The Bank of East Asias Mortgage Loan Securitization

The Bank of East Asia’s Mortgage Loan Securitization By Hugh Thomas Associate Professor of Finance The Chinese University of Hong Kong, Shatin, N.T., Hong Kong SAR, China And McMaster University, Hamilton, Ontario, Canada L8S 4M4 Abstract The case concerns the securitization by The Bank of East Asia (BEA) of US$260,000,000 of mortgages, during the Asian financial crisis. The case introduces students to mortgage loan, asset-backed securities in the context of bank risk management. Students analyze the credit risk of mortgage lending in Hong Kong, the interactions between macroeconomic crisis and financial decision making, and the structure of securitizations: bankruptcy remote vehicles, credit enhancements, swaps, servicing agreements and tranche subordination. Keywords: Amended: securitization, Asian financial crisis, bank mortgage portfolio 2/4/2001 The Bank of East Asia’s Mortgage Loan Securitization Daniel Y.K. Wan, Senior General Manager and Chief Financial Officer of The Bank of East Asia, Limited, (BEA) put down the phone and reflected on his conversation with Brian C. P. Yiu, Executive Director of Capital Markets & Risk Management at Union Bank of Switzerland (UBS). It was Thursday November 13, 1997. Tomorrow, Brian Yiu had told him, UBS would fax the revised pricing proposal for the issuance of mortgage backed securities. For Daniel Wan, that would mean he should review the benefits and costs to BEA of the transaction to determine the maximum pricing revision that BEA would accept before it walked away from the deal. Four months previously, after receiving bids from Merrill Lynch, Morgan Stanley, Societe Generale, and UBS to lead manage a securitization of a portion of BEA’s mortgage loan portfolio, BEA had awarded the mandate to UBS. Shortly thereafter, Daniel Wan had appointed Fergus Mak Po-Kan, Manager, to be responsible for executing the securitization. Often devoting his entire time to it, Fergus Mak had negotiated with UBS on the details of structuring and had poured over the legal documents with BEA’s external counsel, Clifford Chance. He had liaised with Ann Rutledge, Vice President and Senior Analyst at Moody’s Asia Pacific Ltd. (Moody’s) concerning the credit rating to be assigned to the securities and had arranged Moody’s site visit to assess BEA’s loan origination, quality control, and servicing capability. But as the transaction had progressed, the economies of South East Asia had plunged into a currency and economic crisis, increasing global investor apprehension of Asian risk. Now UBS, concerned about the waning global investor appetite for Hong Kong risk, was about to present BEA with new, higher costing for the transaction. With the drop in the Hong Kong property and mortgage markets, however, BEA’s motives for the transaction were also due for review. The ultimate decision to proceed or not to proceed with the transaction would be made by the Board of the Directors of BEA led by The Honorable Dr. David K.P. Li, Chairman and Chief Executive Officer. Dr. Li was the real decision-maker in questions of strategy, but before he approached Dr. Li with his recommendation, Daniel Wan would have to review the transaction. As he picked up the phone to call Fergus Mak, Daniel Wan reflected that his workload for the day had just increased.  Review copy for use of the CaseNet®. Not for reproduction or distribution. October 2, 1998 1 The Bank of East Asia’s Mortgage Portfolio Incorporated in 1918, BEA had grown to become Hong Kong's third largest bank and its largest independent, locally-owned, Chinese bank with assets of HK$113 billion by the end of 1996. Although a publicly listed company whose shares traded on the Hong Kong Stock Exchange, BEA was effectively run by Dr. Li as Chairman, CEO, major shareholder, and a member of the founding family that still maintained a controlling equity stake. With 1996 earnings of HK$1.9 billion on an equity base of HK$11.7 billion, BEA was profitable and very comfortably capitalized, having a total BIS capital adequacy (i.e., capital to risk-weighted assets) ratio of over 17%. BEA had 20 branches and nine representative offices outside Hong Kong, mainly in South East Asia and North America and it was increasingly involved in developing its banking role in the People’s Republic of China. Yet its core business continued to be retail and commercial banking – i.e., the taking of deposits and making loans – conducted through its 97 outlets in Hong Kong. Within its asset portfolio, residential mortgages were by far the most important loans (See Exhibit 1: BEA’s Financial Statements Summary). Residential mortgage lending was considered by BEA to be an excellent, low risk, stable source of income. In originating mortgage loans, BEA followed various guidelines considered to be conservative and prudent in Hong Kong in the mid 1990s. The ratio of each loan’s principal to the mortgaged property’s value at the time of loan drawdown was restricted to less than 70% on residential apartments valued at less than HK$12 million and a lower percentage for higher valued apartments. Each borrower’s ratio of debt service to gross income ratio was restricted to less than 50%. Moreover, BEA did routine checks to ascertain that residential mortgage loans were truly owner-occupied and residential, rather than speculative. BEA’s mortgage loans were amortized monthly over a maximum 30 year maturity with interest floating at BEA Prime1 plus a spread of from 0% to 2.5%. Notwithstanding the long nominal maturity of mortgage loans, however, the actual average life of recent loans was about three years. The reason for this disparity was that homeowners, enjoying rapidly rising incomes and property prices, frequently “traded up” in the quality and size of their homes, contributing to the high turnover of real estate (see Exhibit 2 Real Estate Values). Throughout this period, BEA had invested heavily in 1 BEA Prime was the rate set from time to time, at the sole discretion of BEA to be charged to its top quality borrowers. In practice, prime rates of all of the major banks in Hong Kong tended to be equal or very close at any 2 electronic data processing to maintain an efficient loan monitoring and management information system. These conditions combined to give BEA’s mortgage loan portfolio stable delinquency rates of about 0.25% of aggregate principal outstanding, an average repossession rate of 0.001%, and no charge-offs at all over the last five years2. Yet this enviable portfolio suffered from one major drawback: comprising 44% of total loans outstanding, it exceeded the prudential concentration limits specified by the Hong Kong Monetary Authority (HKMA)3. In 1994, the HKMA had issued a guideline that property-related loans should be no more than 40% of a bank’s loan portfolio. The HKMA’s guideline was not directed at BEA in particular: most of the domestic consumer banking industry shared BEA’s exposure, yet the HKMA made a point of periodically informing BEA that it should comply. While these requests were not directives, they were a source of friction between the HKMA and BEA. Publicly Dr. Li stated that given the high quality of BEA’s mortgage loan portfolio the guidelines were overly restrictive. In early 1995, however, BEA started investigating ways to bring its portfolio more into line with the HKMA’s guideline. Particularly, BEA looked into securitization. Mortgage Backed Securities Securitization is a technique by which a company sells financial assets to a new legal entity called a special purpose vehicle (SPV) and the SPV finances the purchase through the issuance of new securities. Any fixed-income asset, including public securities, commercial loans, mortgages, trade receivables, credit card advances, or leases can be securitized but securitization is only cost-effective for large asset pools with verifiable credit risk. The SPV – legally either a limited liability company or a trust – is “bankruptcy remote” from the company selling the assets. Purchasers of the new securities have no general recourse to the assets of the given time because of competitive pressures. Prime averaged approximately 1.5% over one month interbank rates of interest, but the spread fluctuated and could become negative for short periods. See below footnote 5. 2 BEA defined a loan as being “delinquent” if it was more than two payments (i.e., two months) late. Repossession occurred when BEA foreclosed on a mortgaged property, and auctioned it to obtain funds to repay the delinquent outstanding loan. If auction proceeds were insufficient to pay principal, accrued interest and out of pocket costs of foreclosure, the shortfall would be charged off. If auction proceeds exceeded accrued interest, principal and costs of foreclosure, the excess funds would be returned to the borrower, and no charge-offs would be necessary. 3 The HKMA was the government body that maintained the Currency Board fixing the rate between the Hong Kong and U.S. dollars, monitored banks and other authorized financial institutions, and served as the lender of last resort for the Hong Kong dollar activity of clearing banks. 3 originating company and creditors of the originating company have no claims whatsoever to the assets of the SPV. The new securities derive their credit-worthiness only from the SPV; hence they are known as asset backed securities. When the securitized assets are mortgages, the new securities are called mortgage backed securities. Securitization enjoyed early, rapid growth in the United States residential mortgage loan market during the 1980s. Several conditions proved conducive to this rapid development. The large size of the U.S. mortgage loan market, the standard nature of mortgage loans, the availability of reliable data on historical loan performance, the presence of United States Agency guarantees for many mortgage loans, and a legal environment allowing non-recourse sale of assets to SPVs (in the form of “bankruptcy-remote” companies and trust accounts) all helped. At the same time, the massive growth, structural reform, and consolidation of the deposit taking and lending industry and the breaking-down of barriers between commercial and investment banking provided a powerful impetus to securitization. Throughout the late 1980s and 1990s, securitization spread worldwide. It was variously used to increase the liquidity of asset originators’ balance sheets, allow asset originators and loan servicers to increase fee income, facilitate reduction of unwanted portfolio concentrations, improve use of capital, and better meet the needs of investors. As was the case in the United States, mortgage loans provided a fruitful class of assets for securitization. Hong Kong Mortgage Funding (1) Limited In early July 1997, shortly after Hong Kong changed from a Crown Colony of the United Kingdom of Great Britain and Northern Ireland to a Special Administrative Region of the People’s Republic of China, BEA formally approached investment banks to securitize a portion of its mortgage portfolio. BEA awarded the mandate to UBS based on the sound relationship that existed between the two banks and the fact that UBS provided the lowest all-in-cost of funds, being three basis points per annum less than its nearest competitor. The structure of the proposed securitization is shown in Exhibit 3. An SPV, a new, limited liability, bankruptcy-remote company to be called Hong Kong Mortgage Funding (1) Limited would use the proceeds of US$260 million worth of floating rate notes (placed by UBS) to purchase a Hong Kong dollar equivalent amount of BEA’s mortgages. The mortgages in the prospective pool were all to be for owner-occupied, private apartments of no more than 100 4 square meters (a size limit that included some 92.7% of all Hong Kong dwellings). About two thirds of mortgages would be for apartments ranging from 40 to 70 square meters. Exhibit 4 provides some data on the prospective pool of mortgages. The SPV, would be registered on the Caribbean island of Grand Cayman to ensure that it would attract no corporate taxes. The transaction’s effective contact with Grand Cayman, however, would be limited to corporate registration – activities that would be administered by a small Cayman trust company. The SPV would have no employees, no offices and no business activities except for the holding of the amortizing mortgages against the claims of the noteholders. The sold mortgages would continue to be serviced in Hong Kong by BEA for a loan servicing fee. That fee was to be the difference between the interest receivable on the mortgage loans and the sum of the interest payable on the notes and the out-of-pocket fees and administrative expenses of the SPV. BEA would remit interest and principal payments to the SPV’s account in Hong Kong. Those proceeds would be swapped by UBS, Singapore, acting as a swap counterparty, into U.S. dollars and remitted to the SPV’s U.S. dollar account in Singapore. The swapped proceeds would then be paid by Bankers’ Trust (acting as the transaction administrator and note trustee) to the note holders in payment of interest and (when mortgage principal was amortized or prepaid) principal reduction. The notes would be issued in two tranches: Class A and Class B, and would, subject to market conditions at the time of issue, bear interest at one month LIBOR + .28% and LIBOR + .68% respectively4. Class A notes would comprise 90% (i.e., US$234 million) of the issue and would be rated “Aaa” by Moody’s while Class B notes would comprise US$26 million and would be rated “A”. See Exhibit 5 for a summary of Moody’s ratings classifications. UBS planned to place the notes with institutional investors in Europe. The all-in-cost of the securitization was calculated by UBS in its original offer to BEA to be equivalent to BEA financing its on-balance sheet loan portfolio at a cost of funds of HIBOR plus 0.86%5. 4 LIBOR is the London Interbank Offer Rate, and is the rate of interest at which banks active in the London market in offshore U.S. dollar deposits will place wholesale deposits (i.e., of at least US$1 million) with other creditworthy banks. It represents the wholesale marginal cost of U.S. dollar funds for a creditworthy bank in the Euromarkets. 5 This calculation was made by UBS as an all-in cost of securitization. It has no relationship with BEA’s actual cost of funding. The all-in-cost of securitization is the total cost of funding the assets, as if they remained on the balance sheet. It was calculated as the interest payable on the notes plus the front end underwriting fee, rating agency costs and external legal costs expressed as an annuity amortized over 4 years, the notional life of the mortgage backed securities. HIBOR (the Hong Kong Interbank Offer Rate) is the rate of interest at which banks active in the Hong 5 Both BEA and UBS considered that, for the success of the transaction, the Class A notes should be rated “Aaa” so that they could be placed with quality-conscious institutional investors who wished to bear minimal credit risk. Yet the “Aaa” rating was higher than BEA’s “A3” rating and the Hong Kong government’s rating of “A2” for foreign currency obligations.6 As Exhibit 6 shows, recent Hong Kong securitizations had achieved “Aaa” ratings with “monoline wraps,” full-payment, insurance policies from “Aaa” insurance providers. To reduce the all-incost, however, UBS planned to structure the deal without a monoline wrap. UBS aimed to achieve the “Aaa” rating by using three devices: tranche subordination, a currency swap, and a subordinate line of credit. If cash flows were insufficient to service Class A and B note obligations, the Class B noteholders would not be paid until after the Class A noteholders were paid. Under the currency swap agreements UBS’ Singapore Branch, the swap counterparty, would be obliged to make U.S. dollar payments to the SPV’s U.S. dollar account in Singapore as long as it received HK dollar deposits in Hong Kong7 – even if exchange controls on the Hong Kong dollar were in place. UBS itself was rated “Aaa.” Hence, as long as UBS received the required Hong Kong dollars, the U.S. dollar payments to the SPV were virtually assured, unless the Hong Kong government declared the swap illegal. Finally, BEA was to extend a line of credit, bearing interest based on HIBOR, subordinate to the claims of the note holders. Although the principal amount of the subordinate loan was yet to be determined, UBS had informed BEA that it would be from five to 10% of the principal. Its size would be decided by Moody’s, which would set the size at the amount required to lower the expected losses of the mortgage pool to the expected losses of an “Aaa” security. In deciding the required size of the subordinate loan, Moody’s was concerned with theoretical expected losses to a portfolio of bonds that could be measured by the migration probabilities of the bonds from “Aaa” to “Aa” to “A” and so on. Moody’s took a long-term view, relying on decades of historical data, not the latest change in the market. If the mortgages had been U.S. mortgages, Moody’s would have “stressed” the portfolio of assets by the percent Kong dollar interbank markets will place wholesale funds with other good quality banks. It therefore is the marginal cost of wholesale funds in Hong Kong dollars to a creditworthy bank. 6 As of 1997, no large North American bank enjoyed an “Aaa” rating either. 7 Although referred to as a single swap here, UBS viewed the swap as two swaps. In the interest rate swap, UBS would receive Hong Kong prime and pay HIBOR plus x%. The value for x would be determined at the time of the swap. In recent years, prime had been swapped to HIBOR plus from 150 to 200 basis points, determined by tenor, 6 of losses that were experienced in the 1930s. If the Class A notes, backed by such a stressed portfolio of assets, were still able to pay interest and principal when due, they would be awarded an “Aaa” rating. Because no such stress had yet occurred to the Hong Kong market, Moody’s had to simulate one. The stress that Class A notes would have to bear would be the losses to the underlying mortgage loan portfolio that would result from a major recession from which China would recover but Hong Kong would not. Moody’s considered that such an event would lead to a 66% loss in property value, and would set the required amount for the subordinate loan based on their model of property market losses, economic dislocation, and consequent mortgage loan losses. While the planned issue would substantially reduce the retail mortgage loan exposure on BEA’s balance sheet, the reduction would be insufficient to bring BEA into line with the HKMA guidelines. Hence BEA and UBS had discussed many times that, if the issue proved to be successful, a second and a third similarly priced issue could quickly follow. Once the Hong Kong Mortgage Funding (1) Limited had been launched, a whole family of deals to be known as Hong Kong Mortgage Funding (2) Limited Hong Kong Mortgage Funding (3) Limited, etc. could follow at a fraction of the legal costs. Execution of future deals would take about half of the time required to complete the first securitization. The Asian Economic Crisis Even as the mandate was being awarded, however, the East Asian investment climate was changing. The mid 1990s had seen large inflows of private debt and equity capital into the rapidly growing economies of the region. These capital inflows helped inflate wages and prices, at the same time as they kept down interest rates, further fuelling debt-financed investment. The massive capital inflows also made simple and painless the implementation of fixed rate exchange policies of the governments of the region, effectively pegging their currencies to hard currencies such as the U.S. dollar. The apparently stable exchange rate policies masked the true risk of investments – especially the debt capital that was denominated in non-local currencies. The continued capital inflows that financed the current account deficits were conditional on investor optimism. In mid 1997, however, investor sentiment turned against the region, precipitating a market supply and demand, etc. In the currency swap UBS would receive Hong Kong HIBOR would pay to the SPV US LIBOR at the exchange rate at the time of the swap. 7 drop in asset values, an exodus of capital, and consequent pressure on local currencies. Governments sought to resist the pressure by defending their currencies with tighter monetary policies, raising interest rates and thereby precipitating recessions, further undermining investor confidence. First Thailand, then Indonesia, and finally Korea were forced to accept deep recessions and dramatic devaluations of their currencies. Currency speculators, aware of the profitability of one-way bets – in such an environment, the currencies could fall or stay constant, but would not rise in the short term – took positions against one East Asian currency after another. The Malaysian ringgit, Philippine peso, and Singapore dollar also suffered. For Asian firms with unhedged obligations in hard currencies, the depreciation of home currencies led to increased, often crippling, debt service obligations at a time of reduced economic activity. Corporate bankruptcies increased and the private capital crises turned into a series of sovereign crises, with Thailand, Indonesia, and Korea approaching the International Monetary Fund for relief funding. Exhibit 7 charts the course of the major Asian currencies’ values through 1997. Hong Kong, although financially sound, was also affected by the Asian turmoil. As one of the financial capitals of Asia, it had benefited from the rapid growth of regional equity and debt markets, and so naturally suffered from their contraction. For a decade, Hong Kong had experienced inflation consistently higher than that in the U.S.; however, that inflation differential was not reflected in any change in its foreign exchange rate because the Hong Kong dollar was credibly pegged to the U.S. dollar. The 1997 reversion of Hong Kong to China, however, led some to doubt the resolve of the new government to maintain the peg. In October, the Hong Kong dollar came under increasing pressure, a pressure the HKMA resisted by restricting liquidity. The crisis peaked on October 23, with HIBOR shooting up to a record 250% and the Hang Seng Index8 plunging 10% in a single day, dragging down stock markets around the world. Faced with the rapid rise in their wholesale cost of funds, Hong Kong banks were compelled to increase corporate and consumer lending rates to maintain profitability, yet they raised their prime interest rates reluctantly. Aware that any increase of prime rates undermined businesses and the property market, thereby increasing pressure on their corporate and consumer 8 The Hang Seng Index is an index of the 33 largest (i.e., “blue chip”) companies traded on the Hong Kong Stock Exchange. The companies in the index account for both 90% of the market value and 90% of the turnover of the exchange. 8 borrowers, many effectively continued lending below their marginal cost of funds. In the illiquid prime-HIBOR swaps market, five year swaps started to be booked at less than HIBOR + 1.5% to prime. On October 30, Moody’s cut its ratings outlook for Hong Kong banks from stable to negative, a signal of possible downgrades in months to come. By mid November, the attack on the Hong Kong dollar had subsided. The HKMA had demonstrated that it had the resources (foreign exchange reserves of about US$80 billion) and the resolve to defend the currency, even at the cost of higher rates of interest. With interbank rates remaining four or five percentage points above U.S. rates and prime relentlessly climbing, however, the Hong Kong economy was sliding towards recession and BEA was already feeling the effects. Housing prices had slipped 10 to 15% from their August highs and property was trading in an increasingly illiquid market. As surveyed by the HKMA, mortgage lending fell by 23% economy wide in the month of August and by an identical 23% in the month of September. The October and November outlooks were similarly negative. UBS’s Dilemma UBS’ offer of July 1997 was not fully underwritten: securitizations never were. UBS had agreed to securitize BEA’s mortgages subject to three major conditions: (1) obtaining UBS internal credit approvals for the swap and placing the notes, (2) obtaining Moody’s “Aaa” and “A” ratings for the Class A and B notes respectively and (3) being able to place the notes. Even if adverse changes had not occurred, UBS would have been under no legal obligation to buy the notes if they could not be placed. Such reneging on a best efforts undertaking, however, would undercut UBS’ reputation, a reputation essential to winning future mandates. Although severe adverse changes had occurred in the market, UBS sincerely wanted to complete the deal – as long as it could do so with revised pricing. Moody’s had assured UBS that its assessment of the expected losses on the mortgage loans – and the resultant requirements for credit enhancements for the SPV– was not going to be adversely impacted by the events of the last few weeks. Moody’s strove to take the long term view. UBS considered, however, that prospective investors in the notes would be less sanguine in the market turmoil of late 1997 than Moody’s. As the market’s perception of the creditworthiness of Hong Kong borrowers dropped, credit spreads had increased. The market 9 yield on Hutchison Whampoa’s9 benchmark US$ 2 billion, 10-year Global Bond10 issued in July 1997, due in 2007, and rated A3 by Moody’s, for example, had widened from the issue price of 82 basis points over U.S. 10 year Treasury bonds to 195 basis points in November. Several European institutional investors who had been keen to purchase the securities, now were telling UBS London that they had lost their appetites. Regardless of ratings, those investors would need to be compensated for the increase in perceived risk. The Reassessment Daniel Wan fully appreciated the dilemma: to expect UBS to maintain the pricing of its July mandate was not realistic. Yet BEA was very cost-conscious, and would not proceed with an uneconomic transaction. In some ways, the timing of the crisis was fortunate. Having acquired considerable experience over the last four months on securitizations, BEA could fully re-analyze its needs before giving the final word on whether or not it should proceed with the securitization. 9 Hutchison Whampoa was a prominent, publicly traded real estate development, shipping and retailing conglomerate controlled by Hong Kong tycoon Li Ka-Shing. 10 A “Global Bond” for a non-U.S. issuer is a bond that is simultaneously issued in the Euromarkets as a Eurobond and in the U.S. domestic market as a “Yankee Bond.” A Yankee Bond is a U.S. dollar bond issued in the United States, conforming with Securities and Exchange Commission requirement, but for a non-U.S. issuer. Global bonds are used for particularly large issues where the simultaneous tapping of several markets will improve the bond’s pricing. 10 Exhibit 1 The Bank of East Asia’s Consolidated Financial Statements Fiscal Year Ending December 31 (figures in billions of Hong Kong Dollars) Assets Loans Deposits with Banks Other Earning Assets Total Earning Assets Fixed Assets Non-Earning Assets Total Assets 1996 1995 1994 1993 1992 65.8 30.5 11.8 108.1 4.0 1.0 113.1 53.3 26.9 8.0 88.2 3.8 1.0 93.0 43.4 25.6 6.8 75.8 2.8 1.0 79.6 36.5 23.6 7.5 67.6 2.9 1.0 71.5 30.9 22.6 5.2 58.7 2.6 0.0 61.3 Liabilities Customer and Short Term Funding Of which due to banks Other Funding Non-Interest Bearing Liabilities Equity Total Liabilities and Equity 1996 1995 1994 1993 1992 88.3 76.1 65.1 61.2 56.1 6.4 5.0 3.6 4.9 n.a. 9.2 4.0 2.7 0.0 0.0 3.9 2.8 2.7 3.1 0.2 11.7 10.1 9.1 7.2 4.9 113.1 93.0 79.6 71.5 61.2 Income Statement Net Interest Revenue Other Operating Income Overheads Loan Loss Provisions Other Income Profit Before Tax Tax Net Income Total BIS Capital Ratio 1996 1995 1994 1993 2.91 2.41 1.91 1.69 0.94 0.73 0.65 0.62 1.47 1.24 0.99 0.88 0.26 0.14 0.15 0.12 0.07 0.16 0.43 0.06 2.19 1.92 1.85 1.37 0.31 0.27 0.30 0.25 1.88 1.65 1.55 1.12 17.1 18.2 19.3 n.a. Source: Bankscope Bureau Van Dijk Loan composition Hong Kong Home Mortgages Commercial Mortages and Trade Finance Project Finance and Syndicated Loans Consumer Loans Credit Cards China International Total 1996 1995 44.1 47.2 24.0 21.9 11.5 11.7 2.0 1.6 0.7 0.6 9.7 8.4 8.0 8.6 100.0 100.0 Source: The Bank of East Asia 11 Exhibit 2 Hong Kong Real Estate Values (1980 = 100) 800 700 600 500 400 300 200 100 0 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 19 96 97 1Q Source: Moody’s Investor Service Global Credit Research 12 Exhibit 3 Securitization Structure US $ Proceeds from note placement Class A Note Holders First claim The Bank of East Asia Subordinate Loan Provider Asset Originator Class B Note Holders Subordinate claim Union Bank of Switzerland Lead Manager Swapped US$ US$ Interest and Principal on Notes SPV: Line of Credit Loans & Collateral Purchase price Hong Kong Mortgage Funding (1) Limited Loan Servicer Loan Service Fee HK $ Interest and Principal Hong Kong Residential Mortgage Loan Borrowers Swap Counterparty (Singapore Branch) HK$ Interest and principal 13 Exhibit 4 Prospective Pool of Mortgages: Key Data Summary Number of mortgage loans Principal amount outstanding (HK$) Original principal balance (HK$) Spread over Hong Kong prime rate Current mortgage rate Original loan to property value ratio Current loan to property value ratio Remaining term to maturity (months) Original term to maturity (months) Borrower’s Debt to Income Ratio Current seasoning (months) Owner Occupancy Aggregate 2,122 2,280,071,185 2,773,674,714 N/A N/A N/A N/A N/A N/A N/A N/A 100% Weighted Average N/A 1,074,492 1,307,104 0.68% 10.2% 63.9% 56.9% 188 221 37.1% 25 100% Minimum N/A 11,607 100,000 0.0% 9.5% 7.3% 0.7% 2 36 3.5% 2 -- Maximum N/A 4,981,581 5,000,000 2.50% 12.0% 90.00% 69.9% 299 300 50.0% 109 -- Note: The above pool describes the portfolio from which the SPV would purchase US$260 million face value of mortgages (selected at random and translated into Hong Kong dollars at the rate of exchange effective on the date of purchase) in the event that the securitization were to take place. Source: The Bank of East Asia 14 Exhibit 5 Moody’s Long Term Ratings Definitions Aaa Bonds which are rated Aaa are judged to be of the best quality. They carry the smallest degree of investment risk and are generally referred to as "gilt edged." Interest payments are protected by a large or by an exceptionally stable margin and principal is secure. While the various protective elements are likely to change, such changes as can be visualized are most unlikely to impair the fundamentally strong position of such issues. Bonds which are rated Aa are judged to be of high quality by all standards. Together with the Aaa group they comprise what are generally known as high-grade bonds. They are rated lower than the best bonds because margins of protection may not be as large as in Aaa securities or fluctuation of protective elements may be of greater amplitude or there may be other elements present which make the long-term risk appear somewhat larger than the Aaa securities. Bonds which are rated A possess many favorable investment attributes and are to be considered as uppermedium-grade obligations. Factors giving security to principal and interest are considered adequate, but elements may be present which suggest a susceptibility to impairment some time in the future. Bonds which are rated Baa are considered as medium-grade obligations (i.e., they are neither highly protected nor poorly secured). Interest payments and principal security appear adequate for the present but certain protective elements may be lacking or may be characteristically unreliable over any great length of time. Such bonds lack outstanding investment characteristics and in fact have speculative characteristics as well. Bonds which are rated Ba are judged to have speculative elements; their future cannot be considered as well-assured. Often the protection of interest and principal payments may be very moderate, and thereby not well safeguarded during both good and bad times over the future. Uncertainty of position characterizes bonds in this class. Bonds which are rated B generally lack characteristics of the desirable investment. Assurance of interest and principal payments or of maintenance of other terms of the contract over any long period of time may be small. Bonds which are rated Caa are of poor standing. Such issues may be in default or there may be present elements of danger with respect to principal or interest. Bonds which are rated Ca represent obligations which are speculative in a high degree. Such issues are often in default or have other marked shortcomings. Bonds which are rated C are the lowest rated class of bonds, and issues so rated can be regarded as having extremely poor prospects of ever attaining any real investment standing. Moody's applies numerical modifiers 1, 2, and 3 in each generic rating classification from Aa through Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category; the modifier 2 indicates a mid-range ranking; and the modifier 3 indicates a ranking in the lower end of that generic rating category. Aa A Baa Ba B Caa C Note: Source: Moody’s Investor Services 15 Exhibit 6 Terms of Selected Hong Kong Securitizations in 1997 Issuer: Date: Assets: Amount: Credit Rating: Coupon Rate: Arranger: Management Fee: Selling commission: Sino Commercial Properties Funding Ltd. March 1997 Six year commercial mortgage loans to five office buildings in Hong Kong. The SPV was sponsored by the Sino Group, a blue chip Hong Kong property developer. US$300m (swapped) A (Fitch, S&P) LIBOR +0.90% Morgan Stanley 0.125% flat 0.125% flat Issuer: Date: Amount: Assets: Credit Support: Credit Rating: Coupon Rate: Servicer: Arranger: Hong Kong Mortgage Financing Limited May 1997 Hong Kong $778 million Seasoned retail residential company staff housing loan mortgages sold by Hong Kong Telecom, the monopoly supplier of telephone services. MBIA Assurance S.A (Aaa) monoline wrap Aaa (Moody’s) HIBOR +0.60% Hong Kong Telecom Societe Generale Asian Limited Issuer: Date: Assets: Amount: Credit Support: Credit Rating: Coupon Rate: Servicer: Arranger: Issuer: Date: Assets: Amount: Credit Support: Credit Rating: Coupon: Servicer: Lead manager: Management fee: Selling commission: Hong Kong SAR Residential Mortgages Ltd June 1997 Hong Kong residential mortgages from Dah Sing Bank US$300m (swapped) CapMAC (Aaa) monoline wrap Aaa (Moody’s) LIBOR + 0.20% Dah Sing Bank of Hong Kong HSBC Markets Hong Kong Homes Funding Corp (1) June 1997 Seasoned Hong Kong residential mortgages from Sanwa Finance’s portfolio US$144 million (swapped) MBIA monoline wrap (Aaa) Aaa (S&P and Moody's) LIBOR + .20 % up to August 2007, LIBOR + .45 % thereafter Sanwa International Finance Sanwa International Finance 0.075% flat 0.05% flat Source: International Financing Review 16 Exhibit 7: Exchange Rates and Interest Rates: January to November 1997 a) Currency Values January 1 1997 = 100 1.1 1 0.9 0.8 0.7 1-Jan-97 1-Jun-97 1-Jul-97 1-May-97 1-Aug-97 1-Sep-97 1-Feb-97 1-Nov-97 0.6 1-Mar-97 1-Apr-97 THB IDR KPW MYR HKD Values on January 1, 1997: Thai Bhat (THB) = US$0.0389; Indonesian Rupiah (IDR) = US$0.0004233; Korean Wan (KPW)=US$0.001184; Malaysian Ringgit (MYR) = US$0.3958; Hong Kong Dollar (HKD) = US$0.1293 b) Interest Rates 20 19 18 17 16 15 14 13 12 11 10 9 8 7 6 5 Source: Reuters 17 1/ 1/ 9 1/ 7 15 /9 1/ 7 29 /9 2/ 7 12 /9 2/ 7 26 /9 3/ 7 12 /9 3/ 7 26 /9 7 4/ 9/ 97 4/ 23 /9 7 5/ 7/ 97 5/ 21 /9 7 6/ 4/ 97 6/ 18 /9 7 7/ 2/ 9 7/ 7 16 /9 7/ 7 30 /9 8/ 7 13 /9 8/ 7 27 /9 9/ 7 10 /9 9/ 7 24 /9 10 7 /8 10 /97 /2 2/ 9 11 7 /5 /9 7 HK$ Prime HIBOR US LIBOR 1-Oct-97