First Commercial Bank 2003 Special Purpose Trust

Analysts:
Analyst: Diane Lam, CFA, Hong Kong
Jerry Fang, Taipei
Clementine Kiang, Taipei

This report does not constitute a recommendation to buy, hold, or sell securities. The ratings also do not address the likelihood or timing of prepayment.

Rating Details

New Ratings

*The ARM index is the one-year average fixed savings deposit rate of seven major banks in Taiwan. Such index may differ from bank to bank.

Profile

Rationale
Taiwan Ratings Corp. today assigned its ratings to NT$4.28 billion mortgage-backed floating rate certificates issued by the issuer. This transaction is the first completed residential mortgage backed securitization deal in Taiwan.

The ratings address the full and timely payment of interest and the ultimate full repayment of principal by the transaction's legal final maturity date of Apr. 21, 2033. The final ratings were assigned on the closing date following a satisfactory review of all documents and legal opinions, as well as tax opinions and rulings.

The ratings are based on:
* Taiwan Ratings' analysis of the portfolio of assets transferred to the SPT, consisting of a pool of first-ranking mortgage loans secured over residential properties located in northern Taiwan;
* The appropriate size of the credit enhancement for each rated class of certificates, and the subordination structure as provided for each rated class of certificates, including the unrated, fully subordinated class D certificates;
* The sound payment structure and cash flow mechanics of the transaction;
* The establishment of a cash reserve at closing to mitigate commingling risk, set-off risk, servicer transition risk and to cover temporary interest payment shortfalls on the rated certificates;
* A conservative cash flow analysis, in which the stress assumptions have taken into account the risk of a mismatch in interest rates on certain types of mortgage loans in the asset pool and those on rated certificates. Different prepayment assumptions were tested to determine the cash flow impact. The analysis also factored stressed delinquency for the portfolio as well as stressed recovery period of 24 months;
* The servicing capability of First Commercial Bank (FCB; twAA-/Stable/twA-1);
* The establishment of servicer replacement trigger events, under which Deutsche Bank AG, Taipei Branch, the trustee, will appoint a substitute servicer if necessary;
* The ratings of the service providers such as the account bank; and
* The bankruptcy remoteness of the SPT.

Originator/Servicer/Account Bank
FCB controls almost 6% of Taiwan's banking system assets. Although the bank's market share has gradually declined since the early 1990s, FCB remains a major player in the domestic banking industry. According to figures released by the Ministry of Finance, in terms of current principal outstanding of mortgage loans at the end of 2002, FCB ranked third among domestic banks. The bank's extensive network of 190 offices throughout Taiwan has helped attract low-cost stable retail deposits and maintain its lending margin amid strong competition. FCB's corporate culture has become more profit-oriented since its privatization in 1998, as evidenced by aggressive restructuring of its operations.

Unlike some private domestic banks, which centralize mortgage underwriting in regional centers, FCB mainly originates its mortgages, including collateral appraisal, credit review, and loan approval, at the branch level. The bank maintains its underwriting quality through regular and project-oriented auditing after loan drawdown and by monitoring the portfolio performance of each branch. Moreover, in view of an unfavorable credit trend since 2000, FCB tightened its underwriting policy by lowering the loan amount that can be authorized at the branch level.

Transaction Overview


At the closing of the transaction, FCB transferred a static portfolio of eligible residential mortgage loans (total of NT$4,572,697,182) to the SPT. The loans are first ranking mortgages originated by FCB under its usual origination programs. The SPT issues three tranches of rated certificates - Class A [tw AAA], Class B [tw AA], Class C [tw A] - and unrated Class D subordinate certificates. The certificates will pay monthly and have a final legal maturity of Apr. 21, 2033. The residual Class D certificates are unrated and retained by FCB.

Credit support for the senior certificates is provided by the junior certificates and the residual class D certificates. Credit support for the most junior rated Class C certificates comes from the residual Class D certificates, which will absorb the first losses incurred in the portfolio up to 6.4% of the total loan balance on the cut-off date.

The interest collected from the loans in the loan portfolio, after deducting for taxes and senior expenses, will be used to pay down the interest accrued on the rated certificates. The remaining amount will be used to replenish the reserve account first, cover junior trustee expense if necessary next, pay FCB as the servicer third, and finally allocate to the Class D certificates for distribution as interest. The principal collected from the entrusted loan pool will be used to repay the principal of the Class A certificates in full before the principal of the Class B certificates is redeemed, and so forth. On the other hand, if any losses are incurred in the loan portfolio, they will be allocated to the certificates in the reverse order, i.e., starting with Class D certificates.

Unless previously redeemed by the trustee or prepayment, the certificates will be repaid on the final legal maturity date of Apr. 21, 2033, which is 24 months after the last mortgage matures in the loan portfolio. The tail period of 24 months ensures that any back-ended losses on the loan portfolio can be liquidated, and the recovery proceeds from such types of defaulted loans may be available to repay the certificates.

The mortgages in the portfolio are either mortgages which pay monthly interest based on either FCB's prime lending rate or are adjustable rate mortgages (ARMs). The ARM rate is the one-year average fixed savings deposit rate of seven major banks in Taiwan. The loans paying interest at FCB's prime lending rate may be converted to ARMs, subject to a minimum interest margin of 1.1%. The interest benchmark for ARMs will be reset on the 15th of each January, April, July, and October, and be effective until the following reset date. The contracted interest on the rated certificates is the ARMs index plus a different spread for each rated class (see Rating Details section). The basis risk stemming from the mismatch on interest between FCB's prime lending rate and ARMs has been taken into account in the stress assumptions of the cash flow analysis.

All repayments under the mortgage loans will be collected by FCB as a servicer. Should a servicer termination event occur, the trustee will appoint a substitute servicer within 90 days, failing which it will act as the servicer. Due to this servicing arrangement, a larger liquidity reserve has been sized. The servicer will deposit collections to the collection account within one business day of receipt. On each payment date, the trustee will distribute the payments according to the relevant agreements.

To cover any shortfall in the interest payments to the certificate holders, a liquidity reserve funded by the proceeds from the certificate issuance was set aside from the closing date. Additional cash reserves were also established at closing to mitigate commingling and set-off risks.

The Loan Portfolio
The collateral consists of a portfolio of 2,026 residential mortgage loans, for an aggregate amount of NT$4,572,697,182 as of the cut-off date (Jan. 9, 2004). Pool characteristics include the following:

* All loans are secured by a first fixed lien on the residential properties located in northern Taiwan;
* About 38% of the loans, in terms of current loan balance, are located in Taipei City, while 62% in northern Taiwan, including Taipei County, Taoyuan City and County, as well as Hsinchu City and County;
* In terms of interest benchmark of the loan pool, 7.5% of total loans are loans based on FCB's prime lending rate, while 92.5% of them are ARMs;
* All loans are private label loans originated by FCB. No government-subsidized loans are securitized in this pool;
* The loan pool has a weighted average loan seasoning of 37 months;
* The average outstanding loan balance is NT$2.4 million;
* The average age of the property is 12.5 years;
* In respect of about 15% of the loans, calculated by current loan balance, the borrowers pay only interest for a period of up to the first five years. After the interest only period finishes, these loans will convert automatically into regular amortizing term loans; and
* The geographical concentration, in terms of zip code by current loan balance, is below 6%.

Credit and Cash Flow Analysis
Taiwan Ratings performed the credit analysis of the transaction based on its rating criteria of residential mortgage-backed securities. The credit assessment also took into account the specific attributes of the loan pool and the historical performance of FCB's overall mortgage loans and mortgage loans originated in northern Taiwan. As a result of the analysis, Taiwan Ratings estimated the stress levels in terms of default frequency and loss severity of the loan pool for each rated tranche and incorporated such stress assumptions into the cash flow analysis.

A cash flow analysis was conducted to determine the levels of credit support for this transaction. Besides default frequency and loss severity, the stress scenarios also addressed the flexibility that the servicer will have in reducing the interest margin no less than 1.1%. But this type of resetting is limited to 25% of the loan pool in terms of loan balance. For cash flow analysis purposes, Taiwan Ratings has assumed that FCB will reset loans immediately from closing resulting in a compression in the portfolio's cash flows. The cash flows are further tested by assuming various levels of prepayment, interest indices, and delinquencies.

Structural Analysis
Interest rate risk/basis risk.
The transaction is somewhat exposed to basis risk. The interest payable to the rated certificates will be an ARM-based floating rate. Although 83.7% of the loan pool, in terms of current loan balance, pay interest according to ARM-based floating rates, 7.5% of the loan pool is based on FCB's prime lending rate and 8.8% are based on ARMs with fixed rates for the first one to three years. There will be no basis swap to hedge basis risk. However, such basis risk has been taken into account in cash flow stress tests. For example, loans based on FCB's prime lending rate were assumed to have been converted into ARMs at closing at a minimum margin of ARM plus 1.1%.

Taiwan Ratings also ran various interest rate scenarios, in terms of the ARMs index, to ensure that the level of overcollateralization was sufficient to cover basis risk.

Prepayment risk.
Prepayment may affect the portfolio's ability to generate excess interest spread. Moreover, as the certificates will pay monthly interest, the period of associated negative carry is up to one month. Taiwan Ratings stressed rates of prepayment to ensure that in each case, the portfolio's cash flow is sufficient to deliver timely interest and principal when due to investors. Prepayment of the portfolio may result in an early redemption of the certificates, and the rating however does not address this early return of principal to investors.

Commingling risk.
According to the transaction's legal documents, the servicer is obligated to remit principal and interest collections, such as scheduled repayment, liquidation proceeds and principal prepayment, to the SPT's bank account one business day after receipt. As a result, the transaction is exposed to commingling risk, in the event that the servicer becomes insolvent while holding the proceeds collected for the SPT. By analyzing the distribution pattern of daily mortgage payments in a month and estimating likely prepayment amounts, the commingling exposure is determined and will be mitigated by a cash reserve that was funded at closing.

Set-off risk.
Because the originator is a deposit-taking institution, many of the obligors have deposits with the originator. Those obligors have the right to offset their mortgage loans with their deposits held by the originator. This exposes the transaction to setoff risk. The amount of each obligor allowed to set off was fixed at closing. Set-off risk is partly mitigated by the government's deposit insurance scheme, under which government-funded Central Deposit Insurance Co. offers deposit insurance of up to NT$1 million for every depositor in each banks in Taiwan. Moreover, such static risk was sized and mitigated by a cash reserve established at closing.

Servicer transition risk.
A servicer transition may negatively affect cash flow of the transaction. Should a servicer termination event occur, the trustee would appoint a substitute servicer within 90 days, failing which it would act as the servicer at a predetermined price. According to the legal documents, the trustee would be in a position to service the portfolio no later than 90 days from the resignation or termination of the former servicer. The trustee has an additional 60 days to examine the portfolio data supplied by the former servicer. This back-up servicing arrangement differs from other Asian transactions, but the potential operational and cash flow risks associated with a lengthier transition period have been offset by larger servicer transition liquidity reserves. Ultimately, this deal does have a contracted substitute servicer.

To minimize disruptions, to the extent FCB is capable, it is required to send out notifications within 10 business days after occurrence of a servicer termination event to direct the borrowers to send their remittance to a replacement bank account (which will be in an eligible bank with sufficiently high rating to support the rated certificates). If FCB is unable to perform this function, the trustee (DB) must complete this task. The cost of notification is reserved in the cash reserve at closing.

Earthquake risk.
Earthquake risk is somewhat moderated by earthquake insurance, as 14% of the loan portfolio, in terms of the number of loans, is covered by earthquake insurance. The maximum available earthquake coverage is NT$1.2 million and can only be claimed based on total loss. Earthquake insurance has been mandatory in Taiwan for mortgages extended after April 2002, but refinanced mortgages do not require such insurance.

Earthquake risk is mainly mitigated by geographic diversification in terms of zip code. An analysis of the zip codes reveals that the maximum exposure per zip code is below 6% in terms of loan balance outstanding.

Legal and Tax Analysis
The transaction is structured in accordance with the Financial Asset Securitization Law of Taiwan. The law requires the trustee to withhold 6% on interest paid to certificate holders for tax purposes. Therefore, certificate holders will receive their coupon, net of the required taxes. Prior to assigning the final ratings and the closing of the transaction, Taiwan Ratings received satisfactory legal, tax opinions and tax rulings.