Asset-Backed Securities

In May 2016, Beijing allowed banks to package asset-backed securities (ABS) with non-performing loans (NPLs). The securitization of NPLs—whereby investors can buy a share of a pool of bad loans and receive a return based on funds recovered from those loans—is a way to expand the potential market for distressed debt and to also take the pain out of investing in such debt. Generally speaking, only a niche class of investors is willing to go through the process of extracting value from bad loans, a process that is often time consuming and may require the involvement of courts and legal expertise. Moreover, by using various credit enhancements, NPL ABS in China are invariably rated as being investment grade assets, which make them appealing to a larger pool of potential investors and, in theory, should make it easier for banks to dispose of their loans.

Asset-backed securities (ABS) are yet to take off as a tool for disposing of bad loans in China, with the pace and size of new issuance remaining fairly stable over the last two years. In fact, while the number of ABS sold in 2017 increased slightly from 2016, the face value of non-performing loans (NPLs) packaged in those ABS declined modestly. However, in that time a profound shift has occurred in how banks use NPL ABS. Initially banks packaged NPL ABS with corporate loans, which represent the lion’s share of bad debt in China’s banks. However, from December 2016, almost all new NPL ABS were packaged with loans to individuals—home mortgages, small business loans, consumer loans, and, most important by far, delinquent credit card debt. (For an explanation of why ABS have primarily become a tool for dealing with bad credit card debt, see here). In the chart below (right) each bubble represents an NPL ABS. Their height on the chart corresponds to the face value of their NPLs; the bubble size is proportional to their issuance volume; and the color indicates the nature of the underlying bad loans.

Whereas NPL ABS Were Once Mainly Backed by Corporate Debt, Now Credit Card Debt Dominates
Source: NPL ABS filings.
NPL ABS Issuance Has Increased, But The Face Value Of NPLs In Each Has Declined
Source: NPL ABS filings.

The quality of NPLs backing ABS has been declining. China’s banks catergorize their NPLs into three classes: ‘substandard,’ ‘doubtful,’ and ‘loss,’ ranked in declining order of quality. Initially ‘substandard’ loans were the main class of NPLs packaged into ABS, but over time their share has declined as loans classed as ‘doubtful’ and ‘loss’ have risen. Meanwhile, over that time the yield on the senior tranche of NPL ABS has increased. However, given that all NPL ABS issued in China so far have been triple-A rated, rising yields are likely unrelated to the quality of the NPLs. Rather, yields have moved higher with interest rates (see 1-year Shanghai Interbank Offered Rate, below (right)).

The Quality Of NPLs Used For ABS Has Declined
Source: NPL ABS filings.
Yields On The Senior Tranche Of NPL ABS Have Risen With Interest Rates
Source: SHIBOR; NPL ABS filings.