Korea's Brave New World of Securitization

2001/01/15

The deluge of asset-backed securities unleashed by banks and investment trust companies (ITCs) in Korea this year clearly shows that securitization has become Korean financial institutions' technique of choice for disposing of nonperforming assets. However, because banks and ITCs are repurchasing large tranches of subordinated notes in these transactions, securitization might be doing less than it appears to wash away the mountain of bad debt towering over the financial sector. Moreover, a proposed fund intended to purchase collateralized bond obligations from struggling corporates could end up creating a new class of nonperforming asset, and ultimately exacerbate lingering asset quality problems at Korea's financial institutions.

All told, Korean Won (W)22.9 trillion worth of ABS securities hit the domestic market in the first six months of 2000, more than three times than in all of 1999. Financial institutions have been the main drivers of this growth, and accounted for 86% of issuance during the first four months of the year. Korean Asset Management Co. (KAMCO), a government-run agency initially set up as a clearinghouse for nonperforming assets, has also ramped up its role in the market by engineering a number of ABS transactions, including the first-ever crossborder securitization of Korean nonperforming loans.

"Very early on in the Korean financial crisis, government policymakers strongly endorsed securitization and quickly enacted legislation to facilitate its creation," said Diane Lam, director of structured finance ratings for Standard & Poor's in Hong Kong. "This support, combined with the needs of financial institutions, has made Korea the second-largest securitization market in Asia. Standard & Poor's believes the market is very likely to reach or exceed the W40 trillion level by year's end."

The primary motivation behind these transactions is to sweep nonperforming assets out the door, and off financial institutions' balance sheets. In light of the very poor quality of distressed assets in Korea, however, these securitizations require substantial credit support in the form of large tranches of subordinated notes: the W22.9 trillion of issuance as of June 2000 includes roughly W8.05 trillion worth of subordinated tranches, which have a lesser claim on the underlying assets and as a result carry more risk. These junior notes, usually repurchased by banks or ITCs, are backed by essentially insolvent assets, and as such are less likely to be repaid. In short, securitizations involving large subordinated tranches are leaving financial institutions holding on to the worst of their bad assets.

Such is the case with ITCs, which led the securitization charge after the collapse of the Daewoo industrial conglomerate paralyzed the corporate bond market and left investment trusts with W7.1 trillion in bad debt. Since January, the bulk of those bad assets, or about W4.4 trillion, was sold to special purpose companies, securitized along with other assets into less risky senior tranches supported by subordinated tranches that were repurchased by the ITCs. At the end of June, this arrangement left ITCs with W3.6 trillion worth of subordinated notes backed by nonperforming assets. Roughly W1 trillion of this amount is covered through write-offs or third-party credit support. ITCs are holding on to the remainder, betting that economic recovery will resuscitate the value of the assets behind the notes.

Banks, too, have found securitization to be a useful way to clean up balance sheets spattered with bad debt. Like the ITC deals, bank securitizations usually involve credit support in the form of subordinated tranches, which the banks then repurchase. Moreover, Korean banks, especially those with weaker capital positions, may lack the wherewithal to provision properly for potential losses resulting from these subordinated holdings.

So far, Korea's securitization of nonperforming assets has occurred almost solely in the domestic market. In July, the Korean Asset Management Co. (KAMCO) provided a look at the overseas prospects for Korea-originated transactions with the first international securitization involving Korean nonperforming loans. The deal, roughly based on NPL deals engineered by KAMCO at home, was a $367 million issuance backed by $420 million worth of bad assets that the state-owned agency had purchased from six Korean banks. As with its domestic deals, the transaction included substantial credit support in the form of about $53 million worth of subordinated notes. To make it palatable for foreign investors, however, the transaction was restricted to only assets that banks had agreed to repurchase should they fail to meet various value and performance requirements. Additional support was provided by Korean Development Bank (KDB) through a credit facility worth 30% of the total rated debt, or approximately $110 million, which may be used for credit and liquidity purposes.

"This securitization has been very good from the point of view of KAMCO, and freed up resources to allow the agency to continue to purchase future bad assets," said Graeme Knowd, financial institutions analyst at Standard & Poor's in Tokyo. "However, most of the risk remains within the Korean financial system, through repurchase agreements, guarantees, and the purchase of subordinated tranches. Any further default will have to be covered by the banks providing the repurchase agreements or the KDB, or could ultimately exacerbate the financial burden currently facing the government and the financial sector."

While such maneuvers may not be putting the financial industry back on solid ground, the increased issuance of asset-backed securities is quickly bringing maturity to Korea's precocious securitization market. Aside from nonperforming assets, the market is branching off into a variety of assets classes, such as lease receivables, auto loans, and to a limited extent residential mortgages. The government is promoting further expansion in the market to include credit card receivables, other consumer loans, and asset-backed commercial paper. In addition, these transactions have helped to build the complex infrastructure of arrangers and experts needed to support a healthy environment for structured market. The overall growth and progress in Korean securitization is remarkable for a market that first came into being in 1998.

"Despite its progress, Korea's securitization is still emerging, and as a result many transactions rely heavily on support from third parties, or even in some cases the originators of the deals themselves," said Ms. Lam. "In the case of residential mortgages, for example, investors are looking for high levels of support from originators, or even full guarantees, because of a lack of historical performance data on loan payments."

Nonetheless, the boom in Korean asset-backed securities is attracting the notice of foreign investment banks. In July, KAMCO auctioned off W1.04 trillion worth of nonperforming Korean debt from the retail, construction, and manufacturing sector to foreign investment groups, including Lonestar, Morgan Stanley, and Cerberus. Many of these assets are likely to resurface in the marketplace in the form of asset-backed securities as a viable exit for the bank's principal or warehousing positions.

"The inclusion of foreign players in Korea's securitization game will be beneficial to the financial system by providing fresh funding from outside sources that can be applied to resolving the bad debts that remain in the financial sector," Ms. Lam said. "It will also introduce international experience and techniques to risk assessment and portfolio management. As exit strategies are implemented, foreign players are likely to bring more sophisticated securitization structures to the market."

Hoping to capitalize on the enthusiasm surrounding securitization, the government is pushing for 15 banks and finance companies to create a W10 trillion bond fund intended to bolster Korea's struggling corporates. Under the plan, W7 trillion is to be allotted for the purchase of "primary CBOs," or corporate bonds, from both healthy and unhealthy corporates, that will be pooled and securitized before being offered to the market. In essence, the fund's aim is to provide liquidity to midtier corporates that, based on local rating standards, are deemed to be of speculative quality. By diversifying the risk over a pool of bonds issued by both investment-grade and speculative-quality companies, and by adding structural enhancements and partial credit guarantees, the government hopes to offer a safer way of investing in Korea's corporate sector.

"While the pooling of assets does dilute risk through diversification, to a large extent the purpose of the fund is to provide liquidity to institutions that would otherwise not meet the credit guidelines of the banks," Mr. Knowd said. "The ability of the weaker corporates in the pool to repay this new debt is intricately linked to the overall health of the economy. Further turmoil in the corporate sector and a slowdown in the economic recovery could see holders of such bonds sitting on substantial losses."

The government-proposed fund underscores Korean corporates' crucial need for liquidity, and betrays a bleak view of near-term corporate prospects. Granted, if the corporate sector picks up, the government's plan to collateralize low-level corporate bonds may turn out to have been an efficient way of providing liquidity to a sector just beginning to regain its feet. However, financial institutions, already heavily burdened with corporate debt, have received the plan coolly, with some outright refusing to contribute to the fund. As of the end of July, only about W3 trillion had been remanded to the fund.

On the whole, Korea's rapid acceptance of structured issuance can be applauded, and the prospects for securitization of new assets classes has the potential to offer cheaper sources of funding for some corporates and increased options for investors. However, in Standard & Poor's view the repackaging of bad assets by banks and ITCs through securitization-and essentially concentrating insolvent assets in the form of subordinated tranches-is unlikely to dampen the effect those assets have on credit quality of financial institutions. Moreover, the government push to use securitization to fund low-grade corporates is cause for concern, as future repayment of such bonds is dependent on further improvement in the economy and the health of the corporate sector in general. If Korea's corporate sector continues to stagnate, substantial holdings of subordinated tranches from securitizations and additional portfolios of collateralized corporate bonds could exacerbate the lingering asset quality problems in Korea's financial sector.