Securitization in East Asia

Lejot, Paul; Arner, Douglas; Schou-Zibell, Lotte Working Paper Securitization in East Asia ADB Working Paper Series on Regional Economic Integration, No. 12 Provided in Cooperation with: Asian Development Bank (ADB), Manila Suggested Citation: Lejot, Paul; Arner, Douglas; Schou-Zibell, Lotte (2008) : Securitization in East Asia, ADB Working Paper Series on Regional Economic Integration, No. 12, Asian Development Bank (ADB), Manila, https://hdl.handle.net/11540/2360 This Version is available at: https://hdl.handle.net/10419/109530 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, gelten abweichend von diesen Nutzungsbedingungen die in der dort genannten Lizenz gewährten Nutzungsrechte. Terms of use: Documents in EconStor may be saved and copied for your personal and scholarly purposes. You are not to copy documents for public or commercial purposes, to exhibit the documents publicly, to make them publicly available on the internet, or to distribute or otherwise use the documents in public. If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. http://creativecommons.org/licenses/by/3.0/igo WORKING PAPER SERIES ON REGIONAL ECONOMIC INTEGRATION NO. 12 Securitization in East Asia Paul Lejot, Douglas Arner and Lotte Schou-Zibell January 2008 Paul Lejot, Douglas Arner+ and Lotte Schou-Zibell++ Securitization in East Asia* * The authors acknowledge with thanks the supportive collaboration of Jong-Wha Lee, Head, Office of Regional Economic Integration, ADB, and the invaluable research assistance of Ferdinand Sia and Maria Melody Garcia. Any errors are those of the authors. The research underlying this paper was assisted by the Hong Kong Research Grants Council Competitive Earmarked Research Grant program and the University of Hong Kong Strategic Research Areas Initiative. + Asian Institute of International Financial Law, University of Hong Kong, Hong Kong, China, E-mail: [email protected], and [email protected]. ++ Office of Regional Economic Integration, Asian Development Bank, Manila, Philippines, E-mail: [email protected]. January 2008 The ADB Working Paper Series on Regional Economic Integration focuses on topics relating to regional cooperation and integration in the areas of infrastructure and software, trade and investment, money and finance, and regional public goods. The Series is a quick-disseminating, informal publication that seeks to provide information, generate discussion, and elicit comments. Working papers published under this Series may subsequently be published elsewhere. Disclaimer: The views expressed in this paper are those of the author and do not necessarily reflect the views and policies of the Asian Development Bank or its Board of Governors or the governments they represent. The Asian Development Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility for any consequence of their use. Use of the term “country” does not imply any judgment by the authors or the Asian Development Bank as to the legal or other status of any territorial entity. Unless otherwise noted, $ refers to US dollars. © 2008 by Asian Development Bank February 2008 Publication Stock No. PPA201708 Contents Abstract 1 I. Introduction 2 II. Evolution 4 A. Concepts 5 B. Definitions 7 C. Transaction Mechanics 8 D. Tranching 9 E. Usage 10 III. Development in East Asia 12 A. Securitization Drivers 13 B. Post-crisis Reforms 15 C. Legal and Regulatory Issues 18 IV. National Regulations and International Capital Standards 20 A. Regulatory Incentives to Securitization 20 B. Basel II Implementation 22 C. Variations in Regulation and Practice 24 V. Recent trends 26 A. Global Disruption 26 B. Credit Risk Transfer 28 C. Transaction Appraisal and Management 30 D. Credit Rating Agency Functions 32 E. East Asian Impact 35 F. Post-crisis Outcomes 35 VI. Securitization’s Future in Asia 38 A. Rethinking Securitization 39 B. Incentives to Securitization in Asia 40 C. New Initiatives 42 Appendixes 44 1. Effects of Financial Market Development on Securitization 44 2. Cash and Synthetic Generic Transactions 50 3. Covered Bonds 53 4. Enabling Legislation and Regulation 55 5. Provisions for Securitization 56 References 58 ADB Working Paper Series on Regional Economic Integration 65 Tables A1.1 Summary of Variables and Expected Signs 45 A1.2 Selected Pooled Regression Estimates with Interaction Dummies, 1995–2006 48 A1.3 Complete Pooled Regressions Estimates with Interaction Dummies, 1995–2006 49 A1. Legislation and Regulation to Assist Securitization 55 A2. Assessment of Prevailing Securitization Market Conditions (“5” = excellent) 56 Figures 1. Long-term Drivers of Global Securitization 14 2. Evolving Securitization Drivers in Asia 15 A2.1 Generic Cash Securitized Transaction 50 A2.2 Generic Structure Using Sequential SPVs 50 A2.3 Credit Rating & Risk-return Trade-off 51 A2.4 Generic Synthetic Securitized Transaction 51 A2.5 Generic Synthetic CDO 52 A2.6 CDO Payment Waterfall 52 Abstract Securitization offers a range of benefits for Asia’s financial systems and economies as a mechanism to assist funding and investment. As a form of structured finance, reliable and efficient securitization an assist development by enabling financial systems to deepen and strengthen—thus contributing to overall economic growth and stability. It must be recognized, however, that there are both overt and more subtle risks in certain uses of securitization. The credit and liquidity crisis that began in the United States and spread to other developed financial systems in mid-2007 exposed the danger associated with securitization: excessive risk-taking or regulatory capital arbitrage rather than a tool to assist more conventional or conservative approaches to funding, risk management, or investment. Securitization has also been criticized for rendering financial markets opaque, while contributing to a growing emphasis in the global economy of credit intermediation conducted in capital markets rather than through banks. This study examines the institutional basis of these concerns by investigating the use of securitization in East Asia, questioning both the growth in regional activity since the 1997/98 Asian financial crisis, and the reasons for it remaining constrained. The paper concludes with a discussion of proposals to support proper development of securitization in the region, including institutional mechanisms that could better allow securitization to enhance development and financial stability. If East Asia begins to make fuller use of securitization, its motive will be to meet funding or investment needs in the real economy rather than balance sheet arbitrage of the kind that peaked elsewhere in 2007. Keywords: Securitization, East Asia, debt markets, risk transfer. JEL Classifications: F3, G2, K2. 2 I. Introduction “We shall not cease from exploration And the end of all our exploring Will be to arrive where we started And know the place for the first time.” T.S. Eliot Four Quartets, Little Gidding, V This study questions whether the effectiveness of the financial systems of certain Asian economies can benefit from improved access to securitization as a form of market-based financial intermediation. The practical implication would be a greater reliance on the public and private securities markets in capital funding and portfolio investment, to complement traditional bank lending on which both newly-industrialized and developing East Asian economies now largely depend.1 Given the general loss of confidence and liquidity in global credit markets and structured finance that began in mid-2007, this paper also examines how credit risk transfer and regulatory incentives to securitization will be re-assessed beyond the changes contemplated by the incoming revisions to the Basel capital accords. Commercial interests have insisted since the early 1990s that structured finance has considerable potential in Asia. It was also accepted as a valuable tool in the restructuring of financial sector claims in the Republic of Korea (Korea) after 2000. Yet the overall development of securitization in the region is modest compared with Europe or North America, despite the fact that many national authorities have encouraged its use since the 1997/98 Asian financial crisis. This prompts the question whether this aspect of financial development lags other regions as a function of time, as a matter of national institutional conditions, or as the result of certain economic conditions—such as national savings and investment imbalances or relatively high banking sector liquidity. If effective securitization can support financial sector development and efficiency, which contribute to economic objectives such as growth and financial stability,2 then it may be valuable both commercially and socially to promote its use. However, it must be recognized that there are both overt and more subtle risks in certain uses of securitization. The credit and liquidity crisis that began in the United States (US) and spread to other developed financial systems in mid-2007 exposed the danger associated with securitization in excessive risk-taking or regulatory capital arbitrage, rather than as a tool to assist a more conventional or conservative approach to funding, risk management, or investment. Securitization has also been criticized for rendering financial markets opaque, while contributing to a growing emphasis in the global economy of credit intermediation conducted in capital markets rather than through banks.3 This study examines the institutional basis of these concerns by investigating the use of securitization in East Asia, questioning both the growth in regional activity since the 1997/98 Asian financial crisis, and the reasons for it remaining constrained. The paper concludes with a discussion of proposals to support proper development of securitization in the region, including institutional mechanisms that could better allow securitization to enhance development and 1 Unless otherwise stated, for the purpose of this study East Asia comprises the People’s Republic of China (PRC); Hong Kong, China; Indonesia; Japan; Republic of Korea (Korea); Malaysia; Philippines; Singapore; Thailand; and Viet Nam. 2 Financial stability is taken, in one sense, as the avoidance or mitigation of financial crises, and in another as the effective functioning of the financial system. See Arner (2007). 3 Financialization refers to the relative influence of financial intermediaries and markets in national and international economies, including the scale of financial claims relative to aggregate national output, see Section 4 below. 9 emerged in the early 1970s in the US municipal bond market and have since become a powerful facilitating institution in many structured and project finance transactions.25 D. Tranching The most important aspect of cash and synthetic securitized transaction formation arises from tranching—payment priorities established to create separate securities issues with distinct riskreturn features. This seeks to set payment rules that generate an optimal use of both investor demand and the time value of an asset pool. Even comparatively simple transactions require extensive modeling of pool performance, which demands adequate data, an understanding of the national payment and default experience of sectoral risks of the same type as the pool, and resources to forecast and stress-test as complete a set of outcomes as feasible. Synthetic transactions involve modeling that is identical in concept but still more complex. In all cases, this function has been passed to credit rating agencies, increasingly with the sanction of national regulators.26 Investor preferences provide the starting objective in pricing and structuring, with originators and transaction arrangers seeking to extract the greatest value from the resources available. Such manipulation is central to all securitized issues and partly explains their relative complexity and expense. Structuring the transactions has come to require active participation by credit rating agencies, which model the waterfall treatment of payments under many sets of conditions, and set terms for individual tranches to be given target credit ratings. This level of involvement is markedly different from commercial rating agencies’ practices with non-structured corporate or state bonds issues and is increasingly questioned as a conflict of interest.27 Tranching also explains the potential for securitization to assist in general financial market transparency and development. This is most apparent in the use of securitization to assist in the recycling of nonperforming loans (NPLs), where a market-determined yield acceptable to the ultimate investor provides a transparent mechanism to value a pool of impaired assets where none otherwise existed. Both legal and empirical analyses have seen tranching as a means to extract advantage from segmenting investors. Institutional analysis would see tranching as creating payment priorities that in turn allow a high investment-grade credit rating to be given to as large as possible a portion of any single transaction. The strict contractual priority established by a payment waterfall seeks to eliminate the chance that a creditor of either the pool or the pool originator would challenge payments to a holder of notes. It also serves to avoid payment delays in the event of bankruptcy or receivership. 25 Monoline insurers provide only financial guarantees but most are associated with general insurers or substantial conglomerates. Asian Securitization and Infrastructure Assurance Pte Limited (ASIA Limited) was an Asian regionally-oriented monoline insurer established in 1996 by ADB and certain commercial interests, later becoming dormant due to losses incurred in the Asian financial crisis, see Lejot, Arner, and Pretorius (2006), page 284–285. 26 The limitations of this involvement were cautiously voiced by the BIS Committee on the Global Financial System (2005), which noted at page 11 that Tranching creates a layer of analytical complexity beyond that of estimating the loss distribution of the collateral pool. It requires detailed, deal-specific documentation […] to ensure that the intended characteristics […] are actually delivered under all plausible scenarios. This implies intense transactional interaction between arranger and rating agency that has now become controversial, see Section 4. 27 Such a conflict is disputed by rating agencies, see for example Bell and Rose (2007), but now widely believed to be a concern, especially in the context of the quasi-regulatory function accorded to rating agencies under Basel II, see Prada (2007), and Section 4 below. 10 Experience suggests that tranching takes advantage of investors’ varying risk-return preferences, relying also upon the need of almost all institutional investors in structured transactions for their holdings to be given credit ratings.28 Tranching helps meet the minimum criteria of the rating agencies, and hence minimizes the value of payments to be delivered to investors at a particular credit rating level in relation to the predicted present value of the total pool. This appears inconsistent with both traditional theories of bank intermediation, and the suggestion that securitization represents a Coasian solution29 to the mismatches inherent in simple forms of lending within a conventional intermediary. E. Usage Securitization use is widespread both geographically and by industry risk classification, but not ubiquitous outside of most developed financial markets. Its commercial and financial benefits (in addition to the potential stability benefits discussed above) become manifest in one or more of five ways: (i) A means to make unacceptable risks satisfactory to an investor, assuming that each potential investor has known risk-return objectives. (ii) Providing a credit rating higher than its respective sovereign ceiling or that of the originator. This may be especially attractive in the context of infrastructure financing. (iii) The means to price pools of assets that are difficult to value, usually to make their sale feasible. This applies particularly to NPLs and other impaired financial claims. (iv) A method to create capital market funding where none previously existed. (v) For asset originators, a funding source where none was available at an acceptable cost, especially when lending becomes subject to quantitative regulatory constraints. These applications all represent tools to assist in balance sheet management. For modern financial sector users, securitization has become most crucially a mechanism for credit risk transfer and regulatory capital management, as Section 4 of this study shows. Credit risk transfer needs to be assessed in both the sense of allowing users to manage asset or liability portfolios, and more generally as claims move into and out of the regulated banking sector and across borders.30 It may achieve other objectives for certain users or in particular phases of interest rate or credit cycles, and may have developmental or incentive features for both originators and investors or for general economic welfare. Thus it is now common for regulators to consider the consequences of enhanced risk transfer for the dispersal of risk within and between domestic financial systems. This has several dimensions, some of which may be beneficial for efficiency and financial stability, such as lessening concentrations of geographical or sectoral risk, and includes transfers of credit risk to 28 Firla-Cuchra and Jenkinson (2005), who “also find some support for more nuanced modeling predictions such as the positive impact of the average quality of assets on tranching”, ibid, page 32. 29 Coasian theory, associated with economist Ronald Coase, describes the efficiency of an economic allocation or outcome in the presence of externalities. If trade in an externality is feasible and there are no transaction costs, then bargaining will lead to an efficient outcome regardless of the initial allocation of property rights. 30 See Basel Committee on Banking Supervision (2005) and Section 4 below. 11 lightly-regulated nonbank intermediaries or non-capital-regulated end investors. The increasing velocity of risk transfer over the past decade presents first order information problems when bank transferors are poorly regulated or their compliance standards are uncertain. This was clear in the 1997/98 Asian financial crisis and in the 2007 subprime credit crisis, especially where nonbank intermediaries were active in corporate lending and consumer credit creation. Furthermore, securitization may enable funding or refinancing by financial intermediaries, often through official housing finance agencies. This may include the entry of new commercial parties into established financing sectors such as residential mortgage finance or consumer credit, with consequences for overall efficiency and use of capital.31 Securitization can be applied to all defined credit risks, including delinquent assets or claims, but even in sophisticated markets is for reasons of cost and transaction expense typically associated with risks involving similar, unconnected, predictable cash flows. Assets commonly used in cash securitization include residential or commercial mortgage loans, credit and credit card receivables, vehicle or fleet loans, certain cash receivables, air ticket sales, taxes on revenue, transport or other tolls, licensing fees, foreign worker remittances, and music royalties. Almost all of these risks have been used in transactions in East Asia during the last decade. Dissimilar claims have been successfully securitized in certain highly developed markets, usually using synthetic structures,32 but there are examples in the Japan, UK, US, and elsewhere of highly visible securitized transactions involving large diverse pools of corporate loans.33 The technique has been applied in advanced economies to whole businesses, discrete business streams, and more widely to single large-scale commercial properties. Commercial property transactions may become a potential source of new transactions in East Asia due to the importance of the sector in bank lending, especially if singleor multiple-asset real estate investment trusts (REITs) grow more popular.34 East Asian REITs and their supporting legislation or regulatory codes tend to favor securitization structures to a greater extent than in the US, where REITs first appeared. The use of pooled NPLs is also comparatively new, notably in Germany and other major civil law jurisdictions. In all cases, securitization represents a complex means to achieve the simple objective of making available well-defined risks to single homogeneous classes of investors. As such, the 31 To a greater degree than in East Asia, the introduction of ABS and RMBS in the US arose from banking and securities laws that gave an incentive to investment banks to create and securitize risks historically funded by commercial banks. See also Warnock and Warnock (2007). 32 Based upon basket or index credit default swaps. 33 A 1996 collateralized loan obligation (CLO) transaction for UK-based NatWest Bank was the first significant public issue based on sizeable corporate bank loans, see International Financing Review (1996a, 1996b), where a new SPV participated in receipts from $5 billion of the bank’s loans and credit commitments, all to maximize its efficient use of regulatory capital. This structure has been superseded by CLOs involving outright sales of claims, and by synthetic and actively-managed CLOs. Regulatory changes continue to alter the cost parameters of transactions with similar aims, but it is notable that no similar issue has been made by lenders in Asia outside Japan. A small number of securitizations of lease receivables and bank loans to small and medium-scale enterprises (SME) have been completed for banks in Japan, and since 2005 in single deals in Malaysia; Singapore; and Taipei,China, apparently with official encouragement. These are uncommon due to technical challenges and competing bank sector liquidity, but as refunding sources are similar to transactions intended to support microfinance and agricultural credit, see Section 5. 34 REITs are collective investment schemes that became attractive funding tools for property developers in Japan; Singapore; and Hong Kong, China (in declining scale of use) during phases of weak property prices. They also exist on a modest scale in Korea, Malaysia, and Thailand. To originators, REITs can resemble formal whole business securitizations, although more loosely framed “captive” REITs allow originators to participate in gains derived from trust assets. Singapore’s Business Trusts Act 2004 permits similar schemes involving most forms of non-property risks. Both Singapore and Hong Kong, China now allow REITs to own foreign assets. 12 technique has been known to be overly complex, manifested in high marginal transaction expenses and development periods for single “one-off” transactions that can be protracted, especially when the prevailing law hinders rather than helps.35 These obstacles have yet to be efficiently removed or circumvented in East Asia. More generally, securitization expenses are typically high, even if marginal transacting costs are reduced as a result of deal frequency, or supportive legislative or regulatory change. This can be seen clearly in expenses associated with data collection and verification, deal development, modeling, rating agency negotiation, marketing, and contractual execution. III. Development in East Asia Commercial interests have long argued that structured finance has considerable potential in Asian finance, and its use has been accepted as having been a valuable strategic tool in the restructuring of financial sector claims in Korea after 2000. Yet the region’s modest overall use of securitization prompts the question as to whether this aspect of financial development lags other regions as a function of time, national institutional conditions, or as the result of certain economic conditions such as national savings and investment imbalances or relatively high private sector liquidity. Conservative levels of bank leverage have limited the supply of loans for cash securitization even in Japan—where markets in structured securities have developed successfully. In the sense often associated with structured finance in East Asia, the favorable view of its being encouraged for development is typified by Bank for International Settlements (BIS) analysis: Structured finance can have a positive influence on the financial system because it can transform ordinarily illiquid or risky assets into more liquid or less risky ones. It thus offers an alternative source of long-term funding in both domestic and cross-border markets, and can foster the development of domestic bond markets. In turn, this could promote greater bank and financial market efficiency, as it implies greater competition to meet customer financing needs.36 While acknowledging that proponents of securitization need to be cautioned as to its risks,37 it is notable that a review published in mid-2007 during the global structured finance markets’ most severe dislocation to date is constructive and conforms with a seminal positive BIS view of credit risk transfer.38 Securitization activity increased markedly in parts of Asia after 2000—notably in Hong Kong, China; Japan; Korea; and Malaysia—in each case with housing loans used as raw material, and in Singapore through transactions supported by commercial property. Critically, securitization became a strikingly valuable tool for Korea as part of extensive corporate and financial sector post-crisis restructuring, when new legislation allowed large volumes of NPLs and other impaired financial claims to be employed as collateral for new CDOs, a process of recycling 35 Early cash and synthetic CLOs took many months to prepare and execute, despite originating in sophisticated jurisdictions. 36 Scatigna and Tover (2007), page 71, emphasis added. 37 Id., pages 81–82. 38 Basel Committee on Banking Supervision (2005). 13 defaulted claims instrumental in the recuperation of the wider Korean economy.39 At the same time, completed securitization volumes in the PRC, Indonesia, Philippines, and Thailand remain very limited. Securitization may be undeveloped or poorly used in East Asia partly because factional interests favor the existing financial system, with its emphasis on bank credit creation intended to serve relatively closely-held corporate sectors. This long-standing feature of the region has been taken both as conducive to economic growth and more recently as symptomatic of “cronyism”, poor commercial sector governance, and a factor that helped induce and intensify the 1997/98 financial crisis.40 It should be noted that the study examines structured issuance involving East Asian risks, whether in domestic markets or elsewhere, and takes no direct account of the inclination of East Asian intermediaries or sources of portfolio investment to acquire or trade in non-Asian securitized risks.41 Such capital flows from East Asian sources have often been considerable since 2000. Market-based financial intermediation may induce banks to buy or hold securitized assets, and portfolio investment by Asian domiciled banks and other intermediaries as well as sovereign investors in non-Asian risks has been a substantial private counterpart to the accumulation of international reserves in the recovery from the 1997/98 financial crisis. This may represent a deliberate portfolio risk adjustment by such banks and investors, as well as a response to weak local credit demand. A. Securitization Drivers Structured transactions first appeared in East Asia in the late 1980s, with banks replicating simple private contractual models developed elsewhere. They gained momentum in certain national markets upon official acceptance,42 and by 1997 were widely used, if not prolifically. Most deals were negotiated as single transactions until the crisis brought forward a second generation of issues, with large programmed volumes of Korean impaired risks pooled under CBO structures. The crisis aftermath encouraged several economies to adopt securitization as a part of recovery strategy, but only Korea made the fullest use of its scope in recovery and market reform. This is most often attributed to cultural reasons, but institutional factors are also present. Thus, over a 20-year period, the region’s motives for the use of structured fundraisings have altered, from single deals and commercial promotion, to a feature of broader post-crisis financial policy. Since 2000, capital market reforms have won growing official sympathy in the region, leading to certain changes in laws, but activity appears constrained,43 and in some markets has declined.44 39 By contrast, Crotty, and Lee (2005) typify those hostile to these reforms, claiming that Korea’s “conversion from a state-guided, bank-based to a globally open capital financial system” (page 338) led to damaging falling rates of capital accumulation, and was contrary to the interests of a majority of Koreans. 40 Bank credit creation was pivotal in the developmental state model used to characterize Japan and Korea in the 1950s and 1960s, respectively, see Johnson (1982) and Liu, Lejot and Arner (2008). 41 There may be local technical value in such activity, for example, with banks in Singapore (Burton, 2007) and elsewhere (Tucker, 2007). 42 Notably Malaysia. 43 Issuance has been negligible in Indonesia and the Philippines. In Korea, securitization of housing loans is modest despite the creation in 2003–04 of the state-controlled Korea Housing Finance Corporation (KHFC) to support the refinancing of bank housing loans, see Chensavasdijai et al (2007), pages 47–53 and see Footnote 144 below. 44 Issuance of mortgage-backed securities (MBS) based on residential property in Hong Kong, China and both commercial and residential property in Japan are examples not wholly related to the market dislocation of 2007. In each case, issuance has been limited by shortages of poolable loans relative to available capital. 14 One institutional explanation is that sectoral interests may favor the existing configuration of Asia’s financial systems. Thus governments, financial intermediaries, and transaction arrangers may all derive economic rents from segmented or illiquid securities markets.45 Asia’s governments have often seen the banking sector’s dominance as assisting the management of monetary or exchange rate policy or the deployment of consumer savings, and for many the creation of freely functioning securities markets is both desirable as a mark of sophistication and a threat to fiat control of monetary or credit policy. The negative connotations of this emphasis became clear only during the 1997/98 financial crisis. The pre-1997 transaction focus gave way to a clearer imperative to securitization after the financial crisis, with Korea becoming the first to institute legislative reforms and the most prolific host of activity. More recently, the precautionary incentives to instigate institutional reform to permit securitization have subsided due to lapse of time, a resurgence of economic growth, and in particular the results of reserve accumulation and comparatively high private sector liquidity. These factors have made reforms less urgent than seemed essential at the turn of the millennium. The PRC’s lack of alacrity in introducing long-term securitization legislation is the most significant example,46 but the pattern is observed in Indonesia, Thailand, and elsewhere. In other jurisdictions, the result has been adequate primary legislation but a lack of subsequent regulatory guidance or completeness, and minimal usage. Since the early 1990s, the driving forces for securitization have changed, especially in East Asia’s less sophisticated markets. The shift in emphasis in global drivers shows that traditional commercial motives for borrowers to use securitization as an elective part of funding strategy are supplanted by regulatory motives, largely prompted by bank capital regulation (Figure 1). Figure 1: Long-term Drivers of Global Securitization Increasingly, uniform regulation of bank capital from the late 1980s came to influence the nature, composition, and funding of all lending activity. This produced a new objective for structured finance and led to a material expansion in the application of securitization by banks and other regulated intermediaries. Thus the incentive to securitize shifted from commercial motives to one with roots in transactional or systemic regulatory arbitrage. Rapid growth in issuance in the major developed financial sectors after the early 1990s is largely attributable to the consequences of harmonized capital regulation, including the creation of regulatory capital 45 Especially since financial market innovation is largely unprotected by copyright. 46 The PRC has instead sanctioned trial transactions prior to introducing permanent legislation, most recently sizeable local currency domestic ABS and CLO issues for Shanghai Pudong Development Bank and Industrial and Commercial Bank of China, respectively, in September and October 2007. 15 and the assumption of weightings for bank risk assets, and the implementation of exposure limits on sectoral and single obligors.47 After 2000, this practice accelerated in many developed markets, so that 2007 marked a chronic overreaction to perceived and actual excesses, especially those originated in 2005–06. By contrast, in East Asia, with a shorter securitization history, a more complex pattern has involved both regulatory and other influences, especially after the 1997/98 crisis (Figure 2). Figure 2: Evolving Securitization Drivers in Asia Prior to the crisis, securitization in East Asia resulted from commercial interests seeking to replicate deals used in more established markets, in many cases using domestic assets in offshore transactions for sale to yield-seeking non-Asian investors, rather than as part of domestic financial reform. It became possible to complete transactions in most jurisdictions using complex contractual techniques to avoid obstacles of law or regulation. The resulting deal volumes were inevitably modest. B. Post-crisis Reforms The 1997/98 crisis provided an incentive for certain jurisdictions to adopt securitization to assist with the recycling of NPLs, and in some cases was so strong an imperative that new issuance was unprecedented.48 The incentive to introduce marketoriented reforms included IMF encouragement, but among the crisis-affected ASEAN countries the overall results were mixed: Malaysia avoided Washington consensus practice by increasing controls on cross-border investment but continued to promote securitization in its domestic markets; Indonesia and Thailand allowed relatively unrestricted capital flows but were slow in introducing legal reforms to facilitate securitized deals. A more widespread post-crisis trend was the wave of new publicly-capitalized agencies or asset management companies (AMC). These acquired impaired assets from public and private sector financial intermediaries—in most cases at steep discounts to their nominal value—and handled their subsequent resolution, whether liquidation, further sale, or recovery. The importance of this development is comparable to that of the US Resolution Trust Corporation from 1989 to 1995, especially in terms of the effect on market confidence and initial impact of certain Asian AMCs. The most notable were the Korean Asset Management Corporation (KAMCO), Danamodal 47 BIS analysts describe the expansion in global issuance as “remarkable,” Gyntelberg and Remolona (2006), page 67, but more striking is that growth in the market was unintended on the part of the Basel Committee architects. 48 See Appendix 4 for an outline of recent enabling legislation and regulation. Australia, Japan, and Korea have accounted for around two-thirds of annual regional ABS issuance (Gyntelberg and Remolona 2006). 16 Nasional Bhd in Malaysia, and four PRC AMCs that acquired defaulted loans from the largest state-owned banks. The intention in each case was to derive a clearing price from an assessment of the risk-return objectives of potential investors in securitized issues for the removal of assets from the stricken originator’s balance sheet. With this premise, iterative models of the kind used by credit rating agencies of the behavior and value under different conditions of most asset pools can generate a price indication for the initiating asset sale more openly and less controversially than private sales negotiated between AMCs and privileged investors. This may not be a solution to all forms of financial distress, but has qualities identified as valuable in a developmental sense, most clearly seen in post-crisis Korea. The process has been widely regarded as successful, but the completeness of what is involved is not always acknowledged. Thus in the case of the PRC and Indonesia, sales of NPLs to third party investors were largely conducted under circumstances that precluded securitization, with its underlying need for transparency. The PRC’s AMCs are sizeable undertakings but a lack of timely legal support prevented their becoming more than token securitization users.49 This may change when legal reforms are completed in 2008–09 to introduce a permanent national framework for securitization. Until now, AMC funding has been opaque and transaction activity has mainly involved the auction of impaired loans. When compared with the urgency of postcrisis objectives in fostering largescale securitization in Korea, time has dissipated the PRC’s imperative to instigate NPL recycling through structured finance techniques, aided by growth of international reserves and state bank capital.50 If new securitization legislation is to produce substantial transaction volumes in the PRC, then transaction motives may need to be different from elsewhere in East Asia.51 The post-crisis imperative for balance sheet repair made transaction expenses more tolerable, resulting in a notable shift in assets, some growth in synthetic transactions, and improved bank and corporate balance sheets in certain countries, notably Korea and Malaysia. The gravity of the crisis perversely eased cost constraints by making asset sales and the creation of assetbacked securities essential to bank balance sheet renovation and corporate restructuring. Those conditions encouraged the belief in official and academic circles that the crisis-driven necessity for several jurisdictions to allow securitization could have a broader impact on financial market development.52 In particular, it was argued within ASEAN, ASEAN+3, and APEC that depth in securitization to deal with a pressing problem would lead to more effective debt markets and gradually help the region guard against other unexpected shocks. Asia’s rapid post-crisis recovery and the precautionary accumulation of unprecedented levels of international reserves gradually removed the urgency from this argument. Furthermore, as the recovery progressed and led to improvements in credit ratings, the desire among established monoline insurers to provide wraps for feasible East Asian transactions has increased, so that credit enhancement is not generally a regional resource constraint. The availability of credit enhancement has also been encouraged by yield-seeking investors during a prolonged period of relatively low nominal interest rates, but there are indications that such 49 Ma and Fung (2002). See also Hsu, Arner and Wan (2007). 50 As the scale of such resources obviates the urgency of reform. 51 One spur may be the propensity of consumer demand for new forms of investments to accelerate with general growth (FinanceAsia, 2007). 52 See for example, Lejot, Arner, and Pretorius (2006), page 271. 17 freely available investor demand may have severely diminished or even vanished with the market dislocations of 2007. Until recently, low securitization activity relative to other markets and to bank credit creation may have reflected an actual or artificial shortage of poolable assets, costly institutional impediments, or a lack of derivative instruments to allow the synthetic replication of such risks. For securitization based on non-distressed assets, housing loans have tended to provide the most consistent source material, in part due to official support.53 Thus housing finance was made part of public policy in Japan in 1950 (following the US model); in Malaysia in 1985; Hong Kong, China from 1997; and by Korea in 2004.54 Thailand’s state Government Housing Bank is a substantial mortgage lender and has long planned an inaugural securitized issue.55 This trend reflects two motives. First, the ultimate funding cost provided by securitized corporate debt compares unfavorably with bank lending, especially in a period of capital accumulation among many Asian banks. Second, adequate pool data for mortgages and consumer credit has been more often available than for heterogeneous corporate loans. As a result, securitization has focused more on liquidity and funding enhancement than the reallocation of credit risk by lenders.56 Except for residential mortgage-based deals in Malaysia and Hong Kong, China, the results have yet to be tested in a complete credit cycle. This is important in part due to a lack of credit derivative protection through single-name or index Asian credit default swaps (CDS), even for Japan, and is also a constraint to ABS growth based on corporate risk.57 Thus, securitization in Asia evolved from simple profit-seeking to debt recycling in the periods straddling the 1997/98 crisis. Future Asian securitization may need broader applications to succeed in facilitating the release of capital or assisting in public policy. For securitization to be more widely used in East Asia in a new phase of development, both state and commercial objectives may need to evolve further, especially after the 2007 global market dislocation. For example, if securitization is to support financial development in the region, in part by bridging gaps between prevailing credit quality and investor risk preferences, its use will need to differ from the highly complex, regulatory-orientated form that seems likely to be disfavored for some time in established markets, and to which bank regulators are likely to react. However, altering the reliance on bankbased financial systems would have consequences in terms of control and governance for the corporate sector, and in the risks and rewards associated with the financial industry. 53 See Gyntelberg and Remolona (2006), page 65. 54 Chan, Davies and Gyntelberg (2006), pages 71–83, in a study of Hong Kong, China; India; Japan; Korea; and Malaysia. Statesupported finance for home purchase is well-developed in Singapore, but integrated with a mandatory provident fund and entails no wholesale market funding or refinancing. The authors believe that specialist state-sponsored agencies promoting housing finance have “helped eliminate barriers to securitization” ibid., page 71. 55 International Financing Review (2006), reporting remarks by the bank’s chairman. No issue is likely before the resolution of the current constitutional hiatus and market disruption. 56 Id. 57 Note also that Securitization that uses lower-rated corporate paper as collateral […] only work if there are also investors who are willing to hold […] the equity tranche which absorbs the first losses. See Gyntelberg and Remolona (2006), page 72. The authors indicate that deeply subordinated equity tranches accounted for up to 30% of nominal issuance in KAMCO NPL securitizations, and that KAMCO retained much of those risks in most NPL securitizations. Id. at 73; see Fung, George, Hohl, and Ma (2004). While there is no doubt that KAMCO was a creation of public policy, the extent of state support for the credit risk transfer that it was able to engineer may be less widely understood. 18 C. Legal and Regulatory Issues Securitization places emphasis on intensive contracting as great as in any form of financing, which is broadly confirmed by the empirical findings of this study reported in Appendix 1. It requires a transparent legal framework, clear accounting principles, and regulatory support, although the same quality of conditions will also provide incentives for transactional regulatory arbitrage. Its success therefore depends upon how its governing system of law accommodates these institutions, and may help explain why securitization developed first in common law jurisdictions.58 The accepted essence of a supportive legal and regulatory framework is to ensure that neither law nor regulation lessens the structural integrity of legitimate securitized transactions, and that any transfer of assets is permanent and cannot be disturbed by external events, including subsequent actions by creditors of the originator. In the market for financial claims, securitization is a contractual alternative to intermediation managed within a financial organization, most commonly a bank or quasi-bank. It demands establishing contracts that are either simple (giving flexibility in operation and decision making, especially in relation to ex post events), from which arise agency concerns as with traditional loan contracts, or (more commonly) complex arrangements among many parties.59 It should be noted that market-based nonbank financial intermediation in no way implies that banks do not engage in securitization as investors or traders. Details of cash transactions may vary among jurisdictions. But as the description in Appendix 2 shows, they are assumed to entail the irrevocable transfer of assets to an insubstantive SPV to which the asset seller has no ties of ownership or control. Funding for the asset transfer is provided by the sale of securities to third-party investors. The transaction must withstand legal claims in bankruptcy against the asset seller. Its economics must withstand taxes and duties on transfer and in most cases securities issued by the transaction SPV must provide for the dependable subordination of claims. Jurisdictions where securitization is well established, notably Hong Kong, China; Korea; and Malaysia, are not necessarily alike in needs or objectives, and except in the common law jurisdictions of Hong Kong, China; Malaysia; and Singapore, offshore transactions have usually been used to circumvent institutional weakness or obstacles in law or regulation.60 One way to consider Asian securitization is to look at three groups of jurisdictions: those that in principle freely allow cash transactions, that is, Hong Kong, Korea, Malaysia and Singapore, those for which offshore cash transactions have been completed in significant volume, and those with obstacles to almost all deals. In all the review markets except Hong Kong, China, new domestic or offshore issues are subject to discretionary regulatory approval but this is in no 58 Modern common law systems regard the commercial contract as the result of economic bargaining, the primary aim of which is to bestow identified rights, the erosion of which may entail a penalty. Civil law jurisdictions have tended to view contracts as bundles of mutual obligations, which are thus intrinsically restricted and for which the courts are generally willing to require performance. The effect on lending contracts under civil law systems is generally to limit the potential for their unqualified sale, especially when the transferee is insubstantial. The same approach also tends to complicate the possible sale of future payment rights. 59 Amplified by Scott (2006). The transaction cost decision is summarized by Schwartz and Watson (2004), page 26, When parties choose [contractual] forms that themselves ensure efficient investment and trade (such as a complete mechanism), they strongly prefer that these contracts not be renegotiated. Initial contracting costs can be high in relation to contractual gains, however, and then parties choose more simple contractual forms that require. 60 Malaysia is a prominent center for Islamic finance. Securitized sukuk transactions have been sanctioned by Malaysia’s Islamic Financial Services Board since 2005 (Jobst, 2007). This represents forms of contractual and market segmentation that have value for participants but which creates transactions that are economically indistinct from the generic “conventional’ structures considered here. 25 These differences have two implications for structured finance. First, any single national legal and institutional setting may not favor securitized transactions or any universal model of structured finance contracts. Second, it may be inappropriate or inefficient to import any established transaction model without identifying the need for adaptation to local needs. Errors of this kind have been associated with promoters hoping to create familiar transactions for prospective investors but to the detriment of contractual integrity. The general result may be constricted usage, as in the Philippines, for example. This concern extends beyond the way that commercial lawyers seek contractual solutions to problematic laws or regulations, which is not uncommon in East Asian securitization.86 More positively, Basel II is highly complex in its complete form for both regulators and their supervisory targets, but includes concessions that enable states to legitimately adopt its provisions in stages or according to need. Basel II’s risk weightings are eventually to be applied uniformly but many aspects of national supervision will differ. To what extent has a national legal or regulatory setting acted as an incentive to securitization, especially in the capital regulated sectors? Much securitization activity has an orientation that reflects its modern roots in the US, where securitization developed as a result of competitive tensions between two parts of a divided financial industry, and was heavily influenced by state and federal law and regulation, and social attitudes to the banking sector. Securitization in the US markets is inevitably a systemic and transactional influence, but may not be a model for elsewhere, in spite of globalization trends of convergence in intermediary behavior, regulation, and financial instruments and their treatment in law. US practice has a practical value in that many international and national markets find it attractive to sell foreign transactions to US investors, despite the costs of conforming with demanding disclosure requirements. This is especially true in securitized transactions, given their structural need to target different classes of homogenous investors, which is a particular feature of the extensive US investor base. While the US is the source of modern securitization technology, the reasons for it to enthusiastically adopt this form of actual loan defeasance in the 1970s are embedded in many aspects of US law and financial practice.87 Such variables affect sources of bank funding, encourage the targeting of returns by banks, limit the term of house loans, encourage the formation of mortgage loan aggregators, and generally induce credit risk transfer. These factors are not unique but exist nowhere else to the same comprehensive extent. Thus in promoting institutional reforms it would be inappropriate to identify other markets as synonymous with those of the US,88 but perfectly acceptable to use or amend US transaction technology. More broadly, the “Law and Finance” school has suggested that a primary means by which law influences financial development is through contract formation and enforcement.89 This view aligns with the general economic motives for securitization, which are related to transaction costs factors and not primarily to financial sector regulation,90 and which may increase in importance after the dislocation of 2007 credit crisis. 86 For example, the simple model shown in Appendix 3 that uses sequential onshore and offshore SPVs. 87 Including legislation after the 1929 Great Crash controlling banking by type and by geographical coverage, securities legislation, quantitative controls on lending, interest rate ceilings, the comparatively attractive risk-return profile of traditional mortgage lending, constraints on diversification by mortgage lenders, and a societal wariness of banks. 88 See also Cacdac, Warnock and Warnock (2007). 89 Empirical analysis shows the US financial sector conforms with this result, even though financial activity in the US is subject to a complex rule-based regulatory environment. 90 For example, Schwarcz (2002). 26 These factors have two consequences in an East Asian context. First, even though ASEAN+3 banking supervision was generally poor prior to 1997, its subsequent and future improvement depend upon introducing appropriate objective and minimum common standards, not on any single model solution. Second, if securitization is to grow in the region on a significant scale, it is likely to resemble but not mirror the transaction model and usage of other economies. One further point arises from the staggered national implementation of Basel II’s revised risk weightings. To the extent that banks adopting the standardized approach to capital adequacy maintain subsidiary or affiliated operations in overseas economies that introduce the new weightings at a different time to the bank’s home regulator, then Basel’s plan of implementation may encourage credit risks to be located so as to achieve an optimal use of capital. The impact of this discrepancy has not been quantified but has been taken to be modest. However, this relatively minor aspect raises the possibility of a more complex form of systemic regulatory arbitrage between unconnected parties in economies where Basel implementation differs, and the opportunity that a complex matrix of regulation may offer to even simple lenders. Cooperation among regulators would need to be reconsidered in this event.91 Such practices may also evolve from the significant credit-related activity now associated with lightly-regulated hedge fund investors. Basel II conforming states will force regulatory capital more accurately to reflect credit risk, and improve the economic rationality of regulatory incentives. Removing Basel I’s incentives to securitization may also lead to new shifts in retained bank portfolios. Changes to the incentive structure that regulation has created for financial sector securitization will be incomplete without a parallel reexamination of the supervisory and accounting background. This is the setting against which markets in securitized transactions entered their most unsettled period to date in 2007, which is the main subject of Section 5. V. Recent Trends The medium-term future of securitization in all its forms must be considered in the context of the severe dislocation experienced by global financial markets in 2007. It is certain that, in response, there will be qualitative changes in regulation and supervision. Consequences may arise in changes to national and harmonized financial regulations and crisis prevention measures, credit rating and accounting practices, and they will likely induce changes in transaction structuring and post-execution management. This section will distinguish between recent global events and aspects important to East Asia’s markets, and seek to identify what may transpire in both securitization use and regulatory change following a recovery in credit and liquidity conditions. A. Global Disruption A definitive assessment of the causes of the crisis is premature, but several features are clear, and point to a shock more significant than a periodic downturn in global credit conditions.92 In particular, the widespread loss of confidence that began in early 2007 with increases in loan losses and payment delinquencies among certain US subprime mortgage lenders developed in 91 The second principle of Basel II’s guidelines for home-host regulator implementation provides that “The home country supervisor is responsible for the oversight of the implementation of the New Accord for a banking group on a consolidated basis.” Basel Committee on Banking Supervision (2006a), page 11. 92 A narrative of events until end-September 2007 appears in Bank of England (2007), pages 5–22. 27 the third quarter into a collapse of liquidity in many structured and conventional financial markets, a period of intense risk aversion among global investors in structured issues, and a hiatus in market valuation mechanisms for most structured transactions.93 These events were accompanied by a succession of unusually severe downgradings of structured issues by the three leading international credit rating agencies. A number of financial intermediaries announced or predicted substantial investment and trading losses on structured transactions, both held directly and in SIVs and other similar vehicles,94 and in August several leading central banks began to provide exceptional liquidity to the interbank markets as part of their general liquidity and lender of last resort facilities. The disruption of the first 3 quarters of 2007 included pricing dislocations in several important markets previously considered deep and liquid, and widespread losses of confidence, not only in structured products but also in intermediaries involved in the markets, whether as originator, arranger, or investor. It also included bank failures and reorganizations resulting from illiquidity, insolvency, or a terminal combination of both conditions. With investor participation evaporating, a mid-year hiatus occurred in new cash or synthetic securitized and covered bond transactions. By late September, a trickle of new transactions was announced, all more modest in scale and generous in pricing than earlier issues. The closing of the securitized new issue markets was temporary but is likely to end only with a radical adjustment in the commercial terms and complexity of feasible transactions. The most severe dislocation was associated with all forms of synthetic transactions, and especially CDO or cash transactions associated with loan aggregators, that is, mortgage arrangers who create and warehouse loans solely for subsequent packaging and sale. However, investors took the view that all structured risk was tainted with unquantifiable losses and the loss of confidence penetrated all credit markets—a classic case of asymmetric information, adverse selection, and contagious loss of confidence. Although these events may be part of a cyclical downturn, some aspects were sufficiently alarming to lead to calls for broad regulatory change to curb financialization. A recovery is likely to be accompanied by regulatory reform and changes to market practice (partly to avoid structured finance continuing to be associated with instability).95 The path to substantial losses among banks and investors began with credit stresses in weaker sections of the US home mortgage market. Property values associated with US subprime borrowers fell in the second half of 2006, and began to be disclosed by major lenders in the first quarter of 2007. From there, an accumulation of market analyst and rating agency warnings quickly caused confidence to fall, with many participants fearful of being unable to quantify the extent to which their investments or counterparties were at risk. Widespread risk aversion and a shortage of bank liquidity thus led ABS and CDO holders to be unable to find a market price for 93 One BIS report was prescient of these developments: Growing dependence on financial markets has also increased the exposure to market turbulence. […] [I]n periods of severe market unrest or uncertainty, a whole group of housing finance lenders may suddenly find it difficult to obtain funding. Thus, although internationally active financial institutions build up exposures to non-domestic mortgages to diversify risks, spillover effects from foreign housing markets could become a source of concern. Committee on the Global Financial System (2006), page 32. 94 This included banks domiciled in the PRC; Hong Kong, China; Japan; and Singapore. To date, the greatest losses have been posted by banks in US, Germany, and UK. 95 Following a direction of the G-7 finance ministers to IOSCO, the Financial Stability Forum, and Basel Committee, IOSCO announced on 8 November 2007 a structured finance task force to examine credit rating agency practice, accounting, valuation, transparency and due diligence, and risk management and prudential supervision. 28 either dealing or valuation, or raise or renew funding. This notably included conduits and SIVs whose risk exposure was ostensibly of high credit quality.96 Until the results of the current accounting year are published by all leading participants, the main unknown outcome of the crisis is the extent to which banks will be forced to fund, charge off, or consolidate risk that has been held in conduits and SIVs, as well as resulting demands for new equity or regulatory capital. A related concern arises in the outcome of falls in CDO and bank credit ratings, which will lessen the willingness of investors to make new commitments in bank risk, securitized assets, or covered bonds. B. Credit Risk Transfer Among the most profound financial market developments in the post-Bretton Woods world of deregulated international finance has been the growing emphasis and ease of credit risk transfer. This relies especially on two related financial innovations, credit derivatives, and cash or synthetic securitization.97 It has led to a diffusion of risk geographically, and by type of counterparty or intermediary. Yet before 2007, it had generally been believed that access to credit risk transfer might help in crisis avoidance.98 Instead, credit risk transfer seems to have led in 2007 to profound uncertainty in the interbank markets, caused by valuation difficulties associated with outstanding structured transactions, and the view that dispersal of risk created problems in credit assessment. If the location of credit risk perceived to be threatened could not be identified, then banks and other investors would be unable to determine with any confidence the extent to which any counterparty might itself be exposed to potential problems. This represents an apparent reversal of finance theory’s presumption that portfolio diversification is a favorable and risk averse long-term strategy, and which in this form has underlain recent views of financial innovation. The BIS in particular became associated with a generally favorable view of credit risk transfer that relies on the benefits of risk dispersal. The scale of the 2007 shock will change that outlook. The results are analyzed here in institutional terms. For example, if securitization is dependent upon contractual integrity and can be associated with gains in transparency, how can periods of extreme illiquidity and lapsing confidence be explained, as experienced in all major markets for securitized instruments in mid-2007? One need is for greater focus on contract completeness. If the benefits of increasingly free credit risk transfer are not to be wholly lost, then transparent transaction standards are essential, and the global regulatory system and lenders of last resort may need to focus more openly on liquidity rather than capital adequacy alone. A well-received BIS study in 2005 drew on surveys of market regulators and participants to conclude credit risk transfer to be beneficial overall. A diffusion of risk that it enables would offset a lack of direct regulatory control or insight arising when risk assets leave the capitalregulated banking system or insurance sector, especially given an assumption of indirect or 96 See for example an announcement made on 6 September 2007 to the London Stock Exchange by a Citigroup managed SIV, Beta Finance Corporation, available at http://www.londonstockexchange.com/LSECWS/IFSPages/MarketNews (accessed 15 December 2007) and on file with the authors. The fund had risk exposure in August of approximately $22.7 billion, of which $59 million was to CDOs based on (then) highly-rated subprime ABS issues. The remainder of the portfolio was held in AAA structured securities or unrated “super-senior” notes that rank in priority to AAA-rated tranches of the same CDO transactions. In spite of this theoretically healthy profile, investor caution made Beta Finance unable fully to fund itself from usual short-term sources. 97 Other aspects involve harmonization in aspects of private commercial law, for example the increasing similarity and economic effects of loan and bond contracts. 98 Basel Committee on Banking Supervision (2005). Others argue that credit risk transfer has a negative impact on capital adequacy (Jobst, 2005). 29 outsourced control. The notion that bank credit lines with non-bank intermediaries would act as an effective distant control device, as might “a twitch upon the thread”,99 has now become implausible given that many SIVs and conduits have the primary objective of reducing their sponsors’ need for regulatory capital. Instead, one problem has been the participation of banks more directly, which has endangered capital, however modestly.100 The first SIVs were set up to garner funds from third-party investors and generate management fees for their creators.101 They are generally distinct from bank conduits, which are unconsolidated, non-capital attracting vehicles used by banks to house revenue-seeking activity. Conduits rely heavily on sales of asset-backed commercial paper (ABCP) for funding, and the seizure associated with this market from July 2007 in both Europe and North America has led to considerable concerns as to the long-term solvency of conduits.102 Those banks associated with their creation and management have usually provided standby lines of credit, which may entail commitments to fund the conduit in the event of it becoming impossible to sell ABCP. The result has been increasing pressure for conduits with outstanding assets to be wound up or consolidated into the sponsoring banks’ balance sheets, which would necessitate very sizeable additions to regulatory capital. In the long run, the use of SIVs is likely to become more conservative in all aspects of leverage, risk management and funding, and conduits will not exist in the form known until mid-2007. There may be contractual or structural solutions to this dilemma, such as to include the creation of reserves, or the inclusion of recourse rights to investors in a way similar to cash covered bonds, but in each case the result will be for risk to be consolidated. The concept of specialist vehicles to house structured investments is not eliminated by Basel II, for it contains provision for banks adopting the internal rating-based regulatory treatment to provide committed standby lines to SIVs at a risk weighting of only 20%, providing the lines may be used only in times of general illiquidity. 2007 would clearly have been one such time. 103 One recent empirical study of the behavior of regulated banks in conditions of freely available credit risk transfer using credit derivatives and including synthetic securitization concludes that the BIS was correct to evince benefits from risk dispersal, and points to efficiency gains arising when banks use such techniques.104 It may be ironic that in institutional terms, regardless of commercial factors, the risk management benefits of securitization in intermediation appear to have been neutralized by the common SIV structure. All of these events and a shift in confidence in the results of prolific credit risk transfer can be expected to have consequences in the distribution of risk, the objectives and balance of activity within intermediaries, and eventually in new forms of intermediaries. Credit risk transfer 99 A fictional detective explains apprehending a criminal in a manner similar to the Basel Committee’s homehost objective “with an unseen hook and an invisible line which is long enough to let him wander to the ends of the world, and still to bring him back here with a twitch upon the thread,” Chesterton (1929). 100 For example Burton (2007), Tucker (2007), Batson and Morse (2007), all describing subprime related losses by Asian banks. 101 See Footnote 24. 102 Risk assets held by SIVs and bank conduits at the end of June 2007 exceeded $1,500 billion and $350 billion, respectively. Both types of vehicle have been significant holders of cash and synthetic securitized assets, and may in aggregate have held RMBS positions amounting to 25% of total assets in mid-2007, see Bank of England (2007), page 19 and page 21. The extent of the mid-2007 interruption to SIV and bank conduit funding is considerable: as at end-June 2007, US dollar ABCP represented 54.1% of all outstanding US dollar commercial paper and exceeded $1,140 billion (source, Federal Reserve Board at https://www.federalreserve.gov/releases/ accessed 15 December 2007). 103 See Basel Committee on Banking Supervision (2006a),§ 638. The qualifying term ‘general market disruption’ is defined at § 580. A similar remark appears in Axford and Hart (2007). 104 Goderis, Marsh, Vall Castillo and Wagner (2006). 30 techniques appear certainly to have spread risk among many more legal parties, and have induced funded and contingent claims traditionally held by capital-regulated bank intermediaries to flow to other types of parties, be they hedge funds by any conventional understanding, institutional investors, interests of high net worth investors or others. At the same time, much of this dispersal among parties has not entailed risk leaving the conventional banking sector, but rather seen it become more widely held within the global banking community as a whole. Thus small German public sector lenders, the ostensible mission of which was traditionally to provide credit for activity within a narrow geographical domain, accumulate through a vehicle domiciled in Ireland a portfolio of US subprime mortgages, the value of which collapses or cannot be appraised, and leaves the vehicle unable to renew its liquid liabilities to fund its asset book. These kinds of arrangements threaten the continuation of structured finance techniques. C. Transaction Appraisal and Management The past decade has seen rapid growth in subprime mortgage lending to households with impaired or insufficient credit histories, notably in the US but also in Australia, Canada, and the UK (collectively, the “Anglo-American economies”). The activity is “dominated by new loan originators, who are not deposit-takers”,105 and many will not be regulated as conventional lenders. The recent outcome in the subprime mortgage sectors and that part of it classed as predatory lending suggest a failure in the contractual mechanisms for transaction appraisal and ongoing management. By this argument, it is not securitization as a concept that is the cause of instability, but improperly designed incentive structures leading to poor design of complex transactions, inadequate contract enforcement and risk appraisal. In the same period, forms of predatory lending became a sizeable segment of the market in home mortgage loans in the US,106 and represent a considerable portion of the market in subprime mortgage loans.107 Practices in this market segment were controversial prior to the deterioration in credit conditions in 2006. Certain US academics and mortgage industry representatives have described structured finance as the essential driver of predatory lending. These home loans are always securitized, demand steep tranching to support aggressive transaction economics, and may be said to capture a crucial moral hazard of credit risk transfer, where information is withheld from an investor. They are thus unwilling to see securitization as a 105 Committee on the Global Financial System (2006), page 17. 106 Engel and McCoy (2002), page 1,257, describe predatory lending as “exploitative high-cost loans to naïve borrowers.” They suggest that securitization is a change to the operation of the US home mortgage market that from the 1980s caused growth in new loans to accelerate and allow new loan providers to enter the market, id at 1,273-74. This is uncontroversial but the same authors’ more recent claim that securitized transactions have induced predatory lending appears to be assertive (Engel and McCoy, 2007). A similar attack is made by Peterson (2007), pages 6–7, who describes a process that is abusive, and includes evasive activity: [S]ecuritization […] has not yet proven capable of reliably providing high quality services to consumers and investors. I believe this problem stems from the legal incentives actors in the system operate under. The one uniform feature of residential mortgage law is its failure to recognize and account for the complex financial innovations that have facilitated securitization structures. Id., page 8, but this identifies concerns for which securitization cannot be a primary cause, and which in the absence of securitization are likely to continue. Eggert (2007) is still more hostile, claiming before a US Senate committee that [S]ecuritization has transformed the American mortgage market, atomized the loan process, and to a great extent turned the regulation of the subprime mortgage industry over to private entities. Some aspects of the current meltdown of the subprime market, the increased default rate and threat of rising foreclosures, as well as the difficulty of crafting an adequate response to that meltdown, may be attributed to the effects of securitization. […] Securitization has also led to loosened and inconsistent underwriting standards. But this fails to support the assertion, only indicating that factors other than securitization have not been fully regulated or controlled. 107 As an indication of market contributions prior to the mid-2007 credit crisis, US Mortgage Bankers Association survey data suggest that 19% of mortgage loans created in the first half of 2006 were made to subprime debtors, with 45% of those borrowers using the proceeds to buy homes. 31 technique that has been used by lenders of all kinds, including those making loans that might generally be criticized or made void as part of public policy. Critics of securitization in this context thus suggest that it supports predatory lending, and induces fault and malpractice by allowing abuses arising from the moral hazard of assigning or transferring poorly-originated claims. The removal of a conventional lender’s administrative interest with the sale of a loan leads inevitably to that moral hazard: The protections that securitization provides investors do not safeguard borrowers. To the contrary, securitization inflicts negative externalities on subprime borrowers in at least four ways. First, securitization funds small, thinly capitalized lenders and brokers [… that…] are more prone to commit loan abuses […]. Second, securitization dilutes incentives by lenders and brokers to avoid making loans with excessive default risk […]. Third, securitization denies injured borrowers legal recourse against assignees […]. Lastly, securitization drives up the price of subprime loans because investors demand a lemons premium for investing in subprime mortgage-backed securities. 108 The same sources argue that securitization increases problems of adverse selection arising from asymmetries of information between lender and investor. They suggest that lenders have an incentive to securitize the poorer parts of their loan portfolios, and that ABS or MBS investors cannot know whether any loan or pool of loans was made soundly or is properly maintained. This attack is more a complaint against predatory or unsound lending, rather than the processes involved in securitization. However, it appears also to specify wrongly the nature of any information asymmetry between lender and securitized investor: Before the advent of securitization, lenders typically handled loans from cradle to grave. […] Because lenders bore the full risk of default, they had strong incentives to turn down observationally risky borrowers. […] The lemons [adverse selection] problem occurs because unbundling creates information asymmetries that mortgage lenders (or brokers) can exploit to investors' detriment.109 In institutional terms there is a clear difference between the knowledge that a bank lender can be expected to accumulate of an established corporate borrower, and its insight into a single consumer debtor. Yet many banks in East Asia and elsewhere extend credit to SMEs only if provided with collateral. Although widespread, this has been seen as an obstacle to both SME credit creation and loan securitization.110 In the case of the US subprime sector, it became accepted practice to create a contractual framework for loan servicing and mortgage registration that facilitated loan transfer but weakened the flow of credit information to the ultimate investor.111 It is important to note that US practice is not a model in this respect, even though the collapse of the US subprime market has been a global contagion event. The credit risk profile of a complex corporate debtor may be far harder for an investor than a bank to assess, but a securitization 108 Engel and McCoy (2007), page 2,041. 109 Id., pages 2,048–49. 110 Booth, Arner, Lejot and Hsu (2007), pages 527–28. 111 By means of Mortgage Electronic Registration Systems (MERS), a commercial mortgage loan registration vehicle used by many subprime loan aggregators as the beneficiary of mortgage deeds. 32 transaction that is as contractually complete as possible can create an incentive framework for usable information to be given to the investor.112 The alternative to preventing the use of securitization in predatory loan funding is to adopt strict disclosure provisions for loan aggregators and agents, and to provide for the policing aggressive lending. D. Credit Rating Agency Functions It has been recognized for some time that credit rating agencies can engage in commercially conflicted activities. IOSCO’s code of conduct drew attention to this concern as a regulatory issue but only extended to the general mission of the agencies, not their analytical techniques, which were viewed as sacrosanct in much the same way as many internal quantitative models under the Basel I market risk framework prior to the 1998 collapse of hedge funds managed by Long-Term Capital Management.113 Criticism of the agencies has focused on two particular conflicts of interest, namely compensation being met by issuers whose securities the agencies appraise, and the possibility that a rating agency parent or affiliate may derive revenue or other benefits from issuers or their advisors. This neglects a specific actual conflict inherent in the origination process for structured transactions, and which the recent dislocation has exposed to far wider concern. It arises from the quasi-origination function that the leading rating agencies undertake whenever many complex transactions are under negotiation, and it is this aspect of the current rating agency model that is likely to be reconsidered in the medium-term. In addition, it is highly likely that quantitative risk modeling will be generally subject to an increase in regulatory minimum-setting and scrutiny, not only in structured transaction ratings but in a range of regulatory risk considerations. This potential conflict has become widely criticized within the context of structured finance markets, since agency involvement in the creation of new transactions is profound, interactive, and no less significant than that of arrangers. The resolution of this conflict may include greater transparency in the rating process for structured transactions, and explicit regulatory supervision of agency organization and activity. The greater difficulty may be to create a new model of independent investment appraisal specifically designed for structured finance risks, which allows for challenges to rating agency opinions. If the leading rating agencies are to hold a central place in the transactional process (as well as the regulatory process under at least the standard level of Basel II), then the capital markets must cease to regard their opinions as mere contributions to investor advice. It should also be noted that periods of market disruption tend to include calls for rating agency reform based upon the observation that they often fail to predict imminent credit problems. This criticism was made in the context of the Asian financial crisis and recently after the deterioration in the US subprime mortgage market, during which one agency made without warning controversial steep downgradings of certain CDOs.114 It is not part of this study’s purpose to 112 The institutional analysis of van Order (2007) summarizes at pages 2–3 the transaction cost trade-off associated with securitization: [A] reasonable way of posing the problem (of which funding structure is best) is that it can be defined by a tradeoff between the advantages of securitization as a low cost and elastic source of funds with the disadvantages of securitization due to information asymmetry between investors and lenders (a problem that banks tend to manage better) and costs of setting up deals (which do not apply to deposit funding), and a priori the balance could go either way. However, this fails to acknowledge the effect of wrongly-specified (and thus incomplete) contracts as the core explanation rather than intrinsic information asymmetry. 113 See Footnote 73. 114 For example, International Financing Review (2007) reported that S&P last week downgraded US$80m of Tier 1 mezzanine notes issued by Avendis Group's Golden Key SIV-lite by an astounding and possibly unprecedented 17 notches – from AAA to CCC. At the same time, it downgraded 33 evaluate the methods of the leading agencies but it is appropriate to ask how these organizations function within an institutional setting, and how reforms are likely to result from recent events. In particular, a moral dilemma arises in the iterative process used by originators and rating agencies to structure complex transactions in order to achieve target ratings on deal tranches. It has been further argued in a US context that credit rating agencies have unconstitutionally acquired a quasi-legal position as arbiters of the contractual integrity of securitized issues. This also presents a commercial conflict as the agencies derive revenue from their involvement in creating such securities. US rating agencies claim that their opinions are not actionable in law as mere opinions subject to constitutional protection, or that aggrieved investors lack a basis of claim since they lack a contractual relationship with the agency.115 The paradox is that ratings are central to investors and increasingly risk-based regulation of intermediaries in structured finance, but to date they have not been successfully challenged. Indeed, the conflict that arises from the rating agency being compensated by the issuer is one that is essential to maintain in order to guard against litigation—if the agency were to be paid by the investor, this arrangement could not be sustained.116 Rating agency structured finance practice has been questioned by events and by securities regulators, notably France’s Autorité des Marches Financiers,117 but defended by the principal rating agencies.118 IOSCO’s code of conduct for credit rating agencies includes the exhortation that agencies use “rating methodologies that are rigorous, systematic, and, where possible, result in ratings that can be subjected to some form of objective validation based on historical experience.”119 Yet, this is clearly not the outcome with regard to many structured or synthetic transactions in 2007. The leading French financial regulator has questioned whether structured finance transactions are properly rated, pointing out that unlike with conventional debt issues with a single commercial or sovereign obligor, the role of the rating agency in structured transactions is more active, and akin to a quasi-participatory function:120 US$174m of Tier 1 mezzanine notes from Solent Capital's Mainsail II SIV-lite by 16 notches – from AAA to Triple CCC+. Such sharp downgrades spurred criticism of the ratings agencies, both from market participants and politicians, casting doubts over the agencies' credibility and raising more questions about the value of a Triple A rating. That in turn cast doubt over the fundamental basis of the Basel II regulatory regime, which is intrinsically tied to credit ratings. Bell and Rose (2007) seek to defend structured finance rating practice. Note that there are long-standing conceptual differences in the approach to structured transaction valuation methodology used by the three leading agencies, see also Footnote 123. 115 Kettering (2007), pages 96–118. 116 Id., page 108. 117 Prada (2007). 118 For example, Bell and Ross (2007) ask Why does this dialogue between rating agencies and arrangers occur at all [in structured finance transactions]? The answer lies in two aspects of structured finance: the first is "tranching" and the second is the "structured" nature of structured finance. Both are intrinsic and necessary to the structured finance market. And in both instances, the degree of rating agency interaction is not only beneficial to the structured finance market but almost certainly a prerequisite to having any kind of structured finance market at all. The authors omit to suggest that an alternative business model that lacks the commercial conflicts inherent in assigning a regulatory function to credit rating agencies. They continue to say that The only aim is to design a product that can find investors and still generate a positive economic return. In other words, structured finance is "structured". Ibid, page 5. 119 IOSCO (2004), §1.2, page 4. 120 Prada (2007). 34 can a pure rating approach be an appropriate and sufficient answer to the investors' needs in terms of credit risk assessment on structured finance instruments?121 And continues, [t]he accuracy and the robustness of structured finance ratings are […] subject to the quality and the stability of the models that are specifically developed by each agency. […] as they can have a very high impact on the absolute or the comparative levels of market spreads.122 This point is neglected in academic commentary and by investors. The analytical methods of the three principal agencies are proprietary and different in approach and mechanics,123 in addition to their maintaining wide variations in their respective commercial approaches. They employ different methods, and their ratings and approaches to warnings or making changes are taken by the financial sector as distinct. In addition, this has traditionally led to the belief among other market participants that one agency may be commonly regarded as favoring or being less likely to penalize certain risks. There is thus a commercial decision in selecting a rating agency, or choosing to engage either two or three firms to rate new issues or new classes of risk.124 It seems likely that the quasi-regulatory functions of the agencies in the Basel II process will be re-evaluated, at least in respect of structured transaction ratings.125 The rating agencies have been criticized periodically for slow analytical reaction to deteriorating credit risks, rapid reappraisals, and an asymmetric view of credit improvements and declines. Concern over their structured finance activity is different and more fundamental. The effect of rapid changes in rating is less seen in sober reassessments and changes in expectations of the kind predicted by market economists, but in quantum-like, non-granular reactions. A fall in credit rating below a set level may cause no change in intellectual sentiment but a conditioned and often compulsory sale by institutional investors constrained by ratings-based investment criteria. The implication, rarely acknowledged outside the gossip of market professionals, is that ratings rarely induce or inform a portfolio investment decision but may permit it to happen (institutional investors frequently having contractual-or regulated-ratings minimum mandates for investments), or provide exculpatory evidence if the decision later proves mistaken. The BIS examined the activities of credit rating agencies in structured finance transactions in 2005, and pointed to risks and potential conflicts that have been more widely and urgently discussed since mid-2007. Its assessment describes the vital position granted to the agencies in facilitating synthetic transactions due to their reliance on tranching,126 but it may be fairer to stress the interactivity of this part of transaction formation. The report warned that 121 Ibid, page 7. 122 Ibid, page 8. 123 An explanation of the main differences is given in Raines and Rutledge (2003). Each agency has recently sought to defend its structured rating methodology (Bell and Rose, 2007) but at least one announced in September 2007 changes in its approach to rating certain CDOs. 124 Differences in reputational considerations are trivial in the domestic US markets, where the rating agencies are ubiquitous and the issuer universe large and relatively homogeneous. 125 See Footnote 95. 126 Committee on the Global Financial System (2005), page 6. 41 open securities markets.145 This evolutionary concept sees a “securitized phase” as the pinnacle of financial sector development,146 which is expected to result from growth in output. This paper shows that the growth in securitization in Asia is the result in part of elective strategy, in that governments and regulatory authorities can introduce, or fail to introduce institutional changes that encourage or discourage financial development.147 That securitization has lagged expectations in several East Asian markets results partly from institutional constraints, and suggests that governments have elected to give only limited or cautious support to market reforms. That the need for securitization to assist financial development in East Asia has dissipated since 1999–2000 does not invalidate the proposition that it can be of value in risk management or as an alternative channel for intermediation. This is the basis for promoting institutional change and policy reform. The implication would be a greater reliance on the public and private securities markets in capital funding and portfolio investment, compared to an historic emphasis on national banking systems that characterizes both industrialized and developing East Asian economies. However, such changes require policy support and relevant institutional action. If structured finance is accepted as value-creating, what might advance its use in Asia, and what limits such use now? For example, can development organizations usefully support institutional reforms? This would include strengthening property rights, judicial processes, promoting minimum standards among lenders for risk appraisal, data collection and analysis, establishing common best practices in documentation and risk appraisal among intermediaries, in tandem with regulatory enhancements.148 It could also include support for securitization to fund lending in areas of interest for public policy, such as infrastructural risks, education, and agricultural or community finance. For multilateral bodies to become intermediaries in such areas may be an original and non-conflicting use of capital, with identifiable goals in poverty reduction and incentives for resource development. Even if fully practical, these schemes strain to find support from traditional commercial sources.149 The scope for multilateral involvement may be constrained by conflicts associated with credit risk transfer at a time when national supervision and reporting among substandard bank and non-bank intermediaries needs enhancement. However, support for implementation of the second and third pillars of Basel II would be beneficial in this respect, and might contribute to regional cooperation among national authorities. Successful securitization programs can lead to migration among source asset originators to common standards for facility appraisal, documentation, and enforcement. For example, in Hong Kong, China, competition in the last decade in the market for residential mortgage loans has led to sharp reductions in gross loan margins. Such gains for borrowers are due in part to the creation of the Hong Kong Mortgage Corporation (HKMC), which refinances housing loans and has induced a general improvement and standardization of primary loan documentation and 145 Rybczynski (1997). Although the theory sees institutions such as property rights as important catalysts in the evolutionary process, it regards the legal and regulatory framework as endogenous to growth in output and per capita income, and is thus challenged by empirical findings of causal relationships between financial development and general growth, and between the nature of legal systems and financial development. 146 Id., page 9. 147 This analysis builds on a general framework developed in Arner (2007). 148 A more detailed discussion is given in Arner (2007). 149 Without incentives, banks may elect not to lend for such purposes or do so only with severe limits, especially given Asia’s modest record of financial innovation. An excess of non-deployed personal savings has long been seen as an obstacle to economic growth, see notably Lewis (1955), pages 213–244. 42 credit appraisal, since loan originators must meet HKMC requirements in order to secure credit insurance (necessary for loan-to-value ratios greater than 70%) or subsequent loan sales. In due course this will assist in the diversification of investor classes, and lower the average expenses associated with serial securitizations.150 C. New Initiatives Examples of initiatives open to transnational organizations to encourage the use of securitization include three concepts: • Supporting refunding of microfinance lenders to agricultural or community based projects.151 This can be quite significant in developing financial systems where there is frequently a liquidity constraint on microfinance providers facing increasing demand for their products. This is also true for established banks with excess liquidity but unwilling to lend to borrowers outside traditional large corporations.152 This would require a contingent commitment of capital, as well as resources to help standardize credit appraisal and loan execution. Such efforts could be supported not only at the domestic level, but perhaps at the regional level as well, providing support for regional standards, transparency, and products with the potential to develop liquidity; • Providing credit support and refunding for long-term loans to students and for human resource development.153 Student loans (where available) tend to be treated as unsecured personal lending and are costly. New mechanisms would require incentive structures to encourage repayment, perhaps through changes to insolvency laws or taxation systems. There may also be scope for microfinance providers to engage in student loan financing which could be given by third-party credit support; • The funding and redistribution of infrastructural finance. Projects not associated with revenue generation may be assisted with structured finance techniques, especially when state or provincial revenue raising is inefficient. For example, the securitization 150 KHFC was created for similar purposes, but as yet has had only a modest effect in stimulating or extending the duration of residential mortgage lending, see Footnote 43. 151 Structured funding for established microfinance providers is conceptually new and modest in scale, but has been shown to be feasible by a small number of similar transactions for lenders in South Asia, Latin America, and Eastern European transition economies. In some cases, funding has been arranged or supported by non-profit, non-governmental organizations or public developmental intermediaries such as the Dutch Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden (FMO) or Germany’s KfW Bankengruppe (KfW). Each of the latter provided credit enhancement through partial guarantees of a 2006 passthrough loan sale program for Bangladesh Rural Advancement Committee (BRAC), an established Bangladesh microlender. BRAC’s first tranche of short-term notes was given internal credit enhancement through over-collateralization, with notes carrying pool claims of 150% of their nominal value. Program issuance may eventually reach Tk12.6 billion ($183 million), with notes expected to be issued twice annually. The most sophisticated transaction disclosed to date to securitize microfinance claims may be a $106 million 2006 CLO for Blue Orchid Finance, a specialist lender to microfinance intermediaries, which comprises two tranches with average lives of up to 5 years and which uses a pool of loans to microfinance providers in 13 different states, but unlike the BRAC program, investors in this transaction obtain claims against intermediaries, rather than any ultimate borrowers. 152 Cambodia provides an excellent example: see Royal Government of Cambodia (2007). 153 It is common for commercial or subsidized student loans to be funded or refinanced with structured finance techniques, including securitization. The example best known to the capital markets is SLM Corporation or “Sallie Mae,” a former government agency that is one of a number of specialist US intermediaries providing student loans with public sector support. Sallie Mae, its affiliates, and similar organizations obtain commercial funding through many markets and financing structures, including substantial student loan ABS programs. Student loans have been packaged and sold as pools on more modest scales by banks and agencies elsewhere, including Korea. Separately, a number of universities in North America and Europe have borrowed in the commercial markets using forward sales of revenue as collateral, for example from student tuition or accommodation fees. 43 of future tax receipts may provide a funding source for new projects, while the covered bond concept has scope to refinance public sector claims. These examples share aims that are simple and involve programs that the commercial finance sector is unable or unwilling to create without external assistance. In a global climate of regulatory and systemic reform, such concepts will help regenerate economic securitization in East Asia, with a range of consequent developmental benefits. In addition, as policy responses develop from 2007’s market dislocation, Asia’s regulators and governments could usefully consider regional specifications of new or revised global standards for intermediary liquidity, rating agency practice and certification, and Basel II treatment of securitization.154 In the longer-term it may also be prudent to examine new arrangements among East Asian central banks to share resources to deal with liquidity disruptions involving Asian financial markets or intermediaries.155 Cross-border financial intermediation in Asia is currently insufficient to make such arrangements a necessity, but if financial market liberalization continues it would be beneficial to consider wide-ranging contingencies in advance of any actual need, as has been shown in the approach to crisis and liquidity arrangements made by the European Central Bank. 154 Through the established forums of ASEAN, ASEAN+3, East Asia Summit, APEC finance minister processes, Executives Meeting of East Asia-Pacific Central Banks (EMEAP), and IOSCO’s Asia-Pacific committee. 155 The Chang Mai Initiative (CMI) among ASEAN+3 central banks provides a network of short–term foreign exchange swap lines intended for currency crisis management, the use of which is largely subject to exacting conditions. CMI includes bilateral lines opened by the PRC, Japan, and Korea each with the middle-income ASEAN members that also allow limited securities repurchase agreements, see Arner, Lejot and Wang (2008). 44 Appendixes Appendix 1. Effects of Financial Market Development on Securitization Factors influencing the extent of securitization were estimated with a series of linear regressions, using as dependent variables a series of measures of securitization market capitalization and issuance. These included total outstanding structured issues across five asset classes, namely ABS and MBS issues, pfandbriefe, other covered issues, and cash CDOs.156 Independent variables were: 1. gross domestic product as a measure of economic development; 2. financial market deepening as a proxy for the importance of the financial sector in national economies; 3. an index of rule of law as a proxy for the quality of national legal systems and judicial processes;157 4. an index of capital controls as a measure of financial openness;158 5. credit creation measured by bank lending to the non-financial sector, the commercial real estate sector, and to residential mortgages as a share of total bank lending; 6. quality of bank lending, as shown by NPLs share of total loans; 7. bank capital adequacy ratios as a measure of the robustness of financial intermediaries. These estimates were made in each case using annual data for 16 developed and developing economies for 1995–2006.159 No distinction was made between securitization use and its contractual or legal feasibility in any jurisdiction, so that the results of these estimates should be read in the context of the information given in the table in Appendix 5. Three sets of regressions were run: 1. Pooled data (combinations of time-series and cross-sectional observations); 2. Panel data (combinations of time-series and cross-section observations taking account of country-specific effects); 3. Regressions with interaction dummy variables to capture differences in projected slopes between the two developed and emerging economy samples. The regression equations take the following forms: Without interaction: 156 Covered bonds include synthetic (contractual) issues such as those made to date by UK or US issuers see Appendix 3. 157 The Rule of Law Index is one of six World Bank Worldwide Governance Indicators assembled from many sources. It measures “the extent to which agents have confidence in and abide by the rules of society, in particular the quality of contract enforcement, the police, and the courts, as well as the likelihood of crime and violence” (Kaufmann, Kraay and Mastruzzi, 2007, pages 3–8). Other World Bank data on the control of corruption and regulatory quality were tested as explanatory variables and found to be insignificant. 158 Controls on capital transactions as published in the Annual Report on Exchange Arrangements and Exchange Restrictions, IMF. 159 The developed economies are Australia; Canada; Denmark; France; Hong Kong, China; Japan; Singapore; UK and US. Developing economies are the PRC, Indonesia, Korea, Malaysia, Philippines, Thailand, and Viet Nam. 45 Securitization = β0 + βX + ε With interaction: Securitization = β0 + βX*EmergingEastAsia + θX*DevelopedEconomies + ε where Securitization is total securitization, including ABS and MBS outstandings, X represents the independent variables, and <EmergingEastAsia> and <DevelopedEconomies> are dummy variables for country groupings. Table A1.1: Summary of Variables and Expected Signs Gross domestic product + Financial market deepening + Bank lending + Rule of law + Capital controls - NPLs + Capital adequacy +/- Results and Interpretation The three methods show significant results for the developed economies but generally weaker results for emerging East Asian economies. The depth of securitization measured by total securitization, ABS and MBS thus appears to be aligned with the development of financial markets as measured by financial market deepening, selected indicators of credit creation, growth in GDP, aggregate bank capital adequacy and the extent of NPLs. Rule of law and capital controls showed significant but less consistent results for developed economies, and insignificant results for the emerging economies tested. Estimates for developed economies indicate that financial market deepening contributes positively to the use of securitization, where such deepening is given by the aggregate relative to GDP of bank credit creation and outstanding capitalization of national bond and equity markets. Significant results were found for the emerging economies tested using pooled data for MBS. As financial markets grow in scale and sophistication, so the propensity of intermediaries to engage in credit risk transfer and demand among investors for a broadening range of risks and instruments can both be generally expected to increase. If successful, securitization can be said to lower the transaction costs associated with credit risk transfer and increase the availability of transferable debt instruments. Significant results were found for the effect of credit creation on total securitization for all economies and on MBS issuance in developed economies. No measure of credit creation had a particular value in explaining growth in total securitization, or either ABS or MBS growth. To the extent that the results indicate that credit creation is positively related to the use of 46 securitization, the underlying reasons may be associated with transaction arrangers thus having more feasible commercial sources of suitable pool assets or risks. The estimates also suggest that securitization use increases with economic growth. But it is clear that national institutional factors may hinder its effectiveness or development. This is seen most clearly in the PRC, where despite a record of consistently high growth, the policy, legislative and regulatory setting have to date allowed very few securitization transactions. A further analysis was made excluding data for US securitization. This seeks to reflect the view of US financial market practices being path dependent upon institutions and circumstances that are unusual or unique at the federal or state level, rather than internationally common.160 For example, the origins of ABS and RMBS transactions in the 1970s in the US lay in long-standing geographical and commercial restrictions on banks of all kinds that provided strong incentives to disintermediation, and subsequently led to unprecedented growth in activity among nontraditional financial interests. This would not be inconsistent with the view that innovation in US financial markets may have applications elsewhere in both common law and other jurisdictions, but that US practice may not necessarily be a benchmark for all other states. Thus to the extent that financial innovation in the US results from atypical domestic institutions such as the nature of law and regulation, then the inclusion of US data may have a distorting effect on the regression results. The results, excluding US issuance, are generally less significant in respect of the developed economy sample, and become insignificant in relation to the emerging economies tested. In this respect, the findings appear to conform with those contained in a recent study of housing finance in 61 states and territories—first, that the depth of housing finance in the economy measured by the share of outstanding residential mortgage debt is on average higher in developed economies, and second, that countries’ larger housing finance systems are positively associated with institutions such as legal rights and efficient credit information provisions.161 This suggests that such institutions favor the making and maintenance of housing finance, whether by intermediaries or through the contractual process offered by securities markets. These findings are also supported by measures of both the rule of law and crossborder capital controls, each of which was found to be significant for developed economies but insignificant for the emerging economies sample. The rule of law is likely to influence the use of securitization through its effect on investor confidence and market microstructures. Trust in the judicial system for the unbiased enforcement of claims is typically perceived to be weaker in emerging economies than others. It is widely acknowledged that a supportive legal and regulatory framework will help to avoid eroding the contractual integrity of legitimate transactions, for example, so that a transfer of assets is reliable, permanent and may not be disturbed by subsequent claims. However, it must be noted that the rule of law variable is defined in broad terms and lacks precision. Controls on capital impact negatively on securitization by limiting the extent and diversity of investor participation. The need for prior approval for the purchase or sale of financial assets by nonresidents, withholding taxes on foreign payments or to offshore transactional SPVs, and restrictions on the use of financial derivatives may all discourage cross-border participation in local markets. Limits on trading and transfer will in turn have a limiting effect on securitization, 160 See notably Roe (1994), pages 54–59 and pages 94–101. 161 Warnock and Warnock (2007), pages 14–16. 47 even though states that discourage foreign participation may still sustain vibrant capital markets: Korea is a prominent example. The estimates showed a negative relationship between NPL volumes and securitization for developed economies. No effect was seen in respect of the emerging economies tested. This may be explained by differences in national accounting and reporting requirements, notwithstanding harmonization trends in bank regulation and the fact that reported NPLs have generally fallen since the 1997/1998 financial crisis. In the case of the developed economy sample, securitization is traditionally rarely used in respect of NPL recycling in European civil law jurisdictions. Regulatory standards that demand prompt loan loss disclosure and provisioning may have restricted its use elsewhere. A rise in NPL securitization may follow in due course from the deterioration in conditions in residential mortgage lending since late 2006 in the US and other AngloAmerican economies. Taking data limitations into consideration, the bifurcated development of East Asian structured finance reported in this study, with a separation between usage in Hong Kong, China; Japan; Korea; and Malaysia from the PRC, Indonesia, Philippines, and Thailand can be attributed in part to the effectiveness of enabling law. While the results confirm that common law jurisdictions are comparatively felicitous in providing for effective securitization, the example of Korea shows that other jurisdictions can present a highly effective setting for such activity. Future research may wish to explore whether this outcome results from incentives arising from choices in national policy. 48 Table A1.2: Selected Pooled Regression Estimates with Interaction Dummies, 1995–2006 Dependent Variable: Asset-Backed Securities Dependent Variable: Mortgage-Backed Securities Dependent Variable: Mortgage-Backed Securities Emerging East Asian Economies Developed Economies Emerging East Asian Economies Developed Economies Emerging East Asian Economies Developed Economies Bank Lending to Corporate Sector / Total Loans 0.011 (0.251) 0.011*** (6.069) -0.193 (0.775) 0.423*** (5.180) 0.005 (0.074) Nonperforming Loans/ Total Loans 0.497 (0.630) -6.048*** (8.151) -0.253 (0.084) -79.181*** (6.898) Capital Adequacy Ratio 0.646 (1.072) 1.961*** (5.356) -0.068 (0.022) 24.550*** (5.314) Log Gross Domestic Product 9.758** (3.176) 8.081*** (5.027) 149.893 (1.839) 17.161 (0.252) -2.939 (0.134) -38.927* (2.537) Financial Market Deepening 0.165 (0.345) 2.166*** (3.942) Bank Lending to Commercial Real Estate 1.817*** (41.432) Constant -60.006*** (5.200) -796.653* (1.994) 19.565 (0.203) -60.006*** (5.200) -796.653* (1.994) 19.565 (0.203) Adjusted R-squared 0.739 0.493 0.952 0.739 0.493 0.952 Observations 96 124 149 96 124 149 Notes: Parentheses denote t-values in absolute terms. * significance at the 10% level. ** significance at the 5% level. *** significance at the 1% level. Source: http://www.asianbondsonline.com (accessed 15 December 2007). 49 Table A1.3: Complete Pooled Regressions Estimates with Interaction Dummies, 1995-2006 Dependent Variable: Asset-Backed Securities Dependent Variable: Mortgage-Backed Securities Dependent Variable: Mortgage-Backed Securities Emerging East Asian Economies Developed Economies Emerging East Asian Economies Developed Economies Emerging East Asian Economies Developed Economies Bank Lending to Corporate Sector / Total Loans -0.197 (0.980) 0.166 (1.880) 1.213 (0.182) 28.861*** (11.087) 1.736 (0.471) 27.730*** (14.791) Nonperforming Loans / Total Loans 0.638 (0.479) -6.526*** (7.767) 4.921 (0.471) -253.831*** (10.544) 1.273 (0.171) -261.782*** (11.926) Capital Adequacy Ratio 0.549 (0.706) 2.560*** (6.212) 3.656 (0.349) 75.971*** (6.403) 2.102 (0.225) 68.910*** (6.670) Log Gross Domestic Product 8.798 (1.777) 17.346*** (11.653) 41.798 (0.512) 469.237*** (11.841) 28.503 (0.447) 514.438*** (18.438) Financial Market Deepening -0.015 (0.656) -0.024* (2.172) -0.007 (0.019) 1.058*** (3.166) -0.043 (0.128) 0.871** (2.767) Rule of Law (Log/Level) 0.219 (0.706) -0.637 (1.486) 1.691 (0.405) -45.703*** (7.891) 0.448 (0.132) -49.718*** (12.361) Capital Controls (Log/Level) 16.529 (0.689) 25.980** (2.884) 26.816 (0.112) 895.966*** (3.622) -38.093 (0.203) 1041.964*** (5.001) Constant -67.175 -486.185 -262.078 (1.604) (0.987) (0.807) Adjusted R-squared 0.716 0.843 0.839 Observations 96 123 147 Notes: Parentheses denote t-values in absolute terms. * significance at the 10% level. ** significance at the 5% level. *** significance at the 1% level. Source: http://www.asianbondonline.com (accessed 15 December 2007). 50 Appendix 2. Cash and Synthetic Generic Transactions Figure A2.1: Generic Cash Securitized Transaction Financial assets are sold by their originator to an insubstantive SPV in a shared domicile,162 and simultaneously resold to a second offshore SPV that in turn funds the purchase, immediately or after a short period for asset accumulation, with an array of new securities enjoying direct claims of varying seniority over all or part of the pool of assets (Figure A2.1). Figure A2.2: Generic Structure Using Sequential SPVs In Figure A2.2, “cross-border” indicates the use of SPVs remote from the source assets, located offshore as a means to safeguard an irrevocable asset transfer. Securities created with the sale may be acquired at issue or later by any investor, whether or not of the same domicile from which subject assets are first sold. Qualifying assets may include impaired assets, commercial mortgage loans, corporate loans and major lease receivables. Asset servicing becomes independent of the originator. The originator may continue to deal commercially with any ultimate debtor except in cases involving impaired assets but may not usually derive ongoing economic benefits from claims becoming subject to the sale. 162 The domestic domiciled SPV. 57 Table A5 gives an assessment of prevailing securitization market conditions across selected regional economies.171 The table’s assessments of the effectiveness of enabling legal provisions (column 2), the enforcement of foreclosure or repossession of source assets (column 5), and ongoing threats to the integrity of transfer of assets to a SPV (column 6) are in each case based on transactional evidence and appraisals of governing laws. The PRC and Viet Nam have been excluded from the table due to policy decisions to withhold full support from market development. In addition, the PRC’s recent bankruptcy and property legislation and the ongoing process of regulatory implementation make the treatment of these issues indeterminate, even were transactions to become more freely permitted. In most jurisdictions transactional integrity has yet to be tested through a complete credit cycle. This would apply even in common law jurisdictions such as Singapore and Hong Kong, China, for example, in relation to new rules permitting the creation of REITs, although in each case the probability is small that a completed transaction would be successfully challenged.172 171 See also Arner, Booth, Lejot and Hsu (2007). 172 One substantial public sector REIT transaction in Hong Kong, China for The Link Real Estate Investment Trust was subject to litigation that sought to prohibit its launch. Completion eventually took place in November 2005. 58 References Akerlof, G. 1970. The Market for “Lemons”: Quality Uncertainty and the Market Mechanism. Quarterly Journal of Economics. 84(3). pp. 488-500. Alford, D. 2005. Core Principles for Effective Banking Supervision: An Enforceable International Financial Standard? Boston College International & Comparative Law Review. 28(2). pp. 237297. Andreades, A. 1933. A History of Greek Public Finance, Vol 1. Translated by Carroll Brown. Cambridge: Harvard University Press. Arner, D. 2007. Financial Stability, Economic Growth and the Role of Law. Cambridge: Cambridge University Press. ———. 2002. Emerging Market Economies and Government Promotion of Securitization. Duke Journal of Comparative and International Law. 12(2). pp. 505-519. Arner, D., C. Booth, P. Lejot and B. Hsu. 2007. Property Rights, Collateral, Creditor Rights and Insolvency in East Asia. Texas International Law Journal. 42 (3). pp. 515-559. Arner, D., P. Lejot and W. Wei. 2008. Prospects for an East Asian Economic Community: The Case of Financial Services. In N. Thomas, ed. Governance and Regionalism in Asia, London: Routledge. Axford, S., and R. Hart. 2007. Rescue your Conduit. International Financing Law Review. 10. pp. 18-20. Bank of England. 2007. Financial Stability Report, No. 22, October. Available: http://www.bankof england.co.uk/publications/fsr/2007/fsr22.htm. Barr, M., and G. Miller. 2006. Global Administrative Law: the View from Basel. European Journal of International Law. 17(1). pp. 15-46. Basel Committee on Banking Supervision. 2005. The Joint Forum: Credit Risk Transfer. Available: http://www.bis.org/publ/joint13.htm. ———. 2006. Home-Host Information Sharing for Effective Basel II Implementation. Available: http://www.bis.org/publ/bcbs125.htm. ———. 2006a. International Convergence of Capital Measurement and Capital Standards: A Revised Framework Version. Available: http://www.bis.org/publ/bcbs128.pdf?noframes=1. ———. 2006b. Results of the Fifth Quantitative Impact Study (QIS 5). Available: http://www.bis. org/bcbs/qis/qis5results.pdf. Batson, A. and A. Morse. 2007. Are Asia's Savviest Banks Sitting Pretty? Not So Fast. Wall Street Journal. 30 August. Bell, I. and J. Rose. 2007. The Fundamentals of Structured Finance Ratings. Structured Finance Commentary, Standard & Poor’s Corporation. 23 August. 59 Blackburn, R. 2006. Finance and the Fourth Dimension. New Left Review. 39 (May-June). Buiter, W. 2007. Lessons from the Financial Crisis: Part 1. Financial Times. 26 October. Available: http://blogs.ft.com/maverecon/2007/10/lessons-from-th.html. Burton, J. 2007. DBS Admits CDO Exposure Could Double. Financial Times. 28 August. Warnock, V. C. and F Warnock. 2007. Markets and Housing Finance. NBER Working Paper. Available: http://www.nber.org/papers/w13081. Chan, E., M. Davies and J. Gyntelberg. 2006. The Role of Government-Supported Housing Finance Agencies in Asia. BIS Quarterly Review. (December). pp. 71-83. Chensavasdijai, V., T. Feyzioğlu, R. Semblat, M. Syed, E. Frydl and M. Skaarup. 2007. Republic of Korea: Selected Issues. IMF Country Report No.07/345. Chesterton, G. K. 1929. The Queer Feet. In The Innocence of Father Brown. London, Cassell. Claessens, S., G. Underhill and Z. Xiaoke. 2006. The Political Economy of Global Financial Governance: the Costs of Basle II for Poor Countries. World Economy and Finance Research Working Paper No. 0015. Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=94453 0&high=%20claessens. Committee on the Global Financial System. 2005. The Role of Ratings in Structured Finance: Issues and Implications. CGFS Publications No 23. Bank for International Settlements. Available: http://www.bis.org/publ/cgfs23.pdf?noframes=1. ———. 2006. Housing Finance in the Global Financial Market. CGFS Paper No. 26. Bank for International Settlements. Available: http://www.bis.org/publ/cgfs26.htm. ———. 2007. Financial Stability and Local Currency Bond Markets, CGFS Paper No 28. Bank for International Settlements. Available: http://www.bis.org/publ/cgfs28.htm. Crotty, J. and L. Kang-kook. 2005. The Causes and Consequences of Neoliberal Restructuring in Post-Crisis Korea. In G. Epstein, ed. Financialization and the World Economy. Cheltenham: Edward Elgar. Dore, R. 2002. Stock Market Capitalism vs. Welfare Capitalism. New Political Economy. 7(1). pp. 115-127. Eatwell, J. and L. Taylor. 2000. Global Finance at Risk: the Case for International Regulation. New York, USA: New Press. Eggert, K. 2007. Testimony to US Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, Insurance, and Investment hearing, Subprime Mortgage Market Turmoil: Examining the Role of Securitization. 17 April. Available: http://banking.senate.gov/ index.cfm?Fuseaction=Hearings.Detail&HearingID=256. Engel, K. and P. McCoy. 2002. A Tale of Three Markets: The Law and Economics of Predatory Lending. Texas Law Review. 80(6). p. 1255. 60 ———. 2007. Turning a Blind Eye: Wall Street Finance of Predatory Lending. Fordham Law Review. 75(4). p. 102. Federal Reserve System, Board of Governors. 2001. Expanded Guidance for Subprime Lending Programs. Available: http://www.federalreserve.gov/boarddocs/srletters/2001/SR0104. Fender, I. and P. Hördalh. 2007. Overview: Credit Retrenchment Triggers Liquidity Squeeze. BIS Quarterly Review, (September). pp. 1-16. Finance Asia. 2007. China’s Short-term Bond Funds Love ABS. 10 February. Firla-Cichra, M. and T. Jenkinson. 2005. Security Design in the Real World: Why are Securitization Issues Tranched?. Paper Presented at EFA Moscow Meetings. Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=676730. Fung, B., J. George, S. Hohl and G. Ma. 2004. Public Asset Management Companies in East Asia, a Comparative Study. Financial Stability Institute Occasional Paper No. 3. Bank for International Settlements. Available: http://www.bis.org/fsi/fsipapers03.pdf. Goderis, B., I. Marsh, J. V. Castello and W. Wagner. 2006. Bank Behavior with Access to Credit Risk Transfer Markets. Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=937287. Goode, R. 1997. Usage and Its Reception in Transnational Commercial Law. International and Comparative Law Quarterly. 46 (1). pp. 1-36. Griffith-Jones, S., M. A. Segoviano and S. Spratt. 2002. Basel II and Developing Countries: Diversification and Portfolio Effects. Institute of Development Studies. Available: http://www.ids. ac.uk/ids/global/pdfs/FINALBasel-diversification2.pdf. Guonan, M. and B. Fung. 2002. China’s Asset Management Corporations. BIS Working Papers No. 115. Available: http://www.bis.org/publ/work115.pdf. Gyntelberg, J. & E. Remolona. 2006. Securitization in Asia and the Pacific: Implications for Liquidity and Credit Risks. BIS Quarterly Review. (June). pp. 65-75. Hayward, P. 1990. Prospects for International Cooperation by Bank Supervisors. International Lawyer. 24(3). p. 787. Hill, C. 1996. Securitization: a Low-cost Sweetener for Lemons. Washington University Law Quarterly. 74(4). pp. 1061-1026. Hsu, B., D. Arner and Q. Wan. 2007. Policy Functions as Law: Legislative Forbearance in China’s Asset Management Companies. UCLA Pacific Basin Law Journal. 23. pp. 129-171. International Financing Review. 1996a. Asset-Backed Securities - Rose Blooms. 2 November. ———. 1996b. Corporate Loan Securitisation First - The S&P 500 Race. 28 September. ———. 2006. GHB Prepares Asia’s Biggest Securitization. 29 July. ———. 2007a. SIV-lite Downgrades Highlight Rating Fragility. 25 August. 61 ———. 2007b. The Buck Stops . . . . 8 September. International Organization of Securities Commissions (IOSCO) Technical Committee. 2004. Fundamentals of a Code of Conduct for Credit Rating Agencies. Available: http://www.iosco.org/ news/pdf/IOSCONEWS78.pdf. Janger, E. 2004. The Death of Secured Lending. Cardozo Law Review. 25(5). p. 1759. Jobst, A. 2005. The Basle Securitization Framework Explained: the Regulatory Treatment of Asset Securitization. Journal of Financial Regulation and Compliance. (13)1. pp. 15-43. ———. 2006. Asset Securitization as a Risk Management and Funding Tool: What Small Firms Need to Know. Managerial Finance. 32(9). p. 731. ———. 2007. The Economics of Islamic Finance and Securitization. IMF Working Paper WP 07/117. Available: http://www.imf.org/external/pubs/ft/wp/2007/wp07117.pdf. Johnson, C. 1982. MITI and the Japanese Miracle: the Growth of Industrial Policy, 1925-1975. Stanford: Stanford University Press. Kane, E. 2005. Basel II: A Contracting Perspective. NBER Working Paper 12705. National Bureau of Economic Research. Available: http://www.nber.org/papers/w12705. Kapstein, E. 2006. Architects of Stability? International Cooperation among Financial Supervisors. BIS Working Papers No. 199. Bank for International Settlements. Available: http://www.bis.org/publ/work199.pdf. Kaufman, G. 1994. Bank Contagion: A Review of the Theory and Evidence. Journal of Financial Services Research. 8(2). p. 123. Kaufmann, D., A. Kraay and M. Mastruzzi. 2007. Governance Matters VII: Governance Indicators for 1996-2006. World Bank Policy Research Working Paper No.4280. Available: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=999979. Kettering, K. 2007. Securitization and Its Discontents: The Dynamics of Financial Product Development. New York Law School Public Law and Legal Theory Research Paper Series 07/08 # 7. Available: http://ssrn.com/abstract=1012937. Kiff, J. and P. Mills. 2007. Money for Nothing and Checks for Free: Recent Developments in U.S. Subprime Mortgage Markets. IMF Working Paper WP/07/188. Kilner, P., P. Avanzato, L. Oddy and G Hartnett. 2006. Securitization in Japan. In J. Robbé and P. Ali, eds. Innovations in Securitization Yearbook 2006. The Hague: Kluwer. Kingsbury, B., N. Krisch, R. Stewart and J. Wiener. 2005. The Emergence of Global Administrative Law. Law and Contemporary Problems. 68(3-4). pp. 15-62. Krippner, G. 2005. The Financialization of the American Economy. Socioeconomic Review. 3(2). pp. 173-208. 62 Laffont, J. and J. Tirole. 1991. The Politics of Government Decision-Making: A Theory of Regulatory Capture. Quarterly Journal of Economics. 106(4). pp. 1089-1127. Laiou, A. 2002. Writing the Economic History of Byzantium. In A. Laiou, ed. The Economic History of Byzantium: From the Seventh through the Fifteenth Century, Vol. 1. Washington DC: Dumbarton Oaks. Lastra, R. M.. 2006. Legal Foundations of International Monetary Stability. UK: Oxford University Press. Oxford. Lejot, P., D. Arner and F. Pretorius. 2006. Promoting Market Growth with Structured Finance and Regional Credit Enhancement. In D. Arner, P. Jae-ha, P. Lejot and L. Qiao, eds. Asia's Debt Capital Markets: Prospects & Policies for Development. New York: Springer. Lewis, W. A. 1955. The Theory of Economic Growth. London, UK: Allen and Unwin. Liebig, T., D. Porath, B. Weder and M. Wedow. 2007. Basel II and Bank Lending to Emerging Markets: Evidence from the German Banking Sector. Journal of Banking and Finance. 31(2). pp. 401–418. Llewellyn, D. 1999. The Economic Rationale for Financial Regulation. FSA Occasional Paper No. 1, April. Available: http://www.fsa.gov.uk/pubs/occpapers/OP01.pdf. Macey, J. 2006. Commercial Banking and Democracy: The Illusive Quest for Deregulation. Yale Journal on Regulation. 23(1). Packer, F., R. Stever and C. Upper. 2007. The Covered Bond Market. BIS Quarterly Review (September). pp. 43-55. Peterson, C. 2007. Testimony to US Senate Committee on Banking, Housing and Urban Affairs, Subcommittee on Securities, Insurance, and Investment hearing, Subprime Mortgage Market Turmoil: Examining the Role of Securitization. 17 April. Available: http://banking.senate.gov/ index.cfm?Fuseaction=Hearings.Detail&HearingID=256. Plank, T. 2004. The Security of Securitization and the Future of Security. Cardozo Law Review. 25. p. 1655. Polanyi, K. 1944. The Great Transformation. Boston MA, USA: Beacon Press. Posner, R. 1974. Theories of Economic Regulation. Bell Journal of Economics and Management Science. 5(2). pp. 335-358. Prada, M. 2007. Address to European Securitization Forum European CDOs, Credit Derivatives & Structured Credit Products Summit. 7 September. Available: http://www.european securitisation.com/mPradaSeptSpeech.pdf. Qiao L., P. Lejot and D. Arner. Forthcoming. Finance in Asia: Institutions, Markets and Regulation. Oxford. Routledge. Ranieri, L. 1996. The Origins of Securitization, Sources of Its Growth, and Its Future Potential. In L. Kendall ed. A Primer on Securitization. Cambridge, MA: MIT Press. 63 Raynes, S. and A. Rutledge. 2003. The Analysis of Structured Securities: Precise Risk Measurement and Capital Allocation. New York, USA: Oxford University Press. Roe, M. 1994. Strong Managers, Weak Owners: The Political Roots of American Corporate Finance. Princeton, N.J.: Princeton University Press. Royal Government of Cambodia. 2007. Financial Sector Development Strategy 2006-2015. Phnom Penh. Ruggie, J. G. 1982. International Regimes, Transactions, and Change: Embedded Liberalism in the Postwar Economic Order. International Organization. 36(2). p. 379. Rybczynski, T. 1997. A New Look at the Evolution of the Financial System. In J. Revell, ed. The Recent Evolution of Financial Systems. Basingstoke: Macmillan. Scatigna, M. and C. Tovar. 2007. Securitisation in Latin America. BIS Quarterly Review, (September). pp. 71-82. Schwarcz, S. 2004. Securitization Post-Enron. Cardozo Law Review. 25. p. 1539. ———. 2002. The Universal Language of Securitization. Duke Journal of Comparative and International Law. 12. pp. 285-308. Schwartz, A. and J. Watson. 2004. The Law and Economics of Costly Contracting. Journal of Law and Economic Organization. 20(2). pp. 2-31. Scott, R. 2006. The Law and Economics of Incomplete Contracts. Annual Review of Law and Social Sciences. 2(2). pp. 279-297. Securities and Exchange Commission. 2005. Report and Recommendations Pursuant to Section 401(c) of the Sarbanes-Oxley Act of 2002 on Arrangements with Off-Balance Sheet Implications, Special Purpose Entities, and Transparency of Filings by Issuers (submitted to the President of the US, the Committee on Banking, Housing, and Urban Affairs of the US Senate and the Committee on Financial Services of the US House of Representatives). Slaughter, A-M. 2004. A New World Order. Princeton, N.J.: Princeton University Press. Stigler, G. 1971. The Theory of Economic Regulation. Bell Journal of Economic & Management Science. 2(1). pp. 3-21. Stiglitz, G. and A. Weiss. 1981. Credit Rationing in Markets with Imperfect Information. American Economic Review. 79(3). pp. 393-410. Swart, K. 1949. Sale of Offices in the Seventeenth Century. The Hague. Martinus Nijhoff. H. M. Treasury and Financial Services Authority. 2007. Proposals for a UK Recognised Covered Bonds Legislative Framework. Available: http://www.fsa.gov.uk/pubs/cp/cp_bonds_hmt.pdf. Tucker, S. 2007. Asia Crosses its Fingers on Exposure to Subprime. Financial Times. 28 August. 64 Underhill, G. 2006. Theorizing Governance in a Global Financial System. In P. Mooslechner, H. Schuberth and B. Weber, eds. The Political Economy of Financial Market Regulation: The Dynamics of Inclusion and Exclusion. Cheltenham: Edward Elgar. Van Order, R. 2007. On the Economics of Securitization: A Framework and Some Lessons from US Experience. Ross School of Business Working Paper No. 1082. Available: http://ssrn.com/ abstract=1002404. Williamson, O. 2005. Why Law, Economics, and Organization? Annual Review of Law and Social Science. 1. pp. 369-396. Wolf, M. 2007. Unfettered Finance is Fast Reshaping the Global Economy. Financial Times. 18 June. Wood, D. 2005. Governing Global Banking: The Basel Committee and the Politics of Financial Globalization. Aldershot: Ashgate. Statutes and directives European Union:  Capital Requirements Directive (2006/49/EC). 2006.  Consolidated Banking Directive (2006/48/EC). 2006.  Directive on Undertakings for Collective Investment in Transferable Securities (85/611/EEC). 1985. Singapore:  Business Trusts Act 2004 Cap 31A. State of Delaware:  Asset-Backed Securities Facilitation Act. 2003. Del. Code Ann. tit. 6, §§2701A2703A. United States:  Home Ownership and Equity Protection Act 1994. 15 U.S.C. §§1601-1667.  Sarbanes-Oxley Act 2002. 15 U.S.C. §§ 7201 et seq.  Secondary Mortgage Market Enhancement Act 1984. P.L. 98-440, 12 USCS §§1701 et seq.  Truth in Lending Act 1968. 15 U.S.C. §1641. 65 ADB Working Paper Series on Regional Economic Integration* 1. “The ASEAN Economic Community and the European Experience” by Michael G. Plummer 2. “Economic Integration in East Asia: Trends, Prospects, and a Possible Roadmap” by Pradumna B. Rana 3. “Central Asia after Fifteen Years of Transition: Growth, Regional Cooperation, and Policy Choices” by Malcolm Dowling and Ganeshan Wignaraja 4. “Global Imbalances and the Asian Economies: Implications for Regional Cooperation” by Barry Eichengreen 5. “Toward Win-Win Regionalism in Asia: Issues and Challenges in Forming Efficient Trade Agreements” by Michael G. Plummer 6. “Liberalizing Cross-Border Capital Flows: How Effective Are Institutional Arrangements against Crisis in Southeast Asia” by Alfred Steinherr, Alessandro Cisotta, Erik Klär, and Kenan Šehović 7. “Managing the Noodle Bowl: The Fragility of East Asian Regionalism” by Richard E. Baldwin 8. “Measuring Regional Market Integration in Developing Asia: a Dynamic Factor Error Correction Model (DF-ECM) Approach” by Duo Qin, Marie Anne Cagas, Geoffrey Ducanes, Nedelyn Magtibay-Ramos, and Pilipinas F. Quising 9. “The Post-Crisis Sequencing of Economic Integration in Asia: Trade as a Complement to a Monetary Future” by Michael G. Plummer and Ganeshan Wignaraja 10. “Trade Intensity and Business Cycle Synchronization: The Case of East Asia” by Pradumna B. Rana 11. "Inequality and Growth Revisited" by Robert J. Barro * These papers can be downloaded from: (ARIC) http://aric.adb.org/reipapers/ or (ADB) http://www.adb.org/ publications/category.asp?id=2805