Bond Market Development:The Case of South Korea

1. AFDC Workshop on Developing Asian Bond Markets:Facilitating the pricing mechanism for Asian bondsMay 29- June2, Shanghai Bond Market Development:The Case of South Korea Gyutaeg Oh Korea Fixed Income Research Institute Chung Ang University

2. Overview 1 Development of Korean Bond Market: History 2 Development of Korean Government Bond Market 3 Development of Korean Corporate Bond Market 4 Special Topics: New Asset Backed Securities

3. 1 Development of Korean Bond Market: History

4. Development of Korean Bond Market: History USD Billion IMF Crisis Source: Bank of Korea

5. Development of Korean Bond Market: History USD Billion Source: Bank of Korea

6. Development of Korean Bond Market: History Source: Asia Bond Monitor 2005

7. 2 Development of Korean Government Bond Market

8. Before & After the Crisis • Before the currency crisis: small and under-developed • Markets for government bonds and government-guaranteed bonds were not well-developed (conservative fiscal policy) • As a result, the 3-yr corporate bond emerged as the benchmark bond • After the currency crisis: Dazzling Development • Government bond Market: To finance public fund for financial restructuring and boost depressed economy by fiscal pump priming (Government-led Development) • The government dramatically increased the size of KTB issuance from around W7 trillion ($billion) in 1997 to W56 trillion ($billion) in 2004. • In terms of outstanding balance, the total amount of KTBs has increased from W25 trillions as of the end of 1996 to more than W123 trillion as of end 2004.

9. Government Bond Market -Institution Building Reforms in Korea

10. Treasury bonds Corporate bonds Effect of Reopening System The Fungible Issue System (Reopening System) • Bonds have identical maturities and coupon rates. • Reopening System expands the size of bond issuances of the same maturities. The turnover rates of GB is 6 times larger than that of CB. Turnover Rates Volume of Benchmark Issues 3.5 times greater

11. History of PD System • 1999.3 Establishment of Inter-Dealer market (IDM) • 1999.7 Introduction of Primary Dealer system • - 24 institutions designated as primary dealers • - 2% Minimum requirement: Acquisition & Trading • 2000.2 Introduction of Inter-dealer brokers (IDB) • 2000.3 Providing financing facilities for primary dealers • - Line of credit provided (at cheaper rate)

12. Mandatory Exchange Trading Requirement • Korea Stock Exchange (KSE)& OTC Market • New Policy measures for activating KSE market 2002.10 Mandatory exchange (KSE) trading requirement - 20% of Benchmark Issues 2003.01 Obligations of primary dealers strengthened - Exchange trading requirement increased from 20% to 40% - Minimum trading amount increased from 2% to 5% VS. Primary dealers should trade benchmark issues of the Government Bonds in KSE.

13. Exchange Trading Proportions (%) (Benchmark vs. Non-Benchmark) 60.0 50.0 40.0 30.0 20.0 10.0 0.0 Jan-02 Nov-02 Sep-03 May-03 Mar-03 Sep-02 May-02 Nov-03 Mar-02 May-04 Mar-04 Jul-03 Jan-03 Jul-02 Jan-04 Mandatory Exchange Trading Requirement The proportion of benchmark issue trading within the exchange has significantly increased since Oct. 2002. Benchmark Non-benchmark

14. Mandatory Exchange Trading Requirement Gov Bond Trading Volume (KSE vs. OTC) The Trading volume in the OTC market has not been decreased. Mandatory Exchange Trading Requirement For benchmark issues Strengthening obligations of primary dealers

15. Mandatory Exchange Trading Requirement Bid-Ask Spreads of Benchmark Issues Bid-ask spreads of the benchmark issues decreased sharply after the new policy in 2002. 6.7bp 18.1bp

16. Liquid Gov. Bond Futures Market 3-Year KTB Futures – Global Status <Top 10 Gov Bond Futures Contracts> (in 1,000 contract) (Source: FIA, January~June 2003)

17. Recent Trends in Government Bond Market -Institution Building Reforms in Korea • Before 2005, reform focused on measures to reduce issuing cost by improving liquidity of the benchmark issues • After 2005, reform focuses on measures to reduce issuing cost by meeting diverse investors’ need 2006 • Issue 20 year Bonds • Issue Inflation-Indexed Bonds • Design products for retail investors 2005 • Introduce STRIPS

18. 3 Development of Korean Corporate Bond Market

19. Development of Corporate Bond Market Daewoo Crisis (99.8) Maturity Concentration Crisis (2000) Financial Crisis (97.11) SKG & Credit Card Crisis (03.3) Credit shock Credit shock Credit shock Credit shock • Market Impact • Credit card debt roll-over problems • Realizing the need for systemic risk monitoring system • Realizing the Importance of Credit Bureau • Plunge of ABS markets • Market Impact • Issuance of P- CBOs to Refi Corp Bond Debt • Rapid Pick-Up of ABS Markets • Market Impact • MTM accounting for ITCs • Establish Bond Pricing Agency • Improve Post- Trade Transparency • Improve Credit Rating • Market Impact • ABS (Asset Backed Securities) development to handle NPLs • Massive Corp. Bond Issuance to Refi Bank Debts (From Banks to ITCs)

20. Korea’s ABS system: Introduction The introduction of ABS Act in 1998 Securitization Process under the ABS Act • Establishment of a securitization vehicle - Onshore ABS SPC- Trust company - Offshore ABS SPC • Registration of a securitization plan with the FSC • Acquisition of securitization assets by the securitization vehicle • Appointment of servicer and transaction administrator • Issuance of asset-backed securities • In September 1998, the Asset Backed Securitization Act (the “ABS Act”) was passed. - The ABS Act provides a means to engage in securitization transactions with legal certainty.- Tax benefits are conferred on transactions under the ABS Act.- Processes such as perfection of security interests against third parties are streamlined. • The ABS Act was originally intended to facilitate the disposal of non-performing loans.

21. Troubled Loan Disposed (billion won) By Banks (billion won, %)

22. Corporate Bonds in Bank Restructuring • Contribution: “Spare-Tire theory” * Corporations mitigated credit crunch problems by issuing massive amount of corp. bonds.  Capital market as a parallel circuit to bank financing * Market interest rates were stabilized since corp. credit crunch problems were mitigated & thereby it contributed to high growth in 1999. Amount of bond Issuance (Net) unit: 10 billion won

23. Credit Shocks: Daewoo Default and Maturity Concentration • ITCs assumed credit risk with little discipline. • Unviable firms could extend their lives. • Easy financing reduced Chaebol’s incentive to restructure their businesses. - massive default and recurrent credit crunch - increased ultimate costs of restructuring! • Maturity Concentration & credit crunch in 2001! No Free Lunch!!!!!!!

24. Development of Corporate Bond Market Daewoo Crisis (99.8) Maturity Concentration Crisis (2000) Financial Crisis (97.11) SKG & Credit Card Crisis (03.3) Credit shock Credit shock Credit shock Credit shock • Market Impact • Credit card debt roll-over problems • Realizing the need for systemic risk monitoring system • Realizing the Importance of Credit Bureau • Plunge of ABS markets • Market Impact • Issuance of P- CBOs to Refi Corp Bond Debt • Rapid Pick-Up of ABS Markets • Market Impact • MTM accounting for ITCs • Establish Bond Pricing Agency • Improve Post- Trade Transparency • Improve credit rating • Market Impact • Massive Corp. Bond Issuance to Refi Bank Debts (From Banks to ITCs) • ABS (Asset Backed Securities) development to handle NPLs

25. Bond Pricing Agencies for Mark-to-Market System in Korea • Nov. 1997: decided to introduce “Mark to Market” • Dec. 1999:KSDA provided Matrix Pricing • - Jun. 2000:3 credit rating agencies launched 3 BPAs under government approval • -Oct. 2000: BPAs began pricing on MTM fund • - 2002: MTM applied to Bank’s Trading book, Trust account , Insurance Co.’s special Trust account, securities Co.’s accounts • - Oct. 2003: KDSA stops matrix pricing KIS PRICING Paid-in Capital KRW 3 billion BP Korea Bond Pricing Paid-In Capital KRW 5 billion Paid-In Capital KRW 4.75 billion The KSDA monitors thesecompanies.

26. Improve Post Trade Transparency of Bond Markets • KSDA requires dealers to report all bond transactions (including both corporate and government bonds) to KOSCOM CHECK Terminal within 30 minutes in 1999 (and 15 minutes since 2004) • NASD begins full dissemination of transaction and price data on the entire universe of corporate bonds to retail investors using TRACE (Trade Reporting and Compliance Engine). Dealers must report corporate bond transactions to TRACE within 30 minutes, and that window will be reduced to 15 minutes in July 2005

27. Paid-in Capital: 33.5 billion won KOREA INFORMATION SERVICE Paid-in Capital: 23.8 billion won 163 Employees Paid-in Capital: 24.3 billion won 183 Employees Seoul Credit Rating & Information Paid- in Capital: 13.7 billion won 227 Employees Foreign CRAs Improve the Quality of Credit Rating Agencies (CRA) In 2006, Ministry of Finance and Economy of Korea plans to lower the barriers in entering the Korean credit rating industry in 2006, so that foreign agencies, such as S&P, Moody’s and Fitch may easily get into the Korean market. Korean CRA Market

28. Development of Corporate Bond Market Daewoo Crisis (99.8) Maturity Concentration Crisis (2000) Financial Crisis (97.11) SKG & Credit Card Crisis (03.3) Credit shock Credit shock Credit shock Credit shock • Market Impact • Massive Corp. Bond Issuance to Refi Bank Debts (From Banks to ITCs) • ABS (Asset Backed Securities) development to handle NPLs • Market Impact • MTM accounting for ITCs • Establish Bond Pricing Agency • Improve Post- Trade Transparency • Improve Credit Rating • Market Impact • Credit card debt roll-over problems • Realizing the need for systemic risk monitoring system • Realizing the Importance of Credit Bureau • Plunge of ABS markets • Market Impact • Issuance of P-CBOs to Refi Corp. Bond Debt • Rapid Pick-Up of ABS Markets

29. 1 billion won Maturity Concentration (Rollover) Problem • Create a systemic risk (due to credit crunch problem) • A temporary problem: Chaebols paid off debts (low interest rate, higher earning, less investment)

30. Credit Crunch: Securitization & Credit Guarantee • Credit guarantees for a pool of corporate bonds / loans • Combining mechanisms of ABS and credit guarantee • Facilitated corporate financing in a short period of time Credit Guarantee Services by KCGF 23 SMEs \ Corp. bonds (72billion won) Small Business Corporation Asset sales SPC Credit Enhancement By Korea Housing Bank (10 bil.) Senior bonds (2yr 8.5 bil., 3yr 36 bil.) Junior bonds (27.5 bil.) Repurchased by Small Business Corporation Investor

31. Bonds Evolution of ABS Market in Korea Introduction Stage (’99~’00) Financial Restructuring & Securitization of NPLs Financing tools for companies to overcome flight-to-quality (maturity concentration) problems Developing Stage (‘00-’01) Maturing Stage (’02~’04) Deepening of ABS market Financing tools for SMEs, credit card companies mortgage, student loans, Future Cash Flow Securitization & others

32. Lessons from Korean Experiences • Securitization can be an effective policy tool for overcoming credit crunch problems (or credit quality gap) • Public sectors can facilitate securitization • Securitization evolves as market need arises • USA : Mortgage  Lease/Cards  Junk Bonds/CBOs  Future Cash Flows • Korea: NPLs  CBOs  Cards  Future Cash Flows

33. Development of Corporate Bond Market Daewoo Crisis (99.8) Maturity Concentration Crisis (2000) Financial Crisis (97.11) SKG & Credit Card Crisis (03.3) Credit shock Credit shock Credit shock Credit shock • Market Impact • Issuance of P- CBOs to Refi Corp Bond Debt • Rapid Pick-Up of ABS Markets • Market Impact • MTM accounting for ITCs • Establish Bond Pricing Agency • Improve Post- Trade Transparency • Improve Credit Rating • Market Impact • Credit card debt roll-over problems • Realizing the need for systemic risk monitoring system • Realizing the Importance of Credit Bureau • Plunge of ABS markets • Market Impact • Massive Corp. Bond Issuance to Refi Bank Debts (From Banks to ITCs) • ABS (Asset Backed Securities) development to handle NPLs

34. Credit Card Industry in Korea ◇ Untapped new market of consumer finance • Before 1998, individuals had a lower pecking order in the credit market • After 1998, business entities stopped financing new investment • Every financial company in Korea began to enter consumer loan market ◇ In the beginning it was lucrative! • Average lending rate of bank: 6~7% per annum • Cash advance fee: over 20% per annum • Financing cost of credit card companies: 6~7% per annum ◇ Especially Credit card companies with less financial market experience which are subsidiary of business conglomerate used market share maximization strategy. ◇ Credit card companies financed its lending by issuing corporate bonds and by securitizing credit card receivables.

35. Beginning of Crisis in Credit Card Industry in Korea Market Situation ◇ SK Global event (February 2003) • Family owner was arrested as a suspect of accounting fraud • Investors of Money Market Fund which invested in debt instruments issued by SK Global suffered loss. ◇ Investors getting more sensitive about over-issued credit card companies’ bonds • Increasing concern about credit card companies’ loss ◇ Past due ratio (excluding rescheduled debt) increased ◇ Investors began to redeem investment trust funds in the fear of loss ◇ Investment trust companies had to sell or stop rolling over credit card bonds ◇ Other institutional investors were deeply concerned about their investment positions in credit card bonds

36. Government Measures in 2003 • Initiatives by the Government in April 2003 • Rolling over maturing debt securities issued by credit card companies • Funding a pool to support refinancing credit card companies’ debt securities held by investment trust companies • Large shareholders joining in new capital raising (8 credit card companies with their own plans to raise capital in the amount of U$ 80m~U$ 400m) • Credit card companies reconstructing cost structure and asset management • Strengthening guidance on sound management • Reintroduction of loan service ratio • In calculating past due ratio, liquidated asset should be included • In calculating adjusted capital ratio, 20% of liquidated asset should be included in the denominator • Starting Credit Counseling & Recovery Service (founded in 2003) • 1 out of 10 economically active population is registered as insolvent and the number was increasing • Increasing personal insolvency not only hurts financial institutions profitability but becomes the reason of social unrest • Financial companies co-founded CCRS to reschedule personal debts and help finding jobs for troubled people • Number of applications for debt rescheduled: 2003: 62,550 → 2004: 287,352

37. Credit Card Industry after Crisis • Credit card companies are recovering from crisis • • Assets are still shrinking • • Past due ratio (including rescheduled debt) has decreased to 11.9%(Sep 2005) from 28.3%(end of 2003) • Number of credit card companies has reduced • - Three companies were merged into mother banks • - Six credit companies left on business (billion U$, %)

38. Monitoring Systemic Risks Create indices to monitor systemic risks in bond markets • Concentration Index • Credit Spread Index • Market Sentiment Index Create indices to monitor individual credit risks • Strengthen credit bureau business • Create individual credit risk index

39. ABS related business guideline Market’s self-regulatory guideline for those engaged in ABS business (from ’05.5) • Clarify the role and responsibilities of ABS related party • Embody device for surveillance among ABS related parties • Strengthen ABS related disclosure Minimize instability in the ABS market and create an environment favorable to ABS investment

40. 4 New Asset-Backed Securities: Student Loan Securitization

41. Establishment of Korea Housing Finance Corporation • Korea Mortgage Corporation was established as a joint venture with IFC in 1999. • Establishment of State-run Secondary Mortgage Market Enterprise • Korea Housing Finance Corporation Act enacted in Dec. 2003 • KHFC officially established on Mar. 1, 2004 • Korean government & Bank of Korea are sole contributors of the capital. • Losses, in excess of reserves, to be covered by the government (KHFC Act) • Major Lines of Business • Purchases mortgages and issues MBS • Purchases mortgages and Issues MBB (Mortgage-Backed Bond) • Mortgage Portfolio Business (Issuance of MBS or MBB required) • Provides credit lines to lenders to support the origination of mortgages • Mortgage Securitization Business • As of Jan. 31, 2006 • 7.6 trillion won of mortgages originated (104,496 mortgages) Currently mortgages are originated by 22 Approved Lenders • 9 Approved Lenders started to originate mortgages from Mar. 25, 2004 • 17 MBS Issuances completed (Total 7.3 trillion won) • The first MBS issuance completed in June, 2004 • The first SLBS Issuances completed in Oct. 2005 (517 billion won) • Now preparing the 2nd and 3rd SLBS issuances scheduled to be completed in the coming Apr. and May

42. MBS Issuance Structure FSC Registration of Securitization Plan, Transfer/Trust Sales of Mortgages Trust Issuance of MBS Lenders (Seller/Servicer) Trust (Trustee: KHFC) KHFC Investors Guarantee Fee Trustee Fee MBS P&I Repayment Mortgages Servicing Fee Monthly Repayment of P&I Guarantee on MBS P&I payment Borrowers

43. - Need to support the cost of living besides the tuition - Government’s excessive burden for subsidization - Need to lengthen the Repayment Period - Mismatch in the bank’s Asset-Liability Management - Need to develop stable supply system of student loans Existing Subsidized Student Loan • Major Problems of the old Student Loan Program • Annual subsidization increases as the outstanding balance of student loans increases • Difficult to increase the government-sponsored student loans • Max. 7 years of Repayment Period needs to be lengthened. • To mitigate the repayment burden • Short-term deposits vs. Long-term loans with fixed interest rate • Heavily depends on the banks’ discretion or business strategy

44. New Government-Guaranteed Student Loan • Student Loan Securitization • KHFC issues Student Loan-Backed Securities(“SLBS”) backed by Student Loans purchased from 15 designated Banks • KHFC guarantees SLBS P&I payment • Student Loans are funded from the Bond Market • Banks will not hold Student Loans under their balance Sheets • Banks act as the Servicers once they sell Student Loans to KHFC • Borrower repay P&I through the Banks (Originator/Servicer) • Banks get Servicer Fee Income • Banks are free from Credit Risk

45. Student Loan Securitization Program • Current Status • In the 2nd half of 2005, 15 Banks originated student loans and sold them to KHFC for securitization • Origination period : Aug. 12 ~ Sep. 28, 2005 • SLBS Issuance : Oct. 25, 2005 (517 billion won) • Currently 16 banks are originating student loans for securitization • Origination period : Feb. 2 ~ Mar. 24, 2006 • Targeted volume : 800 billion won (1st half of 2006 only) • SLBS Issuance : Apr. & May, 2006 (400 billion won respectively)

46. Student Loan Securitization(SLBS) • SLBS Issuance Structure FSC Registration of Securitization Plan, Transfer/Trust Sales of Student Loans Issuance of SLBS Trust Banks (Seller/Servicer) Trust (Trustee: KHFC) KHFC Investors Guarantee Fee Trustee Fee SLBS P&I Repayment Student Loans Monthly Repayment of P&I Servicing Fee Guarantee on SLBS P&I payment Guarantee Student Loan Credit Guarantee Fund Borrowers Guarantee Fee

47. Student Loan Credit Guarantee Fund • Specialized Fund for Credit Guarantee • Korean Government established「Student Loan Credit Guarantee Fund」 • On July 18, 2005 • To enhance the credit of student loans • By providing 90% Partial Loss Coverage • Ministry of Education & Human Resources Development directs the Fund • KHFC appointed as the Manager of the Fund • Borrowers apply for the guarantee through 16 designated Banks which originate the student loans • Provided guarantee related to the origination of 522 billion won of student loans in the 2nd half of 2005 • The Fund plans to provide guarantee to support 1.6 trillion won of student loans in 2006 • Targeted Number of Student Loans : 500,000

48. Thank You !