Bad Banks Turn Toxic China Debt to Treasure for Investors
Lai Xiaomin, chairman of China Huarong Asset Management Co., found his schedule packed one morning this year with back-to-back meetings with visitors from Goldman Sachs Group Inc. (GS) and Morgan Stanley. (MS)
Since the nation’s largest bad-loan manager was restructured into a commercial company last October, Wall Street banks have been clamoring to get in the door. Executives including Goldman Sachs Vice Chairman J. Michael Evans and Morgan Stanley’s co-head of investment banking in the Asia-Pacific region, Shane Zhang, lauded Huarong’s success and expressed interest in buying stakes, according to statements issued by the firm after the meetings in Beijing in January.
The reason: China’s four state-owned asset-management companies, known as AMCs, set up during the banking crisis of the late 1990s to oversee 1.4 trillion yuan ($229 billion) of nonperforming loans, have been delivering profits. They did it by selling some loans and converting others into equity stakes. Now they’ve expanded into licensed financial firms doing everything from investment banking to trusts and real estate.
“The AMC balance sheets are relatively clean at this point,” said Charlene Chu, Beijing-based head of China financial institutions at Fitch Ratings. “You can make a ton of money on NPL workouts if you do them right.”
Foreign investors led by UBS AG (UBSN) and Standard Chartered Plc (STAN) already have bought stakes in China Cinda Asset Management Co., which is preparing a $3 billion initial public offering in Hong Kong. The IPO is currently planned for December, a person with knowledge of the matter, who asked not to be identified because the deal is private, said today.
Buying shares in China’s bad-loan managers could help the global firms profit from a new round of nonperforming loans following a $6.5 trillion lending spree since the end of 2008.
“At some point, China will embark on sales of NPLs resulting from the 2009-2012 credit binge,” said Ted Osborn, a Hong Kong-based partner at PricewaterhouseCoopers LLP and a specialist in bad debt. “International investors are keen to invest in the AMCs, as they are seen as being supported by the government, and this will enhance their future prospects in China’s ever-developing financial sector.”
China set up Huarong, Cinda, China Orient Asset Management Corp. and China Great Wall Asset Management Corp. in 1999 to clean up a financial system on the brink of bankruptcy after decades of government-directed lending to unprofitable enterprises. Bad-loan ratios reached as high as 40 percent. Authorities gave each company 10 billion yuan of capital and a 10-year period to dispose of assets.
The four AMCs reported combined assets of 560 billion yuan and profits of 16 billion yuan in 2011, according to a bond prospectus Cinda issued last October. At Cinda, the second-largest of the firms, profit rose 6 percent to 7.2 billion yuan last year, according to the company’s annual report. Huarong, the largest by assets, posted a 68 percent jump in 2012 profit to 5.9 billion yuan.
The AMCs helped rejuvenate China’s economy by turning 405 billion yuan of delinquent borrowings into equity stakes in 601 of the biggest state-owned enterprises, according to Cinda’s bond prospectus. Freed of their unpaid bank debts, once chronic money-losing firms including Aluminum Corp. of China, known as Chalco (601600) and now the nation’s biggest aluminum producer, and China Petroleum & Chemical Corp. (600028), Asia’s largest refinery, were overhauled into industry leaders and have since gone public.
That made the AMCs’ stakes valuable. About 2 billion yuan of Chalco bad loans given to Cinda converted in 2001 to a 21 percent stake in the company worth 2.2 billion yuan when it listed on the Hong Kong Stock Exchange less than three months later. Cinda still owns a 5.9 percent stake, now valued at 3.5 billion yuan based on the current share price.
Besides turning soured debt into equity, the AMCs enhanced the value of distressed assets by restructuring, bridge loans and other instruments available through their subsidiaries.
The combined capital of the AMCs has more than tripled to 148 billion yuan since 1999, according to Tan Ming, a Hong Kong-based analyst at Jefferies LLC. That will give AMCs the “financial wherewithal and appetite” to deal with more nonperforming assets still to emerge in China’s financial industry such as trusts, he wrote in a June note.
China’s leaders are under pressure to rein in credit following a lending spree since the end of 2008 of a magnitude similar to the one that pushed Asian nations into crisis in the late 1990s and preceded Japan’s lost decades. China’s economy probably will expand 7.6 percent this year, the weakest pace since 1999, according to the median estimate of economists surveyed by Bloomberg News.
Goldman Sachs estimated in August that China might face losses of as much as $3 trillion as the speed of its credit expansion over the past four years, particularly by non-bank lenders, has exceeded that seen prior to other credit crises.
During the late 1990s, the four Beijing-based AMCs borrowed 570 billion yuan from the central bank and raised 820 billion yuan by selling bonds to four state-owned banks to pay them for the bad loans at face value, according to the Cinda prospectus. They inherited more soured loans from Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. (939), Agricultural Bank of China Ltd., Bank of China Ltd. and Bank of Communications Co. during a 2003-2005 restructuring and also acquired distressed assets from smaller banks after 2005.
The bailouts removed trillions of yuan of soured loans off the books of China’s four biggest banks, enabling them to transform from insolvent institutions into the world’s most-profitable lenders, reporting less than 1 percent of their loans as nonperforming by the end of June.
While the AMCs claimed success in dealing with the 1999 bailout, they only recovered 20 percent in cash out of the 866 billion yuan in nonperforming loans they sold by the end of March 2006, when disposal of those debts was completed, according to the China Banking Regulatory Commission.
The Finance Ministry in 2010 allowed the firms to extend bonds that should have been due that year by another decade, raising concerns that the bad-loan managers were unable to repay the four banks that purchased them.
“I don’t believe the AMCs are really profitable if they had to demonstrate cash flow and debt-service coverage to support their debts,” said Jack Rodman, a former partner at Ernst & Young LLP who advised top China banks and AMCs on bad-loan disposals from 2002 to 2007 and is now a Seattle-based senior adviser at Crosswater Realty Advisors LLC. “Their liabilities to the banks and the state are huge.”
Under a government-approved restructuring plan, Cinda marked down legacy-related nonperforming assets and liabilities to market value in 2010 as part of its transformation into a commercially viable operation, enabling the new company to book profit when getting rid of legacy loans.
Since then, almost 45 percent of the AMCs’ bonds have been repaid, according to Mike Werner, a Hong Kong-based analyst at Sanford C. Bernstein HK Ltd. AMCs’ commercial operations appear financially healthy and their returns on equity are in the 14 percent to 21 percent range, Werner said, citing the direct result of the Finance Ministry carving out the legacy bad-loan disposal business from commercial operations.
Cinda credited its expertise in restructuring distressed assets and ownership in state firms for helping it sell a 16.5 percent stake to Zurich-based UBS, Standard Chartered, China’s Social Security Fund and Citic Capital Holdings Ltd. for 10.4 billion yuan in March 2012.
“The debt-to-equity swaps in many SOEs not only provided AMCs with a decent return but also improved their bad-loan management skills by helping them grow,” said Li Ying, a Beijing-based analyst at China Chengxin International Credit Ratings Co., partly owned by Moody’s Investors Service. “The AMCs have been a stabilizing factor in China’s last financial crisis, and the government would definitely need their expertise and contribution if there’s ever another one.”
Cinda had inherited and purchased 1.5 trillion yuan of nonperforming loans from more than 10 financial institutions by the end of 2011, with the majority from Construction Bank, the nation’s second-largest bank, and China Development Bank Corp., the world’s biggest policy lender. It recovered almost 300 billion yuan in cash as of Dec. 31, according to China Chengxin International.
As of the end of last year, Cinda still held stakes worth at least 45 billion yuan in 136 state-owned companies. As many of these firms are overhauled and prepared for public share sales, Cinda has turned dud loans into cash cows.
Huarong acquired 680 billion yuan of bad loans as of the end of 2012, mostly from ICBC, the nation’s largest lender, according to its 2012 annual report. It executed debt-to-equity swaps in 393 state-owned firms and still held stakes valued at 46 billion yuan in 261 firms, the report showed.
Orient Asset Management acquired more than 710 billion yuan of nonperforming assets and converted 25.3 billion yuan of debt into stakes at 166 state-owned firms, according to its website. The company last month became the first of the four AMCs to sell U.S. dollar bonds abroad, raising $600 million through a unit after attracting $3.7 billion of orders from international investors, according to a Sept. 29 statement.
Spokesmen for Huarong, Goldman Sachs and UBS declined to comment on the AMCs in e-mails. Cinda, Great Wall and China Orient didn’t respond to faxes. Xu Li, a Beijing-based spokeswoman for Morgan Stanley, confirmed the January meeting with Huarong without giving further details.
The Finance Ministry remains Cinda’s largest shareholder with an 83.5 percent stake, while the national pension fund owns 8 percent. UBS holds 5 percent, with Citic Capital and Standard Chartered having 2 percent and 1.5 percent, respectively.
Cinda said in March 2012 that the equity-stake sales were a precursor to its eventual IPO. The company, with 20,488 employees and 31 branches across China, in December raised 10 billion yuan from the first public bond sale by an AMC.
Huarong said last year 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 Inc., Goldman Sachs, Morgan Stanley, Barclays Plc and Taiwan’s SinoPac Financial Holdings Co. have paid visits to Huarong’s offices in Beijing, according to the Chinese firm’s press releases. No deal has been reached.
The plans by Cinda and Huarong add to signs that China is getting ready to begin a new round of bad-debt disposals and bank recapitalizations, Yao Wei, China economist at Societe General SA in Hong Kong, wrote in a Sept. 13 note.
“Investing in Chinese NPLs is fraught with risk, particularly for foreign investors new to the China market,” said PwC’s Osborn. “Teaming up with local partners helps to mitigate this risk and can lead to higher returns,” as China may impose new restrictions on foreigners participating in future sales of soured debt.
Huarong set up ventures with Morgan Stanley and Goldman Sachs in 2002 as part of China’s first sales of bad loans to overseas investors. Other Wall Street banks including Citigroup Inc., JPMorgan Chase & Co. and Lehman Brothers Holdings Inc. also bought nonperforming loans from the AMCs.
Foreign investors that earmarked as much as $10 billion to buy China’s bad debt missed out on the opportunity as the government limited purchases, according to a 2006 PwC survey.
“The last time we had the big carve-outs in 1999-2000, so many foreign firms moved in, and they just weren’t allowed to do anything,” said Fitch’s Chu. “It wouldn’t surprise me if now they are saying basically the only way we are going to get access is by doing a tie-up with one of these companies. This could be foreign investors looking ahead and saying, ’Let’s get in now on the ground.’”
The AMCs have been allowed to expand into underwriting the sale of stocks and bonds, insurance and leasing. Cinda has nine subsidiaries, including ones 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 spanning banking and fund management to securities and property.
That will give potential foreign investors “access to unique licenses for activities that should one day be worthwhile middle-market enterprises,” Rodman, the debt adviser, said.
Cinda and Huarong insist that buying and selling bad assets will continue to be their core business in years to come. Huarong Chairman Lai, 51, said at the National People’s Congress in March that rising nonperforming loans at Chinese banks may create an opportunity for AMCs and that local-government debt is one of the top financial risks China must tackle.
Huarong spent 61.8 billion yuan in 2012 buying distressed assets valued at 109 billion yuan, according to its annual report. That’s more than triple the value of assets it acquired a year earlier.
“No matter how diversified they become, the AMCs shouldn’t run off their main course as a bad-loan manager,” Chengxin’s Li said. “That’s what the government is supporting them for.”
Nonperforming loans at Chinese banks grew for a seventh consecutive quarter in the three months ended June 30 to 539.5 billion yuan, extending the longest streak in at least nine years. Still, that accounted for only 0.96 percent of the nation’s outstanding loans, according to the China Banking Regulatory Commission.
The level of bad loans is underestimated, as banks have moved loans off balance sheets and little local government debt was marked as nonperforming because of implicit government guarantees, according to Fitch’s Chu.
“The problem being an investor in the AMCs is that they are a receptacle for all the crappy loans and bad investments that the state wants to warehouse or sweep under the carpet,” said Rodman. “I would not be investing in AMC companies.”
Goldman Sachs and Morgan Stanley disagreed. In the Jan. 11 meetings with Huarong’s Chairman Lai, Morgan Stanley’s Hong Kong-based Zhang said his company was “very optimistic” about the future of Huarong, while Goldman Sachs’s Evans offered to help Huarong improve its risk control, according to a Jan. 17 statement on Huarong’s website. Both Zhang and Evans expressed a desire to “participate in China Huarong’s introduction of strategic investors,” according to the statement.
“It’s definitely an opportunity, without a doubt,” Fitch’s Chu said. “The biggest challenge is how to price these things. At what price did you buy this stuff off of other people in a market where no one actually really acknowledges when there’s a loss or marks anything to the appropriate value?”
To contact the editor responsible for this story: Chitra Somayaji at email@example.com