ABN Amro recently brought to market one of the most significant deals to come out of Hong Kong in the last year. Called HK Synthetic MBS, the HK$1.27 billion ($161.7 million) transaction is not only the first time a synthetic structure has been used in non-Japan Asia, but is also the first time that Standard & Poor's has rated a deal backed by existing assets beyond the sovereign ceiling.

A portfolio of almost 1,200 loans with a residual value equal to that of the notes issued backs the transaction - which employs a credit default swap structure between the originator and the SPV. Despite the pool consisting entirely of first-tier prime mortgages, strict eligibility guidelines were imposed as to which loans were included.

No loans in the pool had been delinquent for more than 30 days since origination, the maximum original loan to value of the pool must be no greater than 70%, and there are also age limits on the borrowers themselves. As it is, the average seasoning of the loans is 29 months.

HK Synthetic MBS was split into four publicly issued tranches. The HK$987 million class A notes, rated AA by S&P and Fitch and Aa2 by Moody's Investors Service, have two- year average lives and priced at 65 basis points over three-month HIBOR. The HK$48 million of 5.1-year average life class-B tranche launched at 85 over, and was rated single-A by all three agencies.

Additionally, HK39 million of BBB/Baa2 rated C paper and the double-B rated HK16.61 million D tranche were also in the structure. Both tranches carry the same average lives as the B notes, with the C tranche coming in at 125 over three month HIBOR and the D notes pricing at 350 over.

A credit enhancement level of 10.8% for the senior tranche is provided by subordination on the B (6.5%), C (3%) and D (1.5%) tranches.

The fact that S&P rated the senior notes above the sovereign ceiling of Hong Kong indicates a shift in policy by the agency, although it should be noted that the level of credit enhancement required was higher than usual. "In a sovereign stress scenario, we assume that default on the underlying asset pool is going to be higher than if you didn't have to factor in sovereign risk," explained Calvin Wong, managing director for the Asian Pacific structured finance group. "And if you look at the credit enhancement requirement for the double-A tranche, it is at a substantially higher level than single-A where we didn't have to factor in sovereign stress."

That isn't to say that it was a simple case of ABN Amro adding further enhancement to get the rating. S&P looked at a range of other factors as well. "One of the issues we had to get over is that in a sovereign stress scenario, there's always the risk of government interference with the payment system," continued Wong. "Because this deal involves local obligors, with assets denominated in the local currency, the type of sovereign interference that we normally worry about is not an issue here, such as a government restriction on the convertibility of local currency into local dollars.

"Because the transaction uses a local currency asset pool and it's a domestic note issue, the only interference that could arise is if the government were to place controls on the movement of local currency and temporarily freeze bank accounts," Wong said. "We're assuming that risk is remote in the double-A context because in the past we used to measure that risk by the sovereign ceiling. But the sovereign rating is not really a precise measure of that risk: it measures the risk that the government is unwilling or unable to pay its debts. In this case, the local currency rating is A-plus, so what we're saying now is that you can somewhat divorce the risk of sovereign interference from the sovereign rating itself because that has a more specific meaning."

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