Dao Heng Bank has swapped HK$1 billion in mortgage loans in return for interest-bearing bonds issued by the Hong Kong Mortgage Corp (HKMC). The pioneering swap agreement, announced yesterday, will generate net positive returns to the bank from a combination of an undisclosed interest coupon attached to the three-year bonds, together with a fee for continued administration of the mortgages. It will also reduce the bank's obligation to make general provisioning requirements against its loan portfolio, as well as its capital charges, and hence boost its return on assets. For HKMC, the deal is the first done under an asset-swap programme designed to supplement its programme of outright purchases of bank mortgages. Since the HKMC is engaged in talks with a number of other banks about swap agreements, details of the yield at which the swap was done would not be disclosed, an HKMC spokesman said yesterday. Two-year notes issued by the HKMC in March last year were offered at a fixed rate of interest of 7.7 per cent payable semi-annually in arrears. The swap agreement with Dao Heng is for a three-year bond - close to the typically effective life of a mortgage loan of between four and five years - said the HKMC's chief executive officer, Peter Pang Sing-tong. Mr Pang said after accounting for an additional administration fee which HKMC would pay Dao Heng, the returns to the bank from the swap agreement would exceed the interest it had earned from the mortgages. 'The key thing is that mortgage rates have come down substantially to around 1.75 per cent below prime - or around 7 per cent to 7.5 per cent, and this is close to the yields of HKMC bonds of three- to five-year maturity,' said Mr Pang. This convergence had made a swap arrangement attractive, explained Mr Pang, because in addition to the interest coupon attached to the bond, HKMC would pay a fee to the bank to continue collecting monthly mortgage payments and administering the loan portfolio. 'These two incomes taken together are higher than the interest earned on the mortgage loans,' he said. The HKMC is a public limited company wholly owned by the government through the Exchange Fund and was incorporated in March 1997 to develop Hong Kong's secondary mortgage market. This sovereign ownership structure, along with the low-risk securities in which it invests, qualify bonds issued by the HKMC at close to sovereign risk, which means that banks need not make a general provision on the HKMC bond. The status of the asset also reduces the bank's need to meet capital adequacy charges, and since the bond qualifies as a liquifiable asset under the Banking Ordinance, it also improves the bank's liquidity ratio. In its interim result for the six months to December 31, Dao Heng revealed that its mortgage portfolio had dipped from HK$27.45 billion at the end of June last year to HK$27.22 billion. Dao Heng Markets' general manager, Ping Shing Tam, said the bank was pleased to be the first to enter into such a swap agreement. 'The arrangement is beneficial to both the HKMC and the banks which are offered greater flexibility in balance-sheet management,' said Mr Tam. The swap will be conducted in two tranches, with the first tranche of HK$600 million scheduled for settlement in late July or early August. The balance of HK$400 million will be arranged for settlement in the next 12 months, said the HKMC. The HKMC last year reported profit after tax of HK$271.2 million - up 154.9 per cent on the previous year.