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Chinese bad bank cleanup team

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The prospect of the very first default in China’s burgeoning shadow banking sector has sent shock waves through financial markets this year.

As rumors spread that a trusted Rmb3bn product called “China Credit Equals Gold # 1” was about to default, investors began to question the stability of the entire Chinese financial system.

But just days before the expected default, a mystery buyer bailed out the product, allowing investors to recover all of the principal and most of the interest owed to them.

The Financial Times has learned that the secret savior, so far not publicly identified, was Huarong Asset Management, one of the four “bad banks” created in the late 1990s to deal with a huge amount of non-performing loans in the United States. the banking system.

More than five years after the start of one of the biggest credit booms in history, Chinese banks are bracing for a new wave of bad loans that some analysts and economists say could rival that of the late 1990s. 90s.

Companies like Huarong are expected to play a crucial role again.

“As the economy slows, the market expects a further increase in non-performing assets,” said Harry Hu, analyst at Standard & Poor’s. “We expect business volumes to increase for [Huarong and the other three bad banks]. “

Signs of stress are already emerging as scores and possibly hundreds of high interest fiat loans to subprime borrowers run into trouble and China’s state-backed banking system struggles to avoid outright defaults and simple.

So far, around 60 trusted product bailouts have been reported, but “in our opinion, for every reported case there are many unreported cases,” Bank of America analyst Merrill Lynch wrote in a report. report last month.

Credit Equals Gold, which offered an annual interest rate of 10 percent, was sold to investors by the Industrial and Commercial Bank of China, the country’s largest lender.

Although ICBC was not technically responsible for the losses due to the default, it faced enormous pressure from the government and investors who had purchased the product through its branches.

To bail out the proceeds at the last minute, ICBC granted a Rmb3 billion loan to Huarong, who then bought the loan securing the fiat product at around 95 cents on the dollar (95 fen on the Rmb).

This meant investors could be reimbursed for almost everything they were owed and confidence in China’s shadow banking sector restored, albeit at the expense of lingering moral hazard.

Huarong’s plan to sell shares to global investors as part of an initial public offering, most likely in Hong Kong in the first half of next year, was probably why he was so keen to keep this deal silent. , according to people familiar with the details of the bailout. .

Video: Expect more flaws in China

Huarong’s involvement in such a blatantly political bailout would have undermined his argument to investors that he has transformed from an arm of the state into a commercial entity operating purely on market principles.

He has made this point quite convincingly so far.

Credit growth

On Thursday, Huarong said it had sold a 21% stake for $ 2.4 billion to a group of eight investors, including Goldman Sachs, Warburg Pincus and Malaysian sovereign wealth fund Khazanah.

Huarong’s upcoming IPO and his involvement in the bailout of China’s first major shadow bank default have shed light on the role of Chinese “bad banks”.

In the late 1990s, following a boom and slowdown in government lending, China’s banking sector was technically insolvent, with bad loans accounting for up to 40% of lender portfolios, independent analysts say.

To deal with the problem, Beijing created Huarong and three other “asset management companies” – Orient, Great Wall and Cinda – to take Rmb 1.4 billion of bad debt off the books of banks.

Non-performing loan ratio

The government then injected hundreds of billions of renminbi in new capital into the banks, sold stakes to foreign investors, and eventually listed them all in Hong Kong, although Beijing retains the majority of stakes and control of the lenders.

Prior to their bailouts, bank managers across the country typically made loans on orders from local Communist Party officials regardless of the borrowers’ ability to repay them.

After being listed, banks became much more commercial and more demanding of who they lent to.

But as China faced a growth collapse following the 2008 global financial crisis, the government ordered banks to lend indiscriminately to support growth.

The effort to boost growth rates was successful, but it also resulted in one of the largest and fastest growing credit expansions in history, with much of the money going to borrowers whose repayment capacity was uncertain.

Bad debt ratio, Q2 2014

In their semi-annual statements to the Hong Kong and Shanghai stock exchanges, China’s largest banks all reported an increase in bad loans in the first half of this year.

At Bank of China, bad debt write-offs and sales in the first half of 2014 totaled Rmb 9.4 billion, more than Rmb 9.1 billion for 2013 as a whole.

The official NPL ratio of Chinese banks is at its highest level since March 2011, but it remains very low, at an average of around 1.08% of all loans.

The Agricultural Bank of China, which has 450 million retail customers, is the hardest hit of the country’s major banks, albeit with a still minimal bad debt ratio of just 1.24%.

Bank executives and analysts say banks use a variety of methods to underestimate the true level of their bad debt, including taking the riskiest loans before they go bad and restructuring them into off-balance sheet fiat products such as than Credit Equals Gold # 1.

Aggregate net income of the big four

All of China’s largest publicly traded banks are trading below their book value, implying that investors believe that listed loans are not worth their face value.

As more loans turn sour, Huarong and other bad banks will be on the front lines of yet another Chinese bank cleanup.

They’re already collecting cash by selling bonds and stocks – and taking large loans from a range of state-owned banks that they’ll use to buy bad debt from other state-owned banks.

The next wave of defaults, especially in the trust industry, will provide opportunities for these companies (and their investors) to take advantage of a bad debt resolution process they have become adept at over the past decade.

But it will also expose them once again to the kind of political imperatives and pressures involved in the Credit Equals Gold # 1 bailout.