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Turning Toxic Debt to Gold in China

Turning Toxic Debt to Gold in China

Photograph by Best View Stock/Alamy

In 1999, China set up four companies to help dispose of $229 billion of soured loans that banks had accumulated after years of lending to unprofitable state-owned companies. The strategy worked better than anyone expected. By trading debt for equity and using other restructuring tactics, the asset managers have delivered profits and evolved into diversified financial companies that do investment banking, manage funds, make real estate deals, and sell insurance. Now the four—Huarong Asset Management, Cinda Asset Management, Orient Asset Management, and Great Wall Asset Management—are poised to benefit from a new batch of nonperforming loans (NPLs) generated in China’s latest lending spree. “You can make a ton of money off of NPL workouts if you do them right,” says Charlene Chu, the Beijing-based head of China financial institutions at Fitch Ratings.

The asset management companies’ reported combined assets of 560 billion yuan ($91 billion) and profits of 16 billion yuan in 2011, according to a bond offering prospectus Cinda issued last year. At Cinda, the second-largest of the companies, profit rose 6 percent, to 7.2 billion yuan, in 2012. Huarong, the largest, posted a 68 percent jump in profit last year, to 5.9 billion yuan.

Those profits came with a lot of help from the state. When they were set up, the four companies borrowed 570 billion yuan from China’s central bank. They raised an additional 820 billion yuan by selling bonds to the four biggest state-owned banks. The asset managers sent that money right back by purchasing bad loans from the banks at full value. During a 2003-05 restructuring, they inherited more bad loans from the big banks. The bailouts took trillions of yuan of soured loans off the banks’ books, helping the insolvent institutions become the world’s most profitable lenders. At the end of June, the four big banks—Industrial & Commercial Bank of China (1398:HK), China Construction Bank (939:HK), Agricultural Bank of China (1288:HK), and Bank of China (3988:HK)—reported less than 1 percent of their loans as nonperforming.

The asset management companies also helped rejuvenate China’s corporations. They exchanged 405 billion yuan of delinquent loans for equity stakes in 601 of the biggest state-owned enterprises, according to the Cinda prospectus. Shedding that debt helped once-chronic money-losing companies, including Aluminum Corp. of China (ACH), known as Chalco and now the nation’s biggest aluminum producer, and China Petroleum & Chemical (SNP), Asia’s largest refinery, become profitable industry leaders. At the end of 2012, Cinda still held stakes worth at least 45 billion yuan in 136 government-owned companies. The asset managers “were a stabilizing factor in China’s last financial crisis,” says Li Ying, an analyst at China Chengxin International Credit Ratings. “And the government would definitely need their expertise and contribution if there’s ever another one.”

Because of their success with loans, the four companies have been allowed to expand into underwriting stocks and bonds, insurance, and leasing. Cinda has nine subsidiaries, including those for financial leasing, brokerage, futures, fund management, life and property insurance, trusts, and real estate, according to its website. Huarong owns stakes in financial companies ranging from banking and fund management to securities and property.

Global banks are taking notice. UBS (UBS) and Standard Chartered (STAN:LN) have bought stakes in Cinda, which is preparing for a $3 billion initial public offering as early as yearend. The Finance Ministry remains Cinda’s largest shareholder, with an 83.5 percent stake, while the national pension fund owns 8 percent. Huarong said in 2012 it was seeking Chinese and foreign investors and planned to sell shares in local and overseas markets. Over the past year, executives from Macquarie Group (MQG:AU), Goldman Sachs (GS), Morgan Stanley (MS), Barclays (BCS), and Taiwan’s SinoPac Financial Holdings (2890:TT) have visited Huarong’s offices in Beijing, according to the Chinese company’s press releases. No deal has been reached. The asset managers’ “balance sheets are relatively clean at this point,” says Fitch Ratings’ Chu. “There could be huge returns there.”

Foreign investors may also be attracted by the prospect of a fresh crop of nonperforming loans for the companies to harvest. “At some point, China will embark on sales of NPLs resulting from the 2009-2012 credit binge,” says Ted Osborn, a Hong Kong-based partner at PricewaterhouseCoopers. International investors are “keen to invest” in the companies, “as they are seen as being supported by the government, and this will enhance their future prospects in China’s ever-developing financial sector,” he says.

Potential investors should think twice, because there are hidden dangers, says Jack Rodman, a former partner at Ernst & Young who advised top China banks and asset management companies from 2002 to 2007. “They are a receptacle for all the crappy loans and bad investments that the state wants to warehouse or sweep under the carpet,” says Rodman, now a senior adviser at Crosswater Realty Advisors in Seattle. “Their liabilities to the banks and the state are huge.”

The bottom line: The four companies set up in 1999 to handle $229 billion of bad loans have become profitable financial businesses.

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