In December 2001, the Hong Kong Mortgage Corporation (HKMC) launched its $3 billion Bauhinia MBS Ltd. securitization program. It has now just completed its first issue, the largest-ever Hong Kong dollar-denominated residential mortgage security, and plans to launch at least another this year. Market participants hope that this will reawaken the Hong Kong securitization market.

HKMC is master servicer and transaction administrator, as well as the seller. Merrill Lynch is the program arranger, and the program dealers are Barclays Capital, Dai Heng Bank, Deutsche Bank, HSBC, JPMorgan, Merrill Lynch, Citigroup/Salomon Smith Barney and UBS Warburg.

HKMC is a quasi-sovereign entity owned by the Hong Kong SAR Government. HKMC's credit profile is enhanced by direct and indirect government support. It was set up in 1997, and its roles are to develop the financial sector - in particular, a secondary market for mortgages in Hong Kong - and to promote homeownership.

HKMC does not originate mortgages but provides liquidity to the banking sector and mortgage loan underwriters by acquiring mortgage portfolios to hold or securitize.

The company has 36 approved sellers of mortgages, including the Housing Authority and the Housing Society. HKMC agreed to buy more than HK$20 billion (US$2.6 billion) in mortgage loans from these two organizations in July 2001. In October 2001, its loan portfolio was comprised of 29,800 loans, worth about HK$20.3 billion.

Program aims

The Bauhinia program will provide a platform for HKMC to develop an active secondary mortgage market in Hong Kong, which HKMC also hopes will develop the product range of the domestic financial markets.

"This will pave the way for us to securitize mortgage loans in different structures of MBS from the corporation's retained portfolio," says Philip Li, senior vice president, (finance), at HKMC. "We have four basic objectives in doing this program: to manage credit risk embedded in mortgage loans; to manage market risk embedded in mortgage loans; to manage the level of capital to assets ratio; and to get funds to finance new mortgage purchases."

Furthermore, unless illiquid mortgages can be transformed into tradable securities, a secondary mortgage market cannot be developed. "By establishing a secondary market we can make the pricing mechanism of mortgages more efficient and transparent," adds Raymond Liu, vice president, treasury, at HKMC.

It will also help to educate investors. "This will make investors understand MBS, rather than just plain vanilla products," said Rajiv Garg, vice president at Merrill Lynch in Hong Kong. "It will get them familiar with the cashflow risk."

HKMC says that the program provides a means for banks to better manage their portfolios or clear their mortgages, and also creates a new investment for fund managers and investors. This will also benefit homebuyers by facilitating a supply of mortgage finance. Banks may also invest in MBS originated under the program, as an alternative to competing for mortgage loans in the primary market. The advantage is that HKMC MBS are risk-weighted at 20%, while mortgages are risk-weighted at 50%.

Merrill Lynch notes in a recent report that HKMC mortgages have recorded relatively low delinquencies, and performed better than the domestic average. As of June 2001, HKMC's total loans past 90 days stood at 0.17%, compared to 1.35% for the Hong Kong banking sector as a whole.

Mortgages secured by first or second legal charges are eligible for securitization under the program, and include: prime-based residential mortgage loans; HIBOR-based residential mortgage loans; and fixed adjustable-rate residential mortgage loans.

Setting an example

The Bauhinia securitization program could set an important precedent for other countries. "The HKMC example is a positive experience for other Asian countries to follow both in terms of MBS structure and the setting up of a program," says Li. "We can set an example for other Asian countries, especially for mainland China, which has the most potential.

"I think that China is a potential MBS securitization market because the population is so huge. China has a population of about 1.3 billion, and the primary mortgage market is developing very fast."But before China can do mortgage securitizations, it needs to cross a number of important hurdles. These include legal issues such as trust law and bankruptcy law, as well as accounting standards.

"It takes time to adapt these to international standards," explains Li. Mortgage securitization is also being looked at in Korea and Singapore.

Past issuance

HKMC established the Guaranteed Mortgage-Backed Pass-Through Securitization Program in 1999. It has issued three series of MBS totalling HK$2.2 million. This programonly does private placements. The back-to-back structure of the program, whereby the originating bank purchases back its mortgages in the form of MBS, allows the participating banks to keep a substantial portion of the cash flow from their mortgage pools. It also reduces the credit risk and capital cost, because of HKMC's guarantee of the securities.

"We still use this to cater for banks that want to transform loans into MBS to transfer out credit risk and reduce capital risk weighting," says Li. The program gives banks the option to offload part or all of an issue at any time, as suits their liquidity or trading objectives. It is aimed at banks interested in balance-sheet management, while Bauhinia caters to a wider group of investors interested in the income stream from securitized mortgages.

There have also been a few RMBS and commercial mortgage-backed security issues from banks in Hong Kong. These have been in U.S. dollars and Hong Kong dollars, but have not been enough to spark the development of the Hong Kong MBS market. According to a recent report by Merrill Lynch, there should be growth in the MBS sector, but it may be limited.

Bauhinia MBS Ltd

Bauhinia will securitize single-class guaranteed MBS issues, similar to mortgage transactions launched in the United States by government agencies Ginnie Mae and Fannie Mae. It will also launch multi-class non-guaranteed MBS issues such as pass-throughs and collateralized mortgage obligations, to appeal to a different investor base. The non-guaranteed issues will be credit enhanced by tranching, together with a reserve fund or over-collateralization.

HKMC says it was designed to allow convenient, flexible and cost-efficient MBS issuance. An example of this is the program's master trust structure, which means that all bond issues can be done out of one SPV, rather than using a new SPV every time an issue is launched. It is the first Asian MBS master program outside Australia.

In July 2001, HKMC also introduced the model mortgage deed and model deed of guarantee and indemnity. The aim is to make mortgage securitization easier by removing the need for due diligence by rating agencies and investors. By standardizing product structure and legal documentation, the lead-time for arranging an issue will be shortened. A stand-alone issue takes six to nine months, as opposed to a few weeks when done with the HKMC program. HKMC says this will allow banks to convert illiquid mortgage portfolios into liquid MBS as required.

Bauhinia allows for HKMC to do public and private issues. Li says: "This is very important because it gives us flexibility. We will do a private issue when we want to securitize a small amount of mortgage loans, or if there is investor demand for a smaller issue."

Simple start

Bauhinia is starting with simpler products because mortgage-backed securities are relatively new to Hong Kong, and it takes time for investors to familiarize themselves with a product's features and its economics. Future issues could have different structures, including synthetic. "Our program can cover the major MBS structures," says Li. "Synthetic issues are also possible under this program."

Balance-sheet management is becoming more of a concern for banks. "Consumer credit defaults have gone up in Hong Kong and other parts of Asia over the past three to four months, and although Hong Kong mortgages are still performing well, banks want to manage their balance sheets," says Garg. American Express Bank is preparing a synthetic RMBS program independently of HKMC, which could be as much as HK$7 billion. HypoVereinsbank is acting as arranger. An initial deal is expected towards the end of April. There was also a synthetic securitization of Hong Kong mortgages at the end of 2000, the HK$1.26 billion HK Synthetic MBS Co Ltd issue, and it is thought that ABN AMRO is now working on another.

Bauhinia is a multi-currency program. "We intend to sell future issues to international investors," says Li. "This will most likely be in U.S. dollars, and we might look at euros, depending on demand. We will target different investors and different nationalities depending on prevailing market conditions." But initially the program will concentrate on the Hong Kong market, to fit in with HKMC's aims of promoting an active MBS market locally. The program allows for a number of credit enhancement options to be used, including credit guarantee, tranching, over-collateralization and reserve funds. This is to suit the different balance-sheet management needs of investors, and appeal to investors with different risk appetites.

To what extent these techniques could be adopted by other banks depends on a number of conditions. "Transfer of credit risk embedded in mortgage loans is always an intended objective for banks," says Li. "But whether they do credit enhancement by tranching a securitization, depends on market conditions, including whether there is enough room for the mortgage rate to be tranched out to be acceptable to investors."

He elaborates, "The Hong Kong mortgage rate is very low at present. At its peak before 1997 it reached 1.5% over the Hong Kong dollar prime rate, but now it has gone down to 2.6% below the prime rate - a drop of more than 400 basis points. With such a low mortgage rate level it is very hard to securitize mortgages into senior and junior class MBS." If there is not a higher mortgage rate, the MBS coupon will be too low to attract investors, or the issuer has to suffer a loss to securitize mortgage loans.

The Bauhinia program and its debut issue have not yet been rated. This is because the first issue is guaranteed by HKMC and so relies on its rating. Local institutional investors, to whom the issue was targeted, are familiar with the credit risk of HKMC. HKMC has a local currency rating of Aa3/AA-, and a foreign currency rating of A3/A+ from Moody's Investors Service and Standard & Poor's. HKMC could have achieved the same rating by guaranteeing a straight bond issue, which is simpler to execute than a securitization. But one of HKMC's goals is to develop an MBS market, so it launched a securitization. Garg at Merrill Lynch adds, "The legal maturity on this issue was 2023 with an uncertain principal payment profile, and we also did not want to load a new market with both cash flow and credit risk."

Future issues could be rated. "We have not rated the program but Moody's and Fitch have reviewed the program at our request," says Li. "The review will be very useful since the comment will allow for us to rate future MBS."

Debut Issue

Bauhinia's debut issue closed on March 11, and was lead-managed by Merrill Lynch. Bank of China (Hong Kong), Bank of East Asia, Deutsche Bank, HSBC and JP Morgan were co-lead managers, and the International Bank of Asia and Wing Lung Bank were co-managers. The notes were as follows: Class A-1. HK$800 million, coupon Hong Kong prime rate minus 2.75%; and Class A-2, HK$1.2 million coupon one-month HIBOR +25 basis points.

The notes had an issue price of par, and have a legal maturity in April 2023. The weighted average maturity is 2.3 years, and the expected actual final maturity is 5.8 years.

The issue is the first public MBS transaction to offer investors a choice between a prime based and a HIBOR-based coupon. It is also the first issue in Hong Kong with a prime priced tranche. This is advantageous in that it avoids the mismatch usually incurred between prime-priced mortgages and HIBOR-priced bonds. When pricing the deal, the managers looked to the current pricing of prime mortgages, while taking into consideration features such as HKMC's guarantee, and the fact that HKMC MBS have 20% risk weighting, while mortgages have a 50% risk weighting.

The entire deal was all placed in Hong Kong. Investors included pension and investment fund managers, insurance companies, private banks and commercial banks.

HKMC says that the diversified group of investors indicates the potential breadth of the investor base for good quality Hong Kong dollar securities. Garg at Merrill Lynch says: "The issue went off extremely well. It was significantly oversubscribed and used a book building structure, which is new in Hong Kong. HKMC should now look to doing a non-guaranteed issue."

Li says: "The investors who bought the first issue know HKMC very well. Some were first time MBS buyers, but were willing to invest in this product, even though it was new to them." And investors were not put off because the issue did not have a rating. "The over-subscription really illustrates that our guaranteed MBS are well in demand," says Li.

Both the classes of notes have HKMC's guarantee on principal and interest payments. The notes have qualified as liquefiable assets under the Hong Kong Banking Ordinance.

This issued is secured on a pool of 1,802 mortgages with an aggregate outstanding principal balance of HK$2 million. The weighted average loan to value ratio is 61.78%.

HKMC expects to complete two to three issues totalling HK$3 million to HK$4 million over the next financial year, though it has not yet decided on the exact timing of its next issue. Thereafter, the number of issues will depend on the number of mortgage loans that HKMC purchases.

The extent to which banks start doing issues independently of HKMC will depend on a number of issues, including pricing and the underlying characteristics of their mortgages. However it is rumored that several deals are in the pipeline, including two from Merrill Lynch, which arranged this program. SG and HSBC are reported to be co-arranging a deal for a property developer.

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