Ann Rutledge was in Hong Kong when Mao died, got in on the ground floor of economic reforms and helped set up the modern risk system for the then-colony’s futures exchange before starting R&R Consulting, which focuses on asset-backed securities (ABS)—the same financial tools widely blamed for the global financial crisis of 2008.

By now one might expect China’s financial markets to have long since stopped surprising her. When Rutledge applied for a grant with the SWIFT Institute to study China’s asset-backed securities market, she said, “I assumed the Chinese market would look similar to the US market, but with Chinese-flavored assets… but I figured wrong.”

What she discovered instead was a burgeoning sector bisected by dueling regulators and beset by legal vagaries—but one that could potentially do for China what it did for the United States: Free up otherwise inaccessible liquidity to make the country’s debt market far more dynamic, opening new sources of funding for the smaller companies while also diversifying investment opportunities for the country’s banks and other financial institutions. All, ideally, without culminating in a meltdown.

The market for ABS in China has grown more rapidly than ever this year thanks to a new issuance system, and further healthy growth could also help pull a substantial sum out of the country’s notoriously opaque shadow banking sector and put it back on banks’ books. Kingsley Ong, a partner at law firm Eversheds International who was asked in 2007 to help draft China’s asset-backed security laws, said only half-jokingly that potential for securitization in China was “quite unlimited”.

But for now, a lack of industry experience and widespread failure to disclose vital information on the nuts and bolts of the products on offer in this emerging market have raised questions about its ultimate impact on the broader economy. Even Rutledge acknowledged there was a real risk.

“I believe China has no choice but to do ABS, and moreover I think they have some safeguards that we [in the US] don’t have,” she said. “But they also have a very long learning curve, and a lot can happen between now and then.”

Death and resurrection

China’s first real securitization market took shape in April of 2005 when the People’s Bank of China and the China Banking Regulatory Commission established a pilot market and regulations. Those were suspended in 2009 following revelations about the role of American mortgage-backed securities in what was by then a global financial crisis—a move for which few fault Beijing.

“While I am sometimes a critic, I will say I can understand China saying, ‘Hey, we better figure out this product and this market before we allow it to go full bore in ours,'” said Christopher Balding, a professor of economics at Peking University.

Once the dust had settled policymakers looked again to securitization to diversify China’s capital market structure, and in May of 2012 regulators fully lifted a ban on issuance—though they outlawed the structures, known as re-securitizations and synthetics, that were behind the crisis in the US. They also forbade any further issuance of products backed by non-performing loans.

Since the thaw, issuance of ABS in China has shot up dramatically: In 2014 China overtook South Korea to become the largest securitization market in Asia, and this year issuance had passed RMB269 billion (US$42.14 billion) as of the end of October, according to China Central Depository & Clearing and Shanghai Clearing House.

Eddie Hu, a partner at the Shanghai office of consultancy King & Wood Mallesons who has advised banks, auto finance companies and financial firms on asset-backed securitizations, chalked this year’s rapid issuance up to an easing of regulations. Before November of 2014, firms had to get case-by-case approval from the authorities; now they can sell freely once they’ve registered with regulators.

“The administrative process has been simplified, incentivizing those who originate and issue to do more securitization,” Hu said.

Yet for all that growth ABS remains a practical pipsqueak compared to bank lending or the broader bond market in China, with the latter valued at RMB35.89 trillion (about US$4.24 trillion) in 2014, according to Goldman Sachs (pdf). The question of what’s holding mainland securitization back requires a closer look at what exactly it entails.

Beastly complexity

Balding attributed ABS’s relatively minuscule market size in part to two main factors: A preference among Chinese investors for less complex financial products and a lack of understanding of what exactly ABS are. In the case of the latter they are not alone, as the complexity of securitization is among the many attributes that help make the sector seem impenetrable to outsiders—while also making it incredibly versatile.

An asset-backed security essentially takes contractual future cash flows or expected operating cash flows and converts them into immediately fungible funds by borrowing against those flows and the assets that generate them. For example, as has been done with certain expressways in China, the company that owns a toll road can use that road as collateral in order to get financing from investors now based on the income it has yet to make from tolls paid by drivers who will use said road.

To actually come up with the money, the company can set up a financing vehicle that offers interest-bearing securities to investors based on those expected cash flows from future toll payments. Once investor financing is secured, the vehicle will actually buy the toll road from the company—so the company gets money now, and the financial instrument begins directing money from toll payments directly to the investors holding the securities until the promised payouts are paid off in full.

If the cash flows from the toll road dry up, the investors can take the road and sell it off as compensation. And because the company doesn’t actually own the road anymore, it can’t stop the issuer from transferring ownership to those investors.

A financial institution typically helps set up the issuer – known as a special purpose vehicle (SPV) – that issues securities to investors, often in different batches that are classified based on their level of risk, which is tied to priority of repayment. The risk level of each batch is certified by one or more ratings agencies.

The credit rating for such securities can be higher than that of the company from which they originated because the risk being evaluated is that of the cash flows themselves. “So your company might not be triple-A, but you can still issue bonds that are triple-A,” Eversheds’ Ong said. “That is a phenomenal advantage.”

Thus, securitization can enable a company to raise funds more easily than might be otherwise possible through a loan based on its balance sheet. It also creates a new class of investment with risk portioned out to suit the tastes of investors, which can range from more cautious pension funds to less risk-averse private hedge funds.

But Beijing has added another wrinkle to the proceedings by separating ABS into two categories, administered by two different regulators.

Showcase shortcomings

The first, most-favored variety falls under the Credit Assets Securitization Scheme (CASS), trades on China’s interbank market and is regulat

ed by the China Banking Regulatory Commission. Here, assets originate with banks, trust companies, lenders and auto finance firms, securities for which are issued by trust companies on their behalf to be snapped up by institutional investors.

CASS is the bigger and more liquid ABS market: According to the working paper Rutledge authored for the SWIFT Institute, 62% of all 206 Chinese securitizations were CASS, accounting for 82.2% of total principal issuance of RMB605 billion (US$94.52 billion) as of June 25.

Of the 127 CASS deals analyzed in the working paper, nearly three quarters were collateralized loan obligations (CLOs)—securities backed by a pool of debt, typically sourced from small- and medium-sized enterprises. The next-largest cohort, auto loans, stood at just over 10%.

Yet while similar CLO offerings are priced higher than general-purpose corporate bonds in US and UK markets, Balding noted that’s not the case in China.

“What that seems to indicate is that either the companies aren’t selling the [securitized] bonds properly… or the investors don’t believe what the companies are saying they don’t believe that the securitized bond is giving them anything more tangible in return,” he said.

This apparent undervaluation of the interbank market’s most popular ABS offering may lie in the shortage of two key assets: Information and experience. Rutledge said that about 90% of the deals in China’s showcase CASS market lacked vital information demanded by international standards.

“The only deals that I can get what we call servicer data – what we call underlying performance data – on are coming out of deals that foreign manufacturers are doing, specifically the auto manufacturers,” she said.

Disclosures from automakers like Nissan, BMW and Volkswagen is standardized, allowing ABS investors to determine how many loans are delinquent, how many have defaulted and the likelihood of being repaid in full on time.

Indeed, Hu said the performance record of auto loans’ underlying asset pools was “quite good compared with other corporate loans because they’re very diversified.” That’s the kind of performance record that attracts international investors, he said.

For the remaining 90% or so of the CASS market that isn’t backed by auto loans such data isn’t made public, though it is collected by the China Central Depository & Clearing, the official clearing company for the interbank market.

Trust issues

Outside of China’s interbank market ABS growth is being held back by the uncertain legal status of the framework currently available for use by non-financial institutions in securitizing assets.

The question is that of the vehicle created to issue securities to investors on behalf of a company and which takes on ownership of the assets. While financial institutions use special-purpose trusts, which are well-established in PRC law, those aren’t an option outside of the inter-bank market.

Under the current setup, known as the Asset Backed Specific Plan (ABSP), non-financial firms have to use contracts to transfer ownership of assets. The resulting ABS cannot be traded on the interbank market and are regulated by the China Securities Regulatory Commission, but can be offered to retail investors and even listed on the mainland stock exchanges. But regulatory backing for such deals only amounts to administrative rules, which can be overruled by a host of higher regulations.

As laid out in a recent study (pdf) of China’s securitization law published in the Capital Markets Law Journal and co-authored by Ong, such rules “may have different levels of enforcement in different parts of China, and may be subject to policy changes over time, or even competing political interests.”

Ong said the guidelines were of real use and worked under most circumstances. But if a securitization backed by a company’s most precious assets were to default and investors came calling, a judge might have to decide between honoring the contract and following other, higher-level state laws that hold workers’ rights in higher regard.

“Would the judge say that the securitization investors – who are the big boys, the professional investors – should get the money? Or will they say no no no, the money should be returned to the workers so they can feed their families and what have you?” Ong said. “I think under those circumstances it is less clear.”

This fundamental uncertainty helps explain why as of late June principal issuance in the ABSP market had grown only 3.4 times that seen prior to the 2008 market hiatus, while average deal size had fallen to RMB3.87 billion (US$607.7 million), just 56% of its pre-freeze level.

By comparison, ABS trading on China’s interbank market has expanded to colossal proportions: Principal issuance of CASS had grown to RMB497.6 billion (US$78.09 billion), eight times what it was in 2008, while average deal size grew just over 1% to RMB3.29 billion.

Untapped potential

Eddie Hu at King & Wood Mallesons said that the clearer picture for investors of underlying assets and risk pointed to brighter prospects going forward of ABS issued by financial institutions. But even here he was conservative, citing recent cuts by the central bank to China’s benchmark lending rate as easing any pressure mainland banks were under to find more funding.

“I don’t think there will be a leaping increase in issuance numbers or size, but I think the number of issuances and issuance size will increase gradually in the coming years,” Hu said, pointing in particular to local commercial banks at the city level and below as likely to try their hand at ABS.

That is looking more likely in light of recent regulatory easing: In June, Reuters reported that the China Banking Regulatory Commission had granted provincial branches permission to green-light new issuance for cities’ commercial banks for their ABS plans—though big banks apparently still needed issuance approval from the commission’s headquarters in Beijing.

Yet even those approved by the banking regulator remain opaque by the basest standards of international ABS investing, Rutledge said, adding that local knowledge of the routines industry analysts typically use to rate the different batches produced by securitizations was sketchy in China at best.

“People are doing deals and the deals seem to work, but one of the reasons the deals are working is because the high-performing collateral is what’s being securitized,” said Rutledge. That could change.

Moreover, cordoning off financial institutions’ ABS trading to the interbank market also means they ostensibly aren’t helping disperse risk that is concentrated in the banking sector, instead serving largely to help banks ease pressure on their balance sheets.

But Rutledge cautioned against taking for granted that such restrictions were always observed in practice. Without more performance data transparency, she said, it will remain difficult to judge whether cash flows are as healthy as claimed and going where they’re supposed to.

“When people want to see a market grow they’ll say anything, and they’ll turn a blind eye to things that are obviously problematic,” Rutledge said. “You can’t put a fence up and expect it to contain water. Water flows. Money flows.” ♦

Author: Hudson Lockett (@KangHexin)