It may be early days for Hong Kong's fledgling CMBS market, but things are already getting interesting: the market's second deal is being issued by a company that is it in what Moody's Investor Services calls "technical default".

The transaction comes from Paliburg Holdings, a property company that has signed statutory agreements with its bank group to reschedule its debts and could be forced into insolvency if those banks choose.

Nonetheless, the senior tranche of the HK$1.4 billion (US$180 million) transaction will be rated at Aaa by Moody's, above the agency's local currency sovereign rating for Hong Kong.

The deal is due to hit the local bond market before the end of September, via lead manager SG Asia. It comes through an SPV called Commercial Plaza Securitisation Ltd. and is backed by a fixed-rate Hong Kong dollar mortgage loan which is secured by two cross-collateralized "grade-B" properties, Kowloon City Plaza and Paliburg Plaza.

The transaction is split into a senior tranche rated Aaa by Moody's and worth HK$492 million, plus five junior tranches rated between Aa3 and Ba3. All the notes have final maturities of September 2006, one year longer than the maturity of the underlying loan itself and all but one are floating rate. The transaction also includes a HK$153 million subordinated zero coupon note, which is unrated.

Credit enhancement comes from the senior/subordinated structure plus a fully funded liquidity reserve of HK$28 million.

While securitization deals are designed to cope with the sponsor's insolvency, it is unusual in the relatively unsophisticated Asian markets for companies in such a precarious position to launch issues.

However, as a source close to the transaction pointed out, it is only Hong Kong's second-tier property companies who would consider securitizations, as the first class firms have no shortage of cash or banks willing to lend. "Not only do [the strongest companies] have covenants on their bond deals and loans stopping them issuing CMBS, but they really don't have any need to," the source said. "It is only those who are weaker who are interested and thanks to the ring fencing of securitization, it is possible that such companies can do highly rated deals."

Even so, the problem that a bankruptcy would cause is not just limited to servicing the transaction and managing the property - servicing and management would switch from Paliburg to Vigers' Hong Kong office, if the former went bust - because Paliburg and its subsidiaries are also the major tenants in Paliburg Plaza. Consequently, the disruption caused by the switch in servicing would be combined with a sudden drop in rental income.

"That is the reason for the pre-funded liquidity reserve fund," said Jerome Cheng, a Moody's analyst in Hong Kong. "If Paliburg and/or its related companies are in insolvency proceedings, it takes time to repossess the floor areas occupied by Paliburg and/or its related companies and you lose the opportunity to rent to someone else, so we have assumed a reduction in rental income. In addition, you may incur expenses to reinstate the property to leaseable condition. The liquidity reserve will be able to serve the interest payment obligations as the manager finds substitute tenants and pay the reinstatement expenses."

The strength of the transaction, including the support provided by the liquidity reserve, has allowed Moody's to rate the deal's highest tranche at Aaa, even though it only gives Hong Kong an Aa1 local currency rating. "We have an Aa1 local currency guideline in Hong Kong - it is a guideline not a ceiling," said Michael Ye, the head of Moody's structured finance team in Hong Kong. "We think that there is a potential risk that the Hong Kong dollar could be replaced by another currency, and that risk is one of the factors contributing to Hong Kong's Aa1 local currency guideline.

"But as long as you tell investors, as in this transaction, that the definition of Hong Kong dollar is whatever is the legal currency of Hong Kong and they may receive payments in another currency rather than Hong Kong dollar as of today then it is possible to rate the transaction at Aaa if the availability of the underlying cashflow is consistent with an Aaa rating. It is a disclosure issue."

While this is a position that not everyone in the market will agree with - Standard & Poor's notably will not normally rate a deal above a local currency ceiling, unless it has external support - this deal is not the first of its kind.

Moody's gave similar ratings to Hong Kong's first CMBS, a HK$1.8 billion deal which was issued by Chinese Estate Holdings in November last year. SG Asia also brought that deal to market.

This is the first time, however, that Hong Kong has seen a CMBS from such a weak issuer. What investors make of both factors will soon be seen.

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