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May 21, 2004
Bank of Japan
Financial Markets Department
Secretariat of the Workshop on Securitization
Securitized products have characteristics that make it possible to mitigate risks through the effects of diversification of underlying assets and to attract investors with various risk preferences. Consequently, the development of a well-functioning securitization market should strengthen the financial infrastructure of the Japanese economy.
Recognizing the critical importance of this, the Bank of Japan launched the Workshop on Securitization with market participants representing diverse viewpoints in November 2003. At the Workshop, we conducted a comprehensive review of the securitization process such as originating underlying assets, issuing securities, and trading in the secondary market. We also identified practical issues related to the securitization market and explored possible solutions. The Workshop worked under subgroups and working groups, and endorsed this report at the final meeting in April 2004.
Securitization technology provides firms and households with new financing channels. At the same time, securitization products offer additional flexibility to investors, so that they can select portfolios that better reflect their risk preferences. A vibrant securitization market should also encourage a better balancing of risks and returns in financial transactions including lending. This should invigorate Japanese financial institutions as new kinds of business and frontiers in financial technology begin to emerge. Furthermore, the stability of the Japanese financial system should be enhanced with the development of financial intermediary channels that can complement lending by financial institutions.
Notwithstanding such significant benefits of the development of the securitization market, there remain a number of issues that must be resolved before the market can function efficiently. This is evident from the fact that, although securitization has steadily gained acceptance in Japan since the late 1990s, the size of the primary market remains small and the transaction volume in the secondary market is limited.
In order to price securitized products properly, more information should be made available. Specifically, the following ideas were put forward in the course of discussion. First, a public-sector entity should periodically compile a list of new issues to deal with the recent increase in private issues, for some of which even the fact of their launch is not disclosed. And second, a standardized list and a model format for information disclosure should be made to deal with the situation where it is difficult to obtain information about product prices and also information necessary for proper evaluation of each product.
In order to price securitized products appropriately, it is also necessary to further improve quantitative methods of analyzing the risk of underlying assets. Based on the analysis of multi-seller collateralized loan obligations (CLOs), combined use of multiple criteria, as in, for example, the credit scoring model, was proved to be effective in improving filtering of underlying pools of assets. It was also confirmed that such methods should be repeatedly tested by checking the historical performance of underlying assets.
Three major issues relating to reducing transaction costs were raised in the discussion.
First, costs associated with the physical transfer of underlying assets should be reduced. Major sources of such costs are: (1) fraud and dilution risk; (2) the prohibition-of-transfer clause embedded in the underlying asset contract; and (3) large administration costs required to complete the transfer. The Workshop participants generally agreed that it was important to gain public acceptance of financing through sale of assets and not to generate reputational risk for sellers. On this basis, the Workshop participants discussed the following measures in particular: (1) designing the underlying asset contract to permit straightforward transfer; (2) structuring credit enhancement based on the historical performance of underlying pools of assets; (3) advising the public sector to remove the prohibition-of-transfer clause from generic credit contracts to which the public sector is the counterparty; and (4) making on-line search of previous transfer registrations available.
Second, special purpose vehicles (SPV) should be arranged with more flexibility in order to facilitate sequential multiple issues from a single special purpose company (SPC). It was suggested that the effectiveness of the "limited recourse clause" in the event of a SPC default should be legally confirmed, and more effective ways to collateralize underlying assets should be sought. Also, the following issues were discussed in relation to the need to improve liquidity of trust certificates: the standardization of sales procedure; recharacterization of trust certificates as securities in law; and a review of withholding tax levied on a special purpose trust.
Third, risks generated by servicers should be reduced. Among them, repayment risk in the event of the servicer's default due to commingling of collected cash with its own funds was highlighted. There were discussions about solutions such as segregation of collected cash in a bank account in the name of the SPV or an exclusive account in the name of the servicer and introduction of a framework for activating the back-up servicer smoothly.
It is strongly hoped that receivables will become a means of financing for small and medium-sized firms. In securitizing receivables, 100 percent of the dilution risk of underlying assets has been covered by credit enhancement measures provided by banks. However, as banks elaborate their risk management, the need to introduce new measures is pointed out. Specifically, the effectiveness of the following measures was discussed: designing underlying assets so as to enable straightforward transfer; making direct payment of collected cash into a bank account in the name of the SPV in order to minimize the commingling risk; and structuring the "non-support"-type ABCP based on historical performance data of the pools of underlying assets.
Securitization of CLOs is expected to benefit financial institutions by enabling them to select best performing portfolios, achieve more efficient allocation of their capital, and promote pricing of bank loans at a properly credit-risk-adjusted level. Participants at the Workshop confirmed that it was important to improve information disclosure and further improve methods of analyzing the risk of underlying assets in order to invigorate the CLO market and reduce risk inherent in CLOs. There was also a view that the accounting treatment of synthetic CLOs with embedded credit default swaps (CDSs) should be clarified.
Residential mortgage loans are suitable for securitization, given their characteristics such as large outstanding amount, homogeneity, and long maturities. It is therefore quite possible that the RMBS market will grow approximately to the size of the Japanese government securities (JGS) market. The Government Housing Loan Corporation (GHLC) mortgage loan purchase program is expected to become a benchmark product in the RMBS market. In order to increase the volume of arrangements for such a program, the GHLC may need to gradually withdraw from the conventional mortgage lending business. Also, it was confirmed that the schemes of mortgage contracts offered by private financial institutions needed to be modified in order to securitize them more efficiently, and to facilitate origination of collateralized mortgage obligations (CMOs) and the repo/forward market to encourage active trading in the secondary market.
The Bank of Japan, taking into consideration the discussion at the Workshop, decided at the Monetary Policy Meeting on January 19 and 20, 2004 to amend the terms and conditions for the outright purchases of ABSs. The following points were amended: the criterion regarding the ratio of underlying assets related to small and medium-sized enterprises; the criteria concerning debtors' creditworthiness with regard to underlying assets; rating requirements; and the frequency of selection of counterparties to this operation. As a result of these amendments, the amount of securities eligible for purchase has increased.
The Bank will start a Survey on the Securitization Market and release the results periodically. The Bank will ask arrangers/sponsors and rating agencies to report monthly new issues of bonds, trust certificates, and CP, all of whose underlying portfolio consists mainly of domestic assets. The report for ABCP will be program-based and will be made semi-annually. The Bank decided to conduct the survey based on discussions held with various market participants, after recognizing the need to disclose more information and receiving requests for such a survey from participants of the Workshop. The Bank will start releasing the results of the survey as soon as they are ready. The survey conducted by the Bank is expected to contribute to improving the information infrastructure and thereby achieve more efficient trading of securitized products. The Bank regards the survey as a temporary measure providing catalyst for the development of the Japanese securitization market. The Bank will terminate the survey at the end of March 2006, when it terminates its purchase of ABSs, and allow some private organization to take it over.
Based on the discussion at the Workshop about reduction of costs involved in transfer of underlying assets, the Bank plans to remove the prohibition-of-transfer clause in the contracts such as those regarding the Bank's accounts payable and other types of credit with a notional amount of 5 million yen or above. The Bank will permit the transfer of such credit to SPCs and qualified institutional investors under certain conditions. Similar action has been taken also by several ministries of the government and it is hoped that others will follow suit.
The Bank of Japan hopes that practical problems and their possible solutions identified in this report will be a milestone in promoting sound development of the securitization market. The Bank believes that the Workshop has contributed to establishing a basis for mutual trust and cooperation among a wide range of market participants, which we believe is critical for the continuation of work aimed at fostering the market.
The Bank continues to commit itself to support initiatives taken by market participants in line with the deliberations of the Workshop, and hopes that their efforts will result in further development of the market.