Evolution of CDO Market

Good afternoon, ladies and gentlemen.  I am Tay Bee Bee, from the Monetary Authority of Singapore.  I am head of the Debt Market and Treasury Division, which is responsible for the strategic development of the debt capital market in Singapore.   I am therefore pleased to be invited by Derivative Fitch to speak at today’s Global Structured Credit Conference, to share with you our observation and vision of the development of structured credit products in Singapore. 

According to Fitch, structured finance issuance has outstripped corporate issuance for the past 2 years.   Notably, among the various securitized asset classes, Collateralised Debt Obligations, or CDOs have registered the fastest growth in recent years.  In the last 5 years, CDO global issuances have grown more than 6 fold to US$600 billion in 2006, with the market doubling in the past year.  Excitingly, the growth trend in structured finance and CDOs are expected to continue in the next few years.

Allow me to comment on the growth of CDO market along two dimensions.  CDO started out as a domestic instrument in the US, sold to US investors in the 1990s. It was later sold to European investors, which in turn generate demand for European-based CDOs.   US managers set up offices in Europe to manage European CDOs. At the same time, as more CDO expertise and technology were transferred to Europe, we saw the emergence of European managers. Today, we are experiencing a similar phenomenon in Asia.  Asian investors are already strong buyers of both US and European CDOs. In addition, we are seeing a small number of Asian CDO managers issuing deals to international investors.

Another dimension to examine the CDO growth story is in the underlying assets. The list of the types of underlying assets backing CDOs has expanded to include bank loans, emerging market debt, middle-market loans, REITs and asset-backed securities. The development of liquid markets for credit default swaps (CDSs) led to the appearance of synthetic CDOs, which allowed players to gain exposure to credit risk without the need to hold the underlying collateral. In other words, any asset for which there is a regular cashflow or which a synthetic instrument is used to create that cashflow can be put into a CDO.

Asian Structured Credit Market

What does this portend for the Asian markets? As I had mentioned earlier, we strongly believe that Asia will follow the growth path of US and Europe, and that we can expect to see more Asian-based CDOs and securitization deals to surface in the near future.

In my view, there are at least 3 sources of Asian assets, which are potentially large and diverse enough to support CDO origination. 

First, 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.  An increasing proportion of this will 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 in excess of US$1 billion each. This was fuelled by strong RMBS issuance in South Korea as well as CMBS issuance in Singapore.  While we can expect more CMBS issuances out of Singapore, Standard and Poors also anticipates that mortgage corporations in Thailand and Malaysia will issue in the international capital markets to fund the demand for housing finance in their markets.

In the arena of project financing, project bonds are still relatively rare in Asia.  However, we believe this will certainly grow over time.  Asian countries are projected to invest as much as US$250 billion a year over the next 5 years on infrastructure.  With the strong support rendered to the development of domestic bond markets in Asian countries, we believe there will be an increasing role for debt capital markets in infrastructure financing space.

Let me now touch on the next source of underlying assets - leveraged loans. 

There is a surge in leveraged buyout activity in Asia.  In 2006, LBOs in Asia hit a record level of US$22 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 can lay the foundation for an active leveraged loan market, similar to those in Europe and the US. 

The third, and no least important source of underlying assets, is SME loans.

There are a significantly large number of small and medium sized borrowers in Asia, which are often too small to be rated and to access the bond market. However, securitization technologies now allow these loans to be pooled together, and to be repackaged into rated tranches that appeal to and could be sold to international investors.  In Singapore, we had 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. We have also seen similar SME-linked CLOs issued in Malaysia.

While the prospects for the Asian market look promising, the market is not without its challenges.  It is clear to market practitioners that there are a host of issues that need to be addressed in many countries in the region.  These issues would need to be resolved if we were to see explosive growth of structured finance in the region.

One key challenge is that the market is fragmented: in terms of legal framework, currencies, regulatory treatment as well as accounting standards. This complicates the process of managing CDOs with underlying assets across various Asian countries.

Each of these limbs also poses its own fundamental challenge, for instance, the legal environment.  Financial engineering innovations such as the CDO technology can only modify cash flow and risk structures. What it cannot do is to change the legal environment of the underlying assets. If I can illustrate with an example; English law allows the originator to transfer the underlying assets to the SPV by assigning its rights against the underlying debtor to the SPV. However, the laws in some Asian countries are still not clear as to which transfer methods are legally binding, for both domestic and cross-border transfers. The governments in the region recognize this fundamental requirement and are making concerted efforts in improving and harmonizing their respective legal frameworks. 

There is also a lack of technical expertise and understanding of the Asian market by domestic and international players. However, the various players are taking action to mitigate these risks.  Domestic institutions are building up knowledge in the securitization space. Rating agencies are collecting longer data series on default rates and correlation numbers in Asian credits in order for them to better assess the structure of each deal.  International players are also setting up offices in Asia to better understand this region. I think it is only a matter of time before the securitization market in Asia will truly take off.

Implications for Singapore

As the Asian market grows, we can expect to see the risks and challenges faced by the US and European markets replicated here.

What can the authorities do to mitigate these risks? Singapore’s approach is to ensure that our regulatory framework remains appropriate and robust in addressing these market developments.  For example, we have issued banking guidelines with respect to securitization and credit derivatives and we are constantly reviewing the framework to take into account new instruments and financial innovations.

Financial institutions also need to raise their risk management capabilities and oversight to deal with such new instruments.  Hiring the right people will be important, and the MAS is committed to developing the talent pool within the industry.  I will touch on this in more details later.

Our approach has served us well.  Over the last 3 years, Singapore managers originated more investment CDOs than any other country in Asia ex-Japan, with an estimated S$6 billion of CDOs in 2006. In addition, from managing predominantly US-based deals, Singapore managers are now looking at increasing the Asian content in their deals. A number of international CDO managers have also set up shop in here, with the view to manage Asian-based CDOs.

Now, allow me to take a moment to highlight some of the progress we have made in the regulatory regime in Singapore, to keep pace with the market development and growth in structured finance products. 

In Asia, Singapore has been pro-active in providing clarity and certainty on the treatment of CDOs into our regulatory regime.  Banks have been allowed to invest in all tranches of CDOs, while insurance companies have been permitted to invest in the equity tranches of CDOs since January 2006. 

Also, MAS has updated and amended the banking rules on securitization in September 2005.  As an illustration of the amendments, synthetic arbitrage transactions are now clearly excluded from the scope of those rules.  Previously, banks acting as originators or managers in securitisations had to seek MAS’ prior approval for these transactions. With the amendments, they need only notify MAS after the transaction. Banks have welcomed these and other changes to the rules.

Allowing financial institutions to invest in CDOs is, of course, only a first step in facilitating participation in this new asset class.  Another issue is the amount of regulatory capital that banks and other financial institutions are required to hold against the credit exposures they have acquired.

In this respect, MAS has also taken steps to refine the calibration of regulatory capital required for CDO investments.  This was done through recent amendment to MAS Notice 628 to banks.  Previously all CDO investments, regardless of rating, were deducted in full from capital.  With the amendment, tranches rated BBB- and above are risk weighted at 100%.  The treatment is closer to the risk weights under proposed Basel II standardized approach, which applies a 20% risk weight for investments rated AA- and above.  However, even with this adjustment, we are still more stringent than Basel II standards for rated tranches for the time being.   

Manpower Training          

Lastly, I would like to share with you our thoughts on manpower and training.  The availability of skilled professionals for structured finance is crucial and the MAS is committed to developing the talent pool for the industry.  First, we have put in place a Financial Training Scheme.  This scheme provides co-funding for short-term courses or attachments for risk management professionals.

Last year, we also launched the Finance Scholarship Program.   The aim of this program is to help groom a critical mass of specialists in targeted fields, such as financial engineering and risk management. The scheme provides scholarships for the pursuit of higher degrees at top-ranked universities in these fields globally, as well as in Singapore.

These efforts are complemented by efforts undertaken to provide suitable training program for CDO professionals.  An example is the Certificate in Financial Engineering, launched by The Risk Management Institute, in collaboration with the UC Berkeley.    

In conclusion, Asia is entering a very interesting phase in the development of the structured credit market for the region.  We strongly believe in this vision and are committed to building Singapore as a centre for structured finance activities.  We welcome you to be a part of this exciting growth and development. 

Thank you.