The U.S. Department of Housing and Urban Development (HUD), a department of the U.S. government, and its equivalent in China, the Ministry of Construction, recently announced an ambitious joint project that will test bthe possibilities of developing a mortgage-backed securities market in China.

The project, which thanks to the difficulties and the potential of China will be one of the most scrutinized programs in the international structured finance market, has excited lots of comment from securitization specialists who have followed the developments of securitization and particularly MBS in China, often with a mixture of hope and despair.

The Asset Sales Report International thought we should talk to HUD, to find out if it knows what it is letting itself in for. We talked to Steven A. Bernstein, HUD's Chief Economist for International Affairs who was responsible for designing the program.

ASRI: How did the project come about?

SB: The genesis was President Clinton's initiatives in China, which culminated in Secretary Andrew Cuomo [of HUD] forging a relationship with Minister Yu Zhengsheng of the Ministry of Construction. Basically, we said that we wanted to develop a housing finance project in China. Originally, the project was to be in two parts. First, there was to be a full securitization project and, second, we hoped to work with the Ministry of Construction to develop some type of guarantee facility similar to the way our Ginnie Mae works in the U.S.

But we determined that the primary markets need considerable strengthening all the way from the legal infrastructure, title issues, foreclosure and eviction issues, up to the technology and integration of the financial sector into the consumer area. The Chinese authorities recognize that and that project is on hold.

ASRI: So what are you planning instead?

SB: What we've come back to and what Secretary Cuomo had discussed with Premier Zhu Rongji was to do an experiment in order to examine the mechanics of mortgage-backed securitization. The China Construction Bank in Shanghai has just been issued a license by the central bank to issue mortgage backed securities, so what we have proposed, and I think it is going to happen by the end of the year, is that we do a test securitization.

During that process, we would do a detailed pre-study that will go into helping structure the project and a post-study which will enable us to highlight all the legal, technical and financial areas that have to be addressed before it would be possible to do a full scale securitization operation.

ASRI: What are the areas that need to be addressed?

SB: One of the issues is that the technology is not in place, the mortgages are not in proper databases, the mortgages cannot be stratified properly, etc. The project will allow us to bring in U.S. technology - a major U.S. investment bank has expressed interest - to show how to stratify and price a mortgage pool.

There are also various credit risks. We may not be able to cover everything on the credit risk side, but we have discussed various types of mortgage insurance programs. If you look at where the credit risk stems from in China, it comes from borrowers undergoing unemployment, disability and death, so there are potential programs that could be implemented by insurance firms, particularly foreign firms - given the changes of laws and hopefully the granting of licenses - that would cover those kind of risks. That is under discussion and we will try to implement those in this program.

ASRI: That may deal with the credit side, but what about the considerable legal and regulatory hurdles that would need to be overcome?

SB: The detailed work-study will highlight the areas that are critical to address before we start. We have already started working on that and we are hoping to have that done before the end of the summer. It will provide a pretty thorough blueprint of what we need to do and hopefully give the Chinese a working document with which they can use to strengthen the laws.

ASRI: There are some China-watchers who would argue that the introduction of securitization legislation, however well intentioned, will not be enough to overcome the lack of clarity and certainty in the Chinese legal system. Is that fair?

SB: I get back to the point that this is a test. It is not a true securitization, in the way that we know them in the more developed markets, but it is going to point out the deficiencies in the market and show what the Chinese are going to have to concentrate on in order to have a successful, robust mortgage market.

Remember that this is a securitization where we are creating a security, but it doesn't have all the check and balances that a deal would have elsewhere.

ASRI: What assets will make up the collateral?

SB: We haven't decided yet, though we would probably want some kind of blended portfolio. There is a lot of middle-income housing, with an average mortgage worth the equivalent of between $20,000 and $30,000, so that is likely to be the bulk of the portfolio. The properties will be in Shanghai.

ASRI: Do you plan be to actually sell the bond that is created by the pilot project?

SB: Yes. The final bond will be marketed, though the target market is to be determined. One private sector company has indicated that if they were to come in and provide a certain type of insurance then they would purchase this security. It would be small; we're looking at under a $100 million.

Also, don't forget that Chinese pension funds are contemplating alternative investments and they are writing draft legislation now to ask the central bank to allow them to buy investments other than government securities. It is also possible that the central bank could invest in it.

To the extent that we can make this a marketable security, we're going to try. But there is no guarantee that this will happen; it is an experiment.

ASRI: Will it be in renminbi, rather than dollars?

SB: Yes, it will be in renminbi.

ASRI: There will presumably have to be some kind of government guarantee to attract investors. Is that what you expect?

SB: I think ultimately it is going to take a sovereign guarantee to get a proper rating if you want to sell this to anybody but the government. Unless there is a very explicit sovereign guarantee normal investors are not going to want to invest. It's just not going to happen.

ASRI: So that is the pilot project, which as you say is an experiment, but what happens after that? Do you plan to expand from that initial project to full implementation of securitization in China?

SB: Yes, but we are not sure of the timeline. And it is impossible to guess. This is a limited experiment to see what is possible now and what will be possible in the future.

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