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Dr.
Joseph Hu
China Country Head, Managing Director, Standard
& Poor's
The McGraw-Hill Companies
Discussing Structured Finance:
When a business entity raises money to finance
its activity, it normally does it in three ways:
- Issue debt (float a bond)
- Issue stock (IPO), or
- Borrow from a bank.
I am here to talk about the fourth and
the fifth ways: project finance and structured finance (also conventionally
called asset securitization). If we really try to be innovative,
the two can be combined as just structured finance.
SF is not a new concept.
- It has been practiced in the US for three
decades.
- In European countries, it has also been practiced for at least
the past 10 years.
- In Asia, SF has about five years of experience (Japan is a little
longer, other countries shorter).
- In China, SF has just begun and needs a lot of training and education
to really expand the business.
In a nutshell, SF is a business entity that
raises funds in the capital markets by selling the future cash flow
of its assets. A most popular example of this is residential mortgage
backed securities (RMBS).
In this case, a loan originator, which mostly
is a mortgage banker or a commercial bank, would raise money in
the debt market by issuing RMBS. The underlying assets for the RMBS
of course are residential mortgages that the mortgage banker or
the commercial bank has originated. (Here, the residential mortgages
are permanent financing.) By selling the future cash flow of the
mortgages in a security format, the originator obtains funds in
the debt market to finance the origination of the mortgages. It's
a simultaneous transaction that the originator originates the loans
on the one hand and immediately sells the loans on the other hand.
The proceeds of the permanent financing are to pay off the funds
that finance the building of the residential units.
Why I mention this SF here at this panel?
To start a project, be it a residential housing,
commercial building, a community development, a hospital, a highway,
or anything, the developer needs to
- Acquire the land,
- Develop the land,
- Construct the project on the land, and
- Pay off the ADC financing by securing a permanently financing
for the project.
This is the four-step process, called A, D,
C, P. Actually, from the type and time of financing point of view,
the four steps are in two groups: ADC and P.
In the US, the ADC part usually is financed
variously by equity and bank loans. After the construction, the
developer would seek long term financing to sell the project and
pay off the construction loan. The construction loan usually has
a maturity term of two to three years.
ADC equity and loans are admittedly of high-risk.
Because:
- The acquired land may not be developed
into an economically viable project.
- To the extent the land is developed for construction, the construction
may not be proceeding successfully as planned and timing may be
off that the final structure may no longer be economical.
- In this case, a permanent finance may not be obtained to pay off
the construction loan.
To originate these high-risk loans, banks
need expertise in A, D, and C. Unfortunately, this kind of special
knowledge and experience is hard to come by. Additionally, the real
estate cycle is known for being volatile and timing often can be
off that demand sometime disappears when the project is completed.
That's why in many banks, the non-performing loans are related to
ADC and sometimes even the permanent financing.
Here, now, we can think something bold
and innovative. Why don't we go directly to the capital markets
to seek a comprehensive financing for A, D, C, and P?
The developer can present comprehensively
the entire project to the investors in the capital markets. The
presentation covers:
- The fundamental concept of developing the
project,
- The economics of the project
- The timeline of building the project, and
- The plan of selling the project to return the principal along
with periodical interest to the investors.
This cost of the project include:
- The time and the cost of land acquisition,
- The time and cost of land development,
- The time and cost of construction, and
- Finally, there has to be a plan to obtain a permanent financing
to pay off the debt.
We actually have begun to see in China
a comprehensive financing plan of an ADCP.
A developer may be working with a municipal
government to develop a community, an industrial park, or a hospital
complex that consists of residential housing units, commercial buildings,
community recreational parks, and other amenities.
Instead of going to a bank for an ADC loan,
this developer goes to the capital market for a medium-term debt
financing.
This financing would involve construction,
industrial, and financial experts from an investment banking firm,
an accounting firm, a law firm, and of course, a credit rating agency.
All these experts are doing the due diligence of the project on
behalf of the investors.
Once the funding is secured, the project will
start. The final product of the project would be securitized (selling
the future cash flow of the project) with proceeds to pay off the
medium-term debt.
Actually, the "selling the future cash
flow of the project," is the "P" part which is structured
finance. Here a loan originator for the permanent financing of the
project would securitize the future cash flow of the units by issuing
structure finance securities to raise the funds in the debt market.
This innovative way of financing has several
advantages:
- It allows the private and public sectors
to work together to build infrastructures, which are necessary
for the continued rapid growth of the Chinese economy,
- It channels investment funds from private
and public pension funds and insurance companies to long-term
financing needs of building infrastructures,
- It bypasses banks as the funding source
and goes to capital markets directly for financing. This achieves
the government goal of increasing
- direct financing" by capital
market and reduces the "indirect financing" by banks,
and
- It creates investment products for the
tremendous savings that so far have few viable outlets other than
being deposited at banks.
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