Echoing warnings that everything in South Korea's madcap securitization market may not be healthy (ASRI 4/24/2000 p2), Standard & Poor's recently cautioned that the growth in ABS may be obscuring lingering trouble with asset quality and could be storing up problems for the future.

Korea's ABS market has grown at an astonishing rate, with W22.9 trillion worth of ABS issued in the first six months of this year, more than three times the amount in all of 1999.

The jump in issuance has been accentuated by the closure of the local straight bond market to all but the strongest credits, as investors have become nervous about the financial strength of the country's largest companies, most notably Hyundai.

As a result, ABS accounted for 73.4% of issuance in the local debt market in the first seven months of the year, according to figures released by the Financial Supervisory Service, compared to just 4.4% in the same period in 1999.

The once-vibrant equity markets have also been quiet, while commercial banks have reined in lending nervously.

All this leaves ABS as close to the only game in town. But it is not a game to be taken lightly, S&P argues in a report called "Korea's Brave New World of Securitization".

S&P is concerned that while most of this growth has been fuelled by the securitization of non-performing assets, with issuers such as banks and Investment Trust Companies using the technique to remove dodgy assets from their balance sheets, the fact that they retain large tranches of subordinated notes does little to improve an issuer's true financial position. The agency says that of the W22.9 billion issued up to June 2000, roughly W8.05 trillion is in the form of subordinated notes.

"These junior notes, usually repurchased by banks or ITCs, are backed by essentially insolvent assets, and as such are less likely to be repaid," the report notes. "In short, securitizations involving large subordinated tranches are leaving financial institutions holding on to the worst of the their bad assets."

Similarly, many deals also rely on third-party credit support, such as guarantees or options to put back loans to originating banks, meaning once again that only a proportion of the risk is transferred to the buyers of the ABS.

"Despite its progress, Korean securitization is still emerging, and as a result many transactions rely heavily on guarantees or even in some cases on support from the originators of the deals themselves," said Diane Lam, director of structured finance ratings in the agency's Hong Kong office.

S&P is also concerned that the Korean government's latest wheeze to make use of securitization - the so-called primary CBO program - is storing up trouble for the future.

The program is designed to raise W10 trillion from Korean banks and finance companies of which W7 trillion is earmarked to buy corporate bonds and parcel them into CBOs, which will then be sold on to end investors (ASRI 7/17/2000 p 2, 7/31/2000 p 3 and 8/14/2000 p 10). It is intended to support second-tier firms who cannot borrow because of the liquidity crunch caused by the nervousness in the financial markets.

If that is a temporary problem, then the plan could succeed, but if not, it may end up creating a new class of non-performing assets and ultimately exacerbate lingering asset quality problems at Korea's financial institutions, the agency said.

"While the pooling of assets does dilute risk through diversification, to a large extent the purpose of the fund is to provide liquidity to institutions that would otherwise not meet the credit guidelines of the banks," said Graeme Knowd, financial institutions analyst, at S&P in Tokyo. "The ability of the weaker corporates in the pool to repay this new debt is intricately linked to the overall health of the economy. Further turmoil in the corporate sector and a slowdown in the economic recovery could see holders of such bonds sitting on substantial losses."

Despite these problems, S&P is not completely dismissive of Korea's surge to the forefront of the asset backed world and applauds the country's rapid acceptance of structured issuance, in particular the part that securitization is playing in bringing foreign money and expertise to Korea.

"The inclusion of foreign players in Korea's securitization game will be beneficial to the financial system by providing fresh funding from outside sources that can be applied to resolving the bad debts that remain in the financial sector," Lam added.

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