''Factors which limit the ratings of Hong Kong dollar debt issued by corporate or government issuers, such as macro-economic and exchange-rate issues, may have less impact on the performance of mortgage portfolios,'' the report says.

Securing a credit rating from an international rating agency is seen as a big boost to the infant market, broadening the investor base and assisting investors to assess the risk of papers.

Moody's has been asked to rate several Hong Kong residential mortgage-backed securities and is developing the necessary analytical models and methodologies.

However, while it is possible to get investment-grade ratings, the report warns that issuance of MBSs, which do not adequately address credit issues, could curtail the development of the market.

Three major areas of credit risks for Hong Kong MBSs were outlined: potential volatility in residential property values, risk of declining mortgage credit performance upon sovereignty transfer in 1997, and mortgage concentration risk owing to lack of geographic diversification.

As the property market has enjoyed a bull run in recent years, it may face substantial price volatility. Naturally, price declines would trigger increased mortgage defaults.

In this regard, factors to be examined by Moody's include: the supply and demand for residential property, the efforts by the Hong Kong Government to manage property values, the role of property developers and the increasing role of the investor versus owner-occupier in the market.

Moody's will also assess the degree to which the change of sovereignty will affect the behaviour of mortgage borrowers and mortgage performances.

Pools of Hong Kong mortgages lack geographic diversification which, in other countries, is a protection against poor performance in particular regions.

However, Hong Kong MBSs will be dependent on the territory's economy alone so concentration risk will be an important credit issue, the report says.

Also, the regulator's influence on the quality of the market and valuations used by mortgage lenders will be taken into account.

To protect investors against unexpected credit losses, MBSs are usually furnished with credit supports, such as mortgage insurance, a letter of credit or a subordination, which channels losses to investors in higher risk subordinated tranches of the transaction.

The regulator, the Hong Kong Monetary Authority, has stated its stance clearly on MBSs: the market should be developed entirely on private sector initiatives.

But to facilitate the development of an efficient secondary market, the authority would seek to ensure that the papers had high credit quality, the transaction costs were low and the market was liquid.

The authority will present a report later this year.