证券市场运行报告及展望(2016 NPL ABS Market Operations Report and Outlook),’ China Lianhe Credit Rating Co., February 13, 2017 http://www.chinabond.com.cn/cb/cn/yjfx/jgzs/lhzx/20170213/146310882.shtml.
 ‘深圳金融运行报告（2017）(Shenzhen Finance Operations Report),’ People’s Bank of China, August 4, 2017 http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/3356459/2017080422215522319.pdf.
 中国银监会办公厅关于规范银行业金融机构信贷资产收益权转让业务的通知’, 银监办发82号(‘CBRC’s notice on standardizing financial institution’s transfer of credit assets’ beneficiary rights,’ CBRCNo. 8) , April 27, 2016. http://www.cbrc.gov.cn/govView_218E907994094556979FACD86093ED0A.html
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