Another Sword Hanging Over Seoul

Big losses at investment trusts could trigger a market crash

Yim Chang Yol thought her money was safe with Citizens Investment Trust Management & Securities Co., one of the big Korean mutual-fund houses that manage investments for millions of South Koreans. Yet on Mar. 27, Yim heard unsettling news from a friend in the financial-services industry: Citizens was sitting on $940 million in losses. "So I decided to get my money out quickly," says the 62-year-old housewife. "I am putting my money back in my bank, where the government guarantees the deposits."

The managers of Korea's 29 investment-trust companies, which have taken a huge hit in the Asian crisis, are praying that withdrawals like Yim's will not provoke another financial calamity. If the 8 million Koreans who have invested with the trusts suddenly panic and pull out their money, the trusts would have to dump stocks and bonds to cover the redemptions. In that case, the markets, which have recovered some since January, could crash again. "The investment companies could turn into a time bomb," says Lee Jeung Lak, general manager at Boram Bank.

The government of Kim Dae Jung is not publicizing the perilous state of the trusts. The companies manage about $73 billion, or roughly 11% of all the deposits in financial institutions. The top three, Korea Investment Trust, Daehan Investment Trust, and Citizens, hold 20% of all bonds issued in South Korea and account for 5% of stock holdings. The trusts have also actively traded for their own accounts. Despite recent runups, the markets are still way down from a few years ago. Losses at the trusts exceed their net worth by some $2.6 billion.

Although the trusts haven't hidden their losses, their predicament largely has escaped notice, since the crisis at the commercial banks has dominated the news. But in the last week of March, a news report that the trusts were technically bankrupt pushed redemptions up to $140 million a day. The trusts and the government kept mum, and no other media picked up on the story. Redemptions have now dropped back to a daily level of $70 million, still far above the normal rate. But another wave of panic withdrawals could easily occur.

Heavy debt loads at the trusts are making things worse. In 1989, the government strong-armed the trusts to borrow heavily and use the loans to buy stocks for their own account. The government also urged the trusts to avoid selling stocks in weak markets. These arrangements worked fine as long as the markets boomed and interest rates were low. But now, rates have surged. The top three trusts are laboring under $7 billion in short-term debt. With prevailing rates standing at 20% or so, the trusts' fee income of $730 million covers just half their interest costs. To close the gap, the three trusts have resorted to fresh borrowing.

"FATAL BLOW." Adding to the problem is huge exposure to the bond market. The trusts bought most of their bonds at yields of about 12%. Now, with rates at around 20%, the prices of those bonds have tumbled, and the trusts are sitting on huge losses. But they cannot pass those losses on to customers who want to redeem their shares in the trusts' bond funds. Local regulations require the trusts to pay out bond redemptions at the original purchase price. So if a trust paid $100 for a 12% bond, and that bond's trading price has dropped to $80, the trust still must pay a client redeeming his bond fund the full $100 rate.

That makes redemptions a costly burden for the trusts. "We'll meet redemptions initially by taking out new loans," says Yoon Hyong Joon, assistant manager at Korea Investment. "But if we run out of funds, we'll have to raise more by dumping our securities. That could deal a fatal blow to the capital market." If the trusts rush to sell off their holdings, bond prices will collapse again, and yields will be driven up even further. All hopes of a rate easing would fade for the year. The already high bankruptcy rate of Korea's cash-strapped companies would escalate.

Finance Ministry officials decline comment on the precarious health of the trusts. "The government seems to be thinking there is no other choice but to live with this latent danger for the time being," says Park Kyung Suh, economics professor at Korea University. "If we are lucky, interest rates will fall, and share prices will rise." Rates have eased some since the darkest days of January--but not enough to erase the trusts' losses and the risk of a blowout. This time bomb is far from defused.

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