Investment banks covering China are set to make profits, not from
origination but from restructuring and securitising the bad loans of
the state-owned banks.
It is becoming clear that Chinese authorities’ and banks’ efforts to
resolve the non-performing loan (NPL) problem are failing. At the same
time, the pressure is on to clean up balance sheets and get the banks
privatised if China’s financial system is not to be the Achilles heel
that eventually brings down the entire economy.
“The key for us in China is our restructuring and distribution
business,” says Jeremy Amias, Citigroup’s head of fixed income for Asia
Pacific. “Now in China we are trying to help big banks restructure
their balance sheets.” Citigroup is in talks to buy $500m of bad loans
from a Chinese work-out company and recently bought $1.8bn worth of
NPLs from the Hong Kong subsidiary of Bank of China. Citigroup’s
efforts will be aided by the establishment at firm-wide level of a new
restructuring unit focusing on the workout business in Asia and Europe.
But so far Hong Kong-based investment bankers report that the China
loan sale business has been over-hyped: announced deals are being
exaggerated by using the face value of the loans as the size of the
deal rather than the market value, which could be as little as 10% or
less of the face value.
“There is a lot more noise than action,” says Paul Calello, CSFB’s Asia
Pacific chairman and CEO. “A lot of MOUs [memorandums of understanding]
have been signed but only a very small percentage of MOUs actually come
to fruition.”
Real action
Of more significance, says Mr Calello, is actual agreed transactions.
He points to the advisory mandate that CSFB signed in October with
Industrial and Commercial Bank of China (ICBC) to look at securitising
Rmb2.5bn ($300m) to Rmb3bn of non-performing and sub-performing loans
owned by the bank’s Ningbo branch. The deal was announced during a
visit to China by CSFB’s CEO John Mack and would be the first bad loan
securitisation to emerge from China’s banks.
Earlier in the year the first sale of an NPL portfolio in China was
completed when a Morgan Stanley consortium and Goldman Sachs bought
$1.3bn and $230m of NPLs respectively (these figures are the face
values of the loans) from China Huarong Asset Management Corporation.
The corporation is one of four asset management companies (AMCs) that
China set up in 1999 to resolve the bad loan problem.
AMCs hit the buffers
The Huarong deal gave a first hint of a situation that is now becoming
all too clear: the system using AMCs is not delivering. If China is
serious about resolving the problem, more far reaching measures will
need to be taken and that probably means using the services of foreign
banks.
Even though the Chinese government has given itself 10 years to resolve
the situation, the scale of the problem is such that drastic measures
will be needed even to find a solution in that timeframe. Economists
have amused themselves trying to quantify the NPLs and, according to
who is asked, the answer will be somewhere between 25% and 45% of total
loans with a value of between $180bn and $500bn.
China’s big four banks – China Construction Bank, Agricultural Bank of
China, BoC and ICBC – account for 65% of the system’s assets and its
NPLs. Four years ago the government set up four AMCs – Cinda, Huarong,
Great Wall and Orient – as vehicles into which the bad loans could be
transferred and worked out in exchange for AMC bonds, which replace the
bad loans on the banks’ balance sheets.
Credit risk drifts back
The aim was to transfer the risk out of the banks. But a recent report
by Moody’s Investors Service suggests that the AMCs’ performance has
been mixed and that the credit risk is starting to drift back to the
banks.
This is because the banks are required to reserve the interest they
receive from their AMC bonds against any future losses on the principal
of the bonds when they mature in 2009. Moody’s expects the resolution
loss from the NPLs that the AMCs hold to be in the order of 70% and
that, as a result, the banks will be required to use the reserved
interest to cover principal losses. This is all the more awkward when,
in accounting terms, the 2.25% coupon on the AMC bonds amounted to 10%
of the banks’ net interest margins in 2002.
“The conclusion is that the interest from the AMC bonds does not in
fact directly benefit the owners of the bonds – the big four [Chinese
banks] – but more the obligors of the securities, the AMCs and the
government,” says the Moody’s report. “Consequently, via a roundabout
route, the credit risks – which were first thought to have been
isolated from the originating banks – are now creeping back to their
starting points.”
Another concern is the efficiency of the AMCs. Their operating costs
are clearly higher than if the banks had performed the workout
themselves. That means they have to be much more adept at recovery if
they are to cover their costs and repay the bonds. No wonder the
Chinese authorities may be starting to think more seriously about using
foreign help.
Hazards ahead
But foreign banks rushing into the market need to exhibit a degree of
caution. If they are too successful in China, the reaction will be that
state assets were sold too cheaply. On the other hand, there could be
serious difficulties if foreign banks that seize collateral end up
owning vast swathes of Chinese industry.
“Chinese banks are trying hard to recover the bad loans themselves,”
says Guocang Huan, HSBC’s head of investment banking for Asia Pacific.
“But they may still need the technology of the foreign banks to finally
resolve the issue. Foreign banks need to be cautious, however. The
Chinese authorities will not want to see state assets sold too cheaply.
“Where foreign banks end up owning Chinese real estate, things are
relatively simple. But if a foreign bank got into a situation where it
owned a factory and had to fire half the people, that would be a lot
more complicated.”
Slow-moving elephants
Mr Huan’s view of the China market is that, although the big deals are
still worth chasing – the elephants, as he describes them – the fact
that they are slow moving and attract the attentions of all the major
players means that as much value or more can be obtained from
medium-sized deals.
HSBC has brought several mid-sized corporates to the Hong Kong stock
market this year, such as Beijing Capital Land, supermarket chain
Linhua and Comba Telecom Systems. Chinese corporates raising
international bonds, however, are likely to be few and far between
because they need government permission to do so and this is likely to
be granted sparingly.
By contrast, the Chinese government cannot afford to be so relaxed
about the NPLs clogging up the balance sheets of the banks. Investment
bankers may spend a lot of time in coming months poring over documents,
trying to assess the market worth of bad loan portfolios. Their China
profits will depend on getting the calculation right.
