Guideline No. 4.6
Supervisory treatment on asset securitisation and mortgage backed securities
In light of recent enquiries on the Hong Kong Monetary Authority's supervisory policy towards asset securitisation and mortgage backed securities (“MBS”), I enclose a copy of the policy guidelines that set out:
1. the supervisory tests applied to asset securitisation schemes to decide if the assets concerned can be excluded from the seller's balance sheet for capital adequacy purposes (Annex 1); and
2. the criteria for MBS to qualify for a 50% risk weight (Annex 2).
These guidelines are developed on the following bases:
1. the principal requirements for asset securitisation set out in the Annual Report of the Commissioner of Banking of 1990;
2. the regulatory treatment of MBS endorsed by the Informal Group on Secondary Mortgage Market in 1995. (The Informal Group was chaired by the HKMA and represented by financial institutions which are active participants in the MBS market); and
3. the relevant supervisory policies adopted in other financial centres and the recent developments in the local MBS market.
They will be kept under review and may be modified in the light of experience. Authorised institutions intending to conduct any securitisation transaction should inform the HKMA of their intention well in advance. To determine whether the assets have transferred in the form of a “clean sale”, the HKMA will assess, among other factors, the extent to which the seller has retained an ownership interest in the assets. For example, the HKMA will examine the extent of recourse to the seller for default assets and the subordinated interest retained by the seller. If an institution cannot clearly demonstrate that all responsibility for loss has been removed, then the assets will remain on balance sheet for capital adequacy purpose – even if the assets are regarded as being off balance sheet for statutory accounting purposes.
An institution may undertake the role of servicing the pool of assets held under the securitisation scheme. Significant operational risk can attach to the continuing administration of the assets. The HKMA, in giving its approval for such a securitisation scheme, will need to be satisfied that the institution’s systems are adequate to meet its obligations as a servicing agent.
It is the Monetary Authority’s view that the concessionary risk weighting of 50% should not be applied to the subordinated tranches of any MBS issue. The purpose of subordinated tranches of MBS is to absorb the credit losses which may arise in the mortgage portfolio which support the MBS. They should accordingly be weighted at 100%. The Third Schedule to the Banking Ordinance was amended in July 1996 to clarify this.
I also wish to confirm that, in assessing authorised institutions' aggregate property lending, the HKMA will take into account their holding of mortgage backed securities, originated by either authorised institutions or non-authorised institutions such as property developers.
Updated on 30 Aug 1997
Principal requirements for assets the subject of a securitisation transaction to be excluded from a seller's capital adequacy ratio
The HKMA will apply the following tests to a transfer of assets in connection with a securitisation transaction to determine if the assets concerned can be excluded from the seller's capital adequacy ratio:
(a) The offering documentation must state clearly that the seller is not liable for any losses and does not stand behind the buyer to whom these assets are transferred ("issuer"). The HKMA will look for the availability of legal and auditors' opinions on the transaction to ensure that they are satisfied that the seller is not liable to investors.
(b) The ownership and the name of the issuer must be entirely independent of the seller. The issuer should have independent directors, although the seller may appoint one director.
(c) Any documents relating to the transfer of interests in mortgage loans and related security should be sent to the Collector of Stamp Duty for adjudication pursuant to section 13 of the Stamp Duty Ordinance (Cap. 117).
(d) The transfer of assets from the seller must not contravene the terms and conditions of any underlying agreement governing the assets and all necessary consents should be obtained to make the transfer fully effective.
(e) The seller must be under no obligation to repurchase any assets except where the obligation arises from a breach of the warranties given in respect of the nature of the assets at the time of their transfer. The seller may not give a representation and warranty in respect of the future performance of the assets. The seller may, however, retain an option to repurchase fully performing assets where such assets have fallen to 10% or less of the original amount sold to the issuer. In addition, the seller may repurchase fully performing assets after the issue of the securities by the issuer for the purpose of providing further advances to the borrowers concerned.
(f) Any losses must be borne by the issuer and thus ultimately by investors. The seller should not provide any credit enhancement except that it may make a one-off subordinated loan to the issuer for the establishment of a reserve fund. The subordinated loan should not be repaid during the life of the securitisation transaction unless such repayment has been clearly provided for and stated in the offering documentation. For capital adequacy purposes, the subordinated loan should be deducted from the seller's capital base. The deduction will be capped at the amount of capital the institution would be required to hold in providing a direct credit substitute covering the full value of all securities issued by the issuer.
(g) The seller must not have committed itself to purchase securities prior to the initial issue of such securities by the issuer except where the obligation to purchase is under an underwriting commitment which has been approved by the HKMA (i.e. as provided for under paragraph (h)). Sellers should also not be involved in making a market in such securities by committing themselves to quote two way prices. However, the seller or any of its group companies may purchase senior securities issued by the issuer at market prices for investment or hedging purposes. Such purchase will be subject to a limit of 5% of the original amount of issue.
(h) Subject to the prior consent of the HKMA, the seller or any of its group companies may underwrite the issue of securities by the vehicle on an arm's length basis. The holding of any subordinated notes by the seller as a result of the underwriting will be deducted from the seller's capital base and subject to the cap mentioned under (f) above. A timetable for the disposal of any subordinated and senior notes held arising from an underwriting commitment should be discussed with the HKMA.
(i) The seller must not bear any of the recurring expenses of the transaction or fund the issuer (except in the case of a subordinated loan mentioned in (f) above) e.g. it must not provide temporary finance to cover cash shortfalls arising from delayed payments or non-performing assets.
(j) There can be currency/interest rate swap arrangements between the seller and the issuer for the purpose of enabling the issuer to hedge currency and basis risk. However, it is a condition that the swap is entered into at market rates and that, notwithstanding the swap, the auditors are prepared to treat the securitisation as "off-balance-sheet".
2. The objective of the HKMA is to ensure that the transfer of assets in effect transfers all rights and obligations of the seller to the buyer and that the buyer has no recourse to the seller for losses. If the HKMA is not satisfied that this objective is achieved, the securitisation transaction will be regarded as a financing transaction rather than a sale of assets. If there has not been a clean sale, the seller must reflect the underlying assets on its balance sheet for capital adequacy purposes and risk-weight such assets accordingly.
3. An authorised institution may provide credit enhancement facilities to support a special vehicle established by a third party. Where such facilities are provided to bear more than a pro rata share of the risk associated with the assets held by a special purpose vehicle, the institution will be required to deduct the amount of the facility from its capital base for capital adequacy ratio purposes. The deduction will however be subject to the cap mentioned under (f) of paragraph 1 above. For example, the granting of a subordinated loan to a special purpose vehicle may be subject to this treatment. The HKMA will need to assess, on a case by case basis, as to whether the facility should be regarded as a credit enhancement and if so, whether the treatment of deduction is appropriate.
4. Authorised institutions intending to conduct any securitisation transaction should inform the HKMA of their intention well in advance.
Criteria for mortgage-backed securities (MBS) to obtain the 50% risk weight under the capital adequacy ratio regime
The risk weight assigned to an asset-backed security depends on the nature of the assets that comprise the collateral pool. For a securitisation transaction involving residential mortgages to be eligible for a 50% risk weight, the HKMA must be satisfied that the following criteria are met :
(a) The residential mortgage loans underlying the mortgage-backed securities (MBS) must satisfy the criteria set out in the Third Schedule to the Banking Ordinance (Cap. 115). These refer to a mortgage in respect of which :
(i) the borrower is an individual;
(ii) the principal sum does not exceed 90% of the purchase price or the market value of the property, whichever amount is the lower;
(iii) the debt is secured by a first legal charge on the property; and
(iv) the property secured by the charge is used as the borrower's residence or as a residence by a tenant of the borrower.
(b) The MBS should be fully secured at all times against residential mortgage loans which meet the conditions set out in item (a) above.
(c) The mortgage loans must not be in default at the time at which they are transferred to the issuer.
(d) The issuer of the MBS must be a special purpose vehicle which is entirely independent of the seller. The vehicle's activities are restricted to solely that of issuing the securities and incidental activities. The vehicle may only hold assets qualifying for a risk weight of 50% or less.
(e) The documentation
(i) gives the investors adequate remedies in the event of a default by the issuer; in particular investors or their trustees or agents should be able to initiate legal proceedings directly against the issuer.
(ii) creates adequate security over all of the issuer's assets and undertakings in favour of the investors or their trustees or agents.
(iii) contains provisions which would ultimately enable investors to acquire the legal title to the security (i.e. the mortgagee's interest in the underlying mortgage) and to realise security in the event of a default by the mortgagor.
The issuer should obtain legal advice to the above effect which is made
available to the HKMA.
(f) The documentation must not provide that the investors will absorb more than their pro rata share of losses in the event of arrears or default on payment of interest on, or principal of, the underlying mortgage loans.
2. An institution's purchase of subordinated debt in a multi-class issue at market prices for investment purpose should be risk-weighted at 100% rather than 50%. Where the purchase is regarded by the HKMA as a form of credit enhancement facility to the issuer, the holding arising from the purchase may be required to be deducted from the institution's capital base (see paragraph 3 of Annex 1).