The Enlarged Applicability of

- 7 -

Structured Financing in Korea

Whon Il Park*

*) Ph.D. in law, Asst. Professor of Kyung Hee University

Ever since the Korean government introduced asset-backed securities (ABS) in 1998 by legislating the ABS Act (promulgated on September 16, 1998, and amended from time to time) to overcome the unprecedented financial crisis, the ABS market in Korea has been increasingly expanded. In 2000, public offerings of ABS reached 41 trillion Won, taking 69.9 percent of the total publicly offered corporate bonds. The most remarkable instance is the recently floated ABS-type bonds backed by the assets related with the Chunan-Nonsan Expressway (under construction), whose aggregate principal amount is 730 billion Won and maturity spreads from five to 15 years.

The various advantages of the ABS Act enable financial institutions and business entities to securitize their assets including distressed loan portfolios and real estate backlogs at a competitive cost. This is because the ABS Act does not confine the assets eligible for securitization to specific types, and provides for some exceptions in the registration of real estate transactions. Also the Korean tax laws afford considerable tax benefits to the ABS players.

Bankruptcy Remote Purpose of Structured Financing

The ABS Act allows qualified asset owners, or originators, to transfer assets such as claims, account receivables, real estate and other property rights, that are deemed to generate cash flow, to a special purpose company or a trust company (collectively referred to as the "special purpose vehicle" or "SPV"), and the SPV to float securities backed by such assets. The SPV is required by the ABS Act to register with the Financial Supervisory Commission (FSC) a securitization plan and the transfer of assets, respectively, in order.

Accordingly, a huge amount of non-performing assets owned by Korean financial institutions could be securitized through the SPV, thus improving liquidity and the financial ratio demanded by the Bank for International Settlements (BIS).

The ABS Act also provides that the transfer of assets to an SPV must satisfy certain conditions, under which such a transfer is deemed a true sale rather than a secured borrowing. In other words, a defined group or pool of assets can be structurally isolated, and thus serve as the basis of financing that is independent from the bankruptcy risks of the originator. Thus, ABS is often called structured financing, and the isolation from the originator's bankruptcy is legally termed as "bankruptcy remote".

Brief History

The initial type of asset securitization is mortgage-backed securities issued by the U.S. Government National Mortgage Association (GNMA) in 1970. The securities were modified pass-through certificates representing undivided ownership interests in a fixed pool of GNMA-guaranteed residential mortgage loans. In the early 1980s, securitization of non-mortgage assets flourished.

In 1985, Sperry Corp. created an SPV and sold operating leases for computer equipment to its newly-formed subsidiary, which in turn issued lease-backed notes. The transaction was rated "AAA", despite Sperry's lower rating. In 1986, investors' appetite for ABS expanded to include auto loans and credit card receivables. The structured financing market was soon wide open to all types of assets whose cash flows were fit for pooling and securitization.

<Figure 1>            Mechanism of Asset-backed Securitization

□□□□□□□□□□□□□□    True Sale    □□□□□□□□□□□□□□□□□

□ Originator □                 □Special Purpose□

□ & Servicer □                 □   Vehicle     □

□□□□□□□□□□□□□□      Funds      □□□□□□□□□□□□□□□□□   □□□□□□□□□□□□□□□□□□□

□ Credit Enhancer □

Asset-             □□□□□□□□□□□□□□□□□□□

Asset                  Backed       Credit

Management & Disposition     Securities      Rating

□□□□□□□□□□□□□□□□

□  Investors   □

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Structure and Parties

Parties involved in a structured financing typically include:

- An originator that has financing needs and assets capable of serving as the basis for structured financing;

- One or more entities, or SPVs, specially created to be bankruptcy remote from the originator. The securities that are issued by these entities are called asset-backed securities;

- One or more financial institutions, or credit enhancers, that provide credit enhancements for transferred assets or for ABS directly;

- Servicer that monitors the assets, collects their cash flow, and ensures that such cash flow is properly distributed;

- Liquidity provider that supports structured financing by providing liquidity to avoid mismatches between the receipt of cash flow from the assets and the payment dates on the asset-backed securities;

- Where the asset-backed securities are being distributed in the public capital markets, one or more underwriters that purchase and distribute the securities issued in the course of structured financing;

- One or more credit rating agencies that rate ABS on the basis of the credit quality of the assets and the structural elements of the financing; and

- Investors who are willing to purchase ABS.

Advantages and Disadvantages

If an entity has assets that can be segregated legally, it could use such a structured financing scheme to obtain funds which are otherwise available at a great cost or unattainable. The principal benefits of structured financing are increasing availability of funds and a reduction in the cost of financing. Not only is the credit rating of the financing likely to be enhanced, but the cost of the financing in the capital markets may be considerably smaller than that of comparable financing like bank loans.

The ABS transactions may permit off-balance sheet financing - both the assets and the source of funding are removed from the balance sheet - and thus improving somewhat the BIS capital adequacy ratio. Moreover, structured financing can effectively transform future or conditional cash flow into liquidity available right now. In legal terms, covenants and warranties in structured financing are generally less restrictive in relation to the parties benefiting from the financing than those, for example, engaged in bond issuance.

On the other hand, a secured financing transaction is complex to implement. In addition, a number of parties are involved in the transaction. Therefore it would cost too much for an originator to securitize a relatively small amount of assets. Structured financing may lead to legal entanglement in that the transfer of assets might be regarded as grant of security rights, since the originator violates the negative pledge in its loan agreement. Interested parties with unsecured claims are suspicious of the ABS scheme because general collateral less the to-be-securitized assets runs short of their expectations of the collateral value of the borrower-originator.

Based on the aforementioned merits, Thailand and Japan, among others, have adopted ABS legislation to facilitate the securitization of non-performing assets of financial institutions and business entities. Such laws have helped enterprises saddled with non-performing assets to solve liquidity problems and improve their financial conditions.

Enlarged Applicability of ABS in Korea

Real Estate

Since Korean banks prefer collateral like real estate, most of their loan portfolios have been secured by real estate. In the face of the deterioration of commercial and residential real estate following the financial crisis, financial institutions turned to structured financing to rid balance sheets of mispriced assets.

Though real properties produce little cash flow in a period of business slowdown, owners of non-performing real estate loans make securitization possible by buying back subordinated bonds issued by the SPV. It ensures the SPV to secure the funds for repayment.

For the efficient liquidation of distressed assets, qualified servicers specialized in real estate management and disposition are necessary.

<Figure 2>

ABS Issuance in 2000

By Assets

By Originators2)

Source: Financial Supervisory Service at http://www.fss.or.kr>

Note 1. The total aggregate principal ammount in 2000 was KRW49 trillion 333 billion.

2. On the basis of the aggregate principal ammount.

By Assets	By Originators
S-CBO 41.4% P-CBO 14.8% NPL 20.9% Card Loan & Lease Receivables 11.3% MBS 2.8% Real Estate 2.4% Apt. Installment 2.0% Credit Card 1.7% Equity 2.1% Others 0.6%	Investment Trust Cos. 36.5% Securities Cos. 17.6% Banks 12.3% Credit Specialized Financial Cos. 12.3% Insurance Cos. & Merchant Banks 2.2% Other Financial Institutions 3.6% KAMCO 9.8% Deposit Insurance Corp. 1.1% Other Public Corporations 2.7% General Cos 1.9%

Primary CBO

With the financial crunch caused by the Daewoo debacle prevailing in the capital markets in 1999, small businesses with an ordinary credit standing have difficulties in raising funds. So the government authorities have allowed primary collateralized bond obligations (CBOs).

First, the small companies issue corporate bonds with a credit rating under investment grade. Then securities companies underwrite the whole corporate bonds and sell them to the SPV. Finally, the SPV floats primary CBOs with top quality credit rating, backed by cash flows from the underlying corporate bonds, with an appropriate credit enhancement.

It should be noted that such primary CBOs took the lion's share in the primary bond market in the year 2000. Until the end of December 2000, primary CBOs tapped the market totalling 27,723 billion Won. In terms of the aggregate amount, two thirds of asset-backed securities derived from corporate bonds,  and conventional assets like non-performing loans (21%) and real estate (4%) followed. It showed a sharp contrast from the scene of 1999 when real estate took the lead (43%) followed by non-performing assets (32%).

Future Cash Flow

In December 2000, the Ministry of Finance and Economy decided not to differentiate the future cash flow in ABS structuring. Until then the government authorities was hesitating in allowing such a new scheme.

The first and foremost beneficiaries are credit card companies, department stores, apartment construction companies and so on. They could raise few funds in the 'flight to quality' bond markets. So business entities with sufficient account receivables are expected to turn to securitization by designating a special account for the pooling of account receivables and revolving the underlying assets which will be registered at the FSC.

Project Financing

As a non-recourse financing, structured financing is similar to project financing in that both require the creation of an SPV and initially look to cash flow. The former demands securitization through an SPV while the latter calls for financing of a particular project in which a lender is satisfied to look initially to cash flow and earnings of the project as the source of funds for repayment of the loans. So the project financier is restricted and sometimes not allowed, to seek recourse from the sponsors or contractors in the event that the project fails to generate sufficient revenues. That is why project financing is usually called non- or limited recourse financing.

As exemplified by the Chunan-Nonsan Expressway (CNE) bonds issued at the end of February 2001, ABS-type bonds are tapping the capital market for the financing social overhead capital (SOC) build-up. In this case, the Korea Development Bank (KDB) originally extended a 730 billion Won loan to the Chunan-Nonsan Expressway Co., Ltd., a project company, and KDB transferred the whole loan portfolio to an SPV which, in turn, floated AAA/AA+ ABS-type bonds of the same amount, in other words, collateralized loan obligations (CLOs).

Until now, there have been few cases in which SOC bonds are offered to the public for sale and distribution, since projects with considerably high risk would not generate sufficient cash flow. Credit rating agencies are reluctant to give them an investment grade. Only projects equipped with stable future cash flow or government support are eligible for public offerings.

First, a proposed project shall be feasible in both technical and financial terms. The lender looks to the project structure to see if it is conducive to the preservation of its legal rights and the repayment of the loan and, accordingly, acceptable to the lender. This is called "bankability," a deal-specific concept. For example, if banks should take the risk of a change in law or if sponsors might extract distributions prior to the first repayment date, that project becomes "unbankable" to lenders.

The next question is who will commit a huge amount of money on a long-term basis to the project companies that construct or rebuild, for example, SOC facilities.

In conclusion, an ABS scheme could be applied to project financing by:

- securitizing the loan portfolio of project financiers in general, like the CNE structured financing; or

- securing cash flow directly from a project if the revenues from the project are set aside to ABS holders.

Applicability of ABS in the Development of North Korea

Since the historic inter-Korean summit in June 2000, in-depth research on potential economic cooperation between South and North Korea has started. As North Korea is in great need of SOC investments, how to mobilize financial resources for the development of the North is one of the top priorities on the agenda.

In order to facilitate the economic development of North Korea, project financing is often seen as an efficient financial tool. Both structured financing and project financing will be properly arranged to rehabilitate and renovate deficient and ill-conditioned infrastructure of North Korea just before and after the reunification of the Korean Peninsula. These new methods are believed to curtail unification costs to a controllable limit.

Current Status of the North Korean Economy

Despite the well-organized facade of Pyongyang streets, the overall status of North Korean industries is probably at the same stage South Korea's was in the  early 1960s. Given the national psyche to achieve and "will to economize", the North Korean economy will get a boost with more financial resources and appropriate profit incentives. A recent United Nations Development Program (UNDP) report said the North's gross national product (GNP) was 10.5 billion dollars in 1997.

Production of iron and steel, textile, machinery and other items is suffering a slowdown in operations of up to 30 percent below capacity, which is further aggravated by wear and tear. The overall energy supply is similar to that of the South in the late 1970s. Infrastructure such as roads, railroads, harbors and power stations lacks new supply and appropriate maintenance.

Thus the redevelopment and renovation of the industrial sector of North Korea is estimated to cost up to 51 trillion Won in 1997 prices. In the German case, the reconstruction of East Germany cost 2.128 trillion Deutsche Mark in 1991 prices, almost equal to the entire GNP of West Germany in 1989. A government institute estimates transportation infrastructure renovation in the North would require 21 trillion Won, of which 14.5 trillion Won would go to railroads and 6.5 trillion Won to roads.

How to Mobilize Financial Resources

Balanced development of the South and North Korean economies as declared jointly by the two Korea's leaders on June 15, 2000, calls for the build-up of North Korean infrastructure in the public sector as soon as possible under an integrated national land development plan. Such nationwide development projects demand a huge amount of money on a long-term basis. Any failure of those projects might put the operations of lender banks off track. In this context, sophisticated financing schemes like project and structured financing should be utilized.

Conventionally, infrastructure financing is carried out within the fiscal budget. This would mean a considerable increase of the tax burdens on South Koreans, a move which might discourage effective spending and provoke resistance. Second, infrastructure build-up will be financed by issuing more and more national bonds. But the influx of such bonds will crowd out bond issuance in the private sector and aggravate fiscal deficits beyond control, considering the outstanding volume of national/public bonds that have been floated for the financial restructuring during the past years. Third, financial resources in the private sector shall be tapped in parallel. All types of financial products will be mobilized by financial intermediaries, but there must be a ceiling in the domestic financial market. So inducing foreign capital will be inevitable for stable fund-raising on a large scale.

Foreign capital supply will be spearheaded by international financial institutions like the World Bank and the Asian Development Bank through co-financing and/or guarantees in view of the latest precedents including the foreign exchange crises in East Asia and similar incidents in Russia and Latin America.

In principle, the private sector, including development companies, financial institutions and foreign investors, is expected to take the lead in financing the construction of SOC facilities in North Korea. The government shall assist the private sector by establishing timely master plans including financing programs and, if necessary, extending direct loans to the development projects.

Structured/Project Financing and Risks

These can best be explained by looking at a hypothetical project to construct a power plant in the northern part of the Korean peninsula. Like any typical electric power project financing, contractors, maker of generators, suppliers of fuel, buyers of electricity and others will participate in the project assuming that it is feasible in technical and financial terms. A project company, that is, a power plant, will borrow a large part of construction costs from domestic and foreign financiers.

If the plant wishes to securitize its string of receivables arising from a long-term electricity offtake agreement in order to repay the loans borrowed to finance its share of the construction costs, the following issues and risks shall be taken into consideration:

First, an SPV is established for the 'bankruptcy remote' purpose and the power plant will transfer to the SPV not only receivables but also its participating interest in the plant project. The receivables are contingent future cash flows dependent on continued production of electricity. However, a transfer of the receivables and participating interests to the SPV would require the consent of the lenders of first priority, who look initially to the cash flows and earnings of the project for proper repayment. It may be possible if the lenders are state-owned banks or international financial institutions.

Second, the main risk is whether the power plant is completed as scheduled, or completion risks, and the performance risk is that the electricity of certain specifications is not capable of being produced and delivered to the local electricity company. These risks could be mitigated by a competent third party agreeing to act as a standby undertaker. Also the risk of the SPV running out of funds could be mitigated by arranging for a commercial bank to provide the SPV with a standby subordinated loan facility.

Third, in the early stage of developing and renovating infrastructure facilities, the government and local authorities are expected to ensure sufficient cash flows. For instance, minimum revenue/procurement guarantee in order to facilitate the securitization could serve as one form of guarantee.

Fourth, there is the risk that this kind of ABS holder cannot be sure of proper repayment of the principal and interest, thereby shunning buying such securities. The risk might be mitigated by credit enhancements like taking an over-collateralization technique, senior-subordinated bond structure or monoline insurance policies for the bond issuers.

A good example of securitization of receivables is the case of Pemex, a Mexican oil company. In that transaction, the rating agency in question was satisfied that Pemex could continue to make supplies under relevant sales contracts with major U.S. oil companies, and permitted merely the receivables to be transferred to the SPV. The agency, however, did require letters of credit and other measures to safeguard against short-term failures of supply.

Likewise, structured financing could be utilized by securitizing loan portfolios of the project financiers, who may cash in on the long-term assets, thus improving their BIS ratios.

Conclusion

This article has reviewed the applicability of sophisticated financing schemes including structured financing and project financing for the various financial needs from clearing banks of non-performing assets to developing infrastructure facilities in North Korea.

Now that structured financing has taken root in Korea's capital market in the form of ABS, average investors know well the pros and cons of ABS. Though the revenues of a large scale project are to be securitized via an SPV, lender banks having a great stake in the cash flows would reject the transfer of revenue-producing assets to the paper company specialized in ABS. Otherwise, lenders could jointly securitize their loan portfolios in CLO-type bonds.

Thus any financial technique to combine structured financing with project financing should be based on the mutual understanding that it helps to mobilize badly needed development funds to the utmost extent. Moreover, such features of ABS as bankruptcy remoteness and credit enhancement have a great potential to induce foreign investors in view of a variety of risks of infrastructure projects in North Korea.