Opening Address by Mr Heng Swee Keat, Managing Director of the Monetary Authority of Singapore, Singapore Structured Credit Conference – CDO and ABS Asia Pacific 2007, 25 April 2007
1 Good morning, and to our overseas guests, may I extend a very warm welcome to Singapore.
2 I am pleased to address this gathering of all the key players in this rapidly growing area of structured credit. I understand that there are more than 800 attendees at this Singapore Structured Credit Conference, making this the largest ever for a structured credit conference in Asia. This reflects the strong and growing interest in this area.
3 Given the rapid developments, it is important to have an annual event, where regulators, investors, originators, managers and intermediaries can gather and exchange views on the latest market developments, the opportunities and the risks. I congratulate Pinnacle, the organizer, as well as all the sponsoring banks, investment managers and participating institutions for the success of this event.
Evolution of CDO Market Globally
4 According to Fitch, globally, structured finance issuance has outstripped corporate bond issuance for the past 2 years. Of this, Collateralised Debt Obligations, or CDOs have registered the fastest growth in recent years. In the last 5 years, global issuances of CDOs have grown more than 6 fold to US$600 billion in 2006, with the market doubling in the past year alone.
5 The CDO market has expanded across regions. When CDOs started in the US in the early 1990s, it was a largely US centric-market – US investors, US managers and US underlying assets. In the late 90’s, the market expanded to Europe. At first, it was just European investors buying US-managed CDOs of US assets. Then, European managers started issuing their own CDOs. Subsequently, as the leveraged loan market in Europe grew, CDOs with European assets emerged and surged. Last year, European CDOs tripled in size to more than US$200 billion.
Growth of CDO Market in Asia
6 Estimates of the size of Asia’s structured credit market today range from about US$70 billion to US$100 billion, mostly dominated by CDOs. The market is also evolving rapidly as new assets, new structures and new participants emerged.
7 The conditions in Asia are conducive for a similar growth trajectory as in the US and Europe. On the demand side, Asians are high savers, with both institutional funds and private wealth growing rapidly. To diversify and to seek higher yields, their investment universe has grown to encompass a range of high yield products and credit spectrum. Already, Asian investors are significant buyers of both US and European CDOs. In addition, non-Asian investors are also showing greater interest in Asian assets, to diversify from the more developed markets.
8 On the supply side, there are already a number of Asian-based CDO managers. Last year, Singapore-based managers issued US$6 billion of CDOs. Following the trend in Europe, we are likely to see, in the next phase, managers originating CDOs using Asian assets. While the large amount of liquidity in the banking system might slow the development of the debt capital markets in Asia, this is likely to change. A greater focus on risk-adjusted returns, stimulated in part by the implementation of Basel II, will induce banks to shift to a more accurate mapping of capital to asset risks. Commercial banks will gradually shift from balance-sheet income to more fee-based income. Investment banks, of course, will continue to promote the use of the capital markets. All these will spur a greater use of capital market instruments like CDOs and ABS.
9 Typically, loans that are least attractive for intermediation through the banking system, and thus, most amenable to capital market solutions, are those which are either very large or very small. On the large end of the scale are real estate and infrastructure loans. With strong growth and rapid urbanization, Asia will need to undertake large amounts of fixed investments over the next decade, particularly in real estate and infrastructure development. As the size of such deals grows, an increasing proportion will need to be securitized. Last year, over half of Asia ex-Japan’s cross-border securitization issuance was in mortgage-backed securities, with a number of mega deals exceeding US$1 billion each. This was fuelled by strong RMBS issuance in South Korea as well as CMBS issuance in Singapore. While infrastructure project bonds are still relatively rare, they will certainly grow over time.
10 Another source of large loans is leveraged loans. There is a surge in leveraged buyout activity in Asia. In 2006, LBOs in Asia reached US$30 billion, more than double the level in 2005. This year, with more private equity funds focusing on Asia, LBO activities are expected to grow further. This could stimulate the growth of the leveraged loan market.
11 On the other end of the scale, there are a large and growing number of small and medium sized borrowers in Asia, which are currently under-served by banks. Individually, these are often too small to be rated and to have access to the bond market. However, these loans may be pooled together to be securitized into rated tranches that appeal to a large investor base. In Singapore, we have launched the SME Access Loan Scheme to help Small and Medium Enterprises (SME) gain greater access to the capital markets by issuing bonds backed by SME loans. Similar schemes are present in Malaysia and Taiwan.
Implications of the Growth of the CDO market
12 From a regulatory perspective, the growth of the Asian CDO market brings benefits in enhancing the depth and efficiency of the market. But it also raises risks to financial stability.
13 By reducing market segmentation, CDOs raise the efficiency of markets. For instance, investors of high grade instruments can now have access not only to high grade issuers, but also to the senior tranches of high yield or leveraged loan CDOs. While investors get a wider range of products, borrowers get to enjoy lower costs of financing.
14 Moreover, by spreading credit risks from the banking system to a wider pool of investors, CDOs could reduce the impact of a single default on the entire financial system, and contribute positively to financial stability.
15 In the Asian context, both these benefits are especially important, as capital markets are less developed and most debt financing still take place through bank loans.
16 But there are also risks. Some participants have expressed concerns that yields and volatilities which are at historically lows might have led to the under-pricing of risks. Investors now have greater risk appetite and are more aggressive in their search for yields. If such risk appetite changes abruptly, there would be sharp price corrections.In such a scenario, as CDOs are relatively new and complex instruments, the liquidity and market responses may be difficult to predict. Others are, however, more sanguine. They point to the test that the market went through in 2002, and more recently in the US sub-prime shock. The jury is still out on this, and central banks and regulators have expressed different views. In the absence of clear evidence, it is prudent to remain vigilant and to guard against complacency, especially against tail events.
17 In the Asian context, judgment on the proper pricing of assets is harder because capital restrictions in several jurisdictions, may have led to a bias towards domestic assets. This might be accentuated by the limited availability of public information like default probabilities, recovery rates and correlation factors, thereby making the proper assessment of risks difficult.
18 This is not unexpected, given the relatively short history of Asia’s capital markets, which mostly began after 1997. Certainly with time, we should accumulate more data that span a few credit cycles to make better decisions. In the meantime, market participants will have to rely heavily on their own judgment to price their deals.
19 Another potential risk is market infrastructure, which may not have kept pace with the rapid growth of the market. The credit default swap (CDS) market was a case in point. Last year, the New York Fed and the UK FSA raised the issue of settlement backlogs for CDS transactions. Since then, I am glad to see that many measures have been taken to resolve this backlog. The supporting infrastructure is critical, especially in times of stress.
20 How should central banks and regulators react to these risks? In my view, the appropriate response is not to stop or try to slow the pace of development. Instead, we should ensure that the basic supporting structures of the market are sufficiently robust to allow for more accurate asset pricing and to withstand systemic fallouts.
21 Specifically for the CDO and ABS markets in Asia, there are 3 areas that warrant attention. First, the legal frameworks in each market. Financial engineering may alter the look or feel or a CDO or ABS, but ultimately, it is still a legal contract between creditors and debtors. This contract must be enforceable through a court of law. Creditors must be able to take possession of the collateral should a default occur. In this regard, investors will need to consider the legal and regulatory framework in the countries. These framework are evolving, and would, I hope over time, give greater assurance to international investors.
22 Second, developing the depth of talent and expertise. To sustain growth, the level of expertise in the industry must grow in tandem with the increasing complexity of the products. This applies not only to the front office, but also to the mid and back offices, as well as to key service providers like rating agencies, custodians, and accountants.
23 The third area is risk management. As instruments become more complex and customized, and by extension less transparent and liquid, managers, intermediaries and end-investors must have the system and expertise to understand and manage these risks. As an illustration, the US sub-prime shock last month uncovered a number of gaps. Investors might have been overly complacent in presuming that sub-prime originators would carry out the necessary due diligence when they grant loans. Structuring banks may have under-estimated the risks of warehousing the inventory. Investors who have used index swaps to hedge their positions found that the hedge might not have worked as well as they had assumed. In distressed situation, the performances of the indices and the securities could diverge at the time when the hedge is needed most.
24 Our basic regulatory approach here is to recognise the value of structured credit and CDOs, while managing the risks. These innovations serve a useful market purpose and as regulators, we have to take a proactive stance to understand this development and to craft our regulatory approach appropriately.
25 At the industry level, we continue to work on having a regulatory framework that remains suitable and robust in addressing market innovations. For example, we have issued guidelines with respect to securitization and credit derivatives; and we will continue to review the framework to take into account new instruments and financial innovations. At the institutional level, we are working with the institutions we regulate to build up the necessary capacity to manage their risks and to have adequate capital to absorb losses, not just for normal market conditions but also for extreme situations.
26 Both of these prongs need to be underpinned, of course, by growing the expertise and talent pool to manage these innovative structures. On our part, the MAS is committed to developing the talent pool for the industry. Apart from welcoming talent from all over the world, we are working closely with industry players and training providers to develop a critical mass of specialists in areas like structuring, asset management and risk management.
27 In conclusion, I believe that the Asian structured credit market is at the start of an exciting phase of growth. Opportunities abound – for issuers, investors, managers and banks. However, as we harness these opportunities, I would urge market participants to put effort into building the foundation for the market. This will sustain the market’s growth for the future. On that note, I wish you a very successful and fruitful conference.