Photo: Financial Times
The bad asset management market is presenting fresh opportunities to investors at home and abroad, amid government measures to lessen corporate leverage through debt-to-equity swaps. However, despite the ‘cake’ getting bigger, most players are still hesitant to dive in due to a downward economy and emerging setbacks in disposing bad loans in China.
A new round of investment targeting bad assets is just around the corner, with China moving on the track of rapid debt deleveraging. Soon, China’s commercial banks would kick off their campaigns to raise capital for funding debt-for-equity swaps, and funds from different channels would try to pursue “the best business in the worst of times”.
China’s five largest state-owned commercial banks are all planning to set up their own asset management subsidiaries to carry out debt-for-equity swap programs, Caixin reported. Agricultural Bank of China has approved a proposal to establish a wholly owned AMC in Beijing with a total capital of 10 billion yuan ($1.45 billion).
“Previously, non-performing loans would be packaged and sold to the ‘Big Four’ state-owned asset management companies (AMCs),” a financial institution source specializing in bad assets investment told Caixin. This time, things would be different, he noted. The big four AMCs are the Great Wall, Orient, Huarong and Cinda Asset Management.
As low interest rates and weak stock market performance have led to a shortage of high-yielding assets (referred to as China’s ‘Asset Famine’), non-performing loan (NPLs) portfolios are regarded by many as a better choice. It is predicted that non-performing assets in China could amount to 10 trillion yuan with an annual growth of 20% in the next three to five years. The four large AMCs, investment companies, private funds and foreign investors would all tap in the market.
“Now it’s good time to invest in non-performing loans (NPLs),” Zhang Xiaolin, co-founder and managing partner of Shoreline Capital said at a recent summit on bad asset investment.
The China Banking Regulatory Commission (CBRC), a state banking regulator, is now encouraging broader efforts to manage corporate debt and commercial lenders’ non-performing loans. The CBRC in October allowed local governments to set up more than one local AMC. Meanwhile, asset managers now could sell bad debts they acquire to other companies. A total of 31 local AMCs have been set up at the provincial level. The “Big Four” AMCs are no longer monopolistic.
Besides, the Ministry of Finance recently released documents lowering the threshold of China’s bad debt buyers. Previously, regulators would not allow foreign financial institutions to accept China’s bad asset packages, worrying potential drain of state owned assets. Now the restriction has been lifted.
The competition would be fierce, although investors’ capabilities in pricing, acquiring and managing the distressed assets are widely expected to stabilize the economy.
A ten trillion cake
Based on data from the CBRC, by the third quarter of 2016, total assets of the banking sector amounted to 219.6 trillion yuan. No one really knows the exact market size of China’s bad debts.
According to CBRC data, from the fourth quarter of 2011, commercial banks’ NPL ratio began to climb from less than 1% to1.76% in third quarter of 2016, with its volume rising from 400 billion to 1.4939 trillion yuan. The banking regulator admitted the 1.76% ratio may be underestimated. At the end of 2015, Caixin was informed by some source close to the CBRC that bad debts are not fully disclosed, and the quality of banking assets are not guaranteed.
Considering that commercial banks tend to underrate troubled loans by all means, industry analysts suggest that special-mention loans should also be counted into bad debts.
The China Orient Asset Management (COAMC) recently released its 2016 report on bad assets, suggesting the special-mention loans are mostly at high risk of default.
The pool of special-mention and bad loans could reach nearly 5 trillion yuan, exceeding the total 3 trillion yuan stripped off the five big commercial banks from 1999 till 2009 during which period, the listed commercial lenders completed the equity reform.
Caixin learned at the beginning of the year that policymakers had instructed the central bank to find out asset quality of China’s banking sector. The results are not good, a source close to the central bank told Caixin, citing east China’s Jiangsu province as an example.
“Asset books of the province’s 15 major financial institutions have been audited by the People’s Bank of China. Over 200 central bank staff have spent two months to find that the NPL ratio for the banking sector in Jiangsu should be over 3%,” he said. However, based on the figures provided by the local banking regulator, by the end of this June, NPL ratio for Jiangsu is 1.87%.
Jiangsu province would definitely not be an extreme sample. A Guotai Junan Securities research report found that the Yangtze River Delta economy that had seen first signs of bad debt risks emerge now has been stabilized, while distressed assets in central and western China may need as long as five years to be cleared.
Compared with the underestimated official ratio of 1.69%, the source believed an optimistic figure would be over 3% while a more pessimistic guess would be over 5%, especially in those regions suffering from overproduction in manufacturing and coal.
Besides commercial lenders’ total loans of 110 trillion yuan, around 60 trillion yuan is floating in the asset management market. Writing in Caixin, Wu Rui, a senior analyst of bad asset investment, estimated that bad loans may amount to nearly 10 trillion yuan in the whole lending market.
‘Big Four’ AMCs diversify
China’s four large state-owned asset management companies have diverted from their supposed main business of disposing bad loans for banks. Some industry insiders revealed 60% to 70% of the companies’ returns on investment come from disposing bad claims for non-financial enterprises instead.
There are multiple reasons behind the diversion. In a broader context, the first excessive accumulation of banking NPLs had been cleared between 2009 and 2012. Inspired by the 4 trillion stimulus package, China’s ensuing economic boom left little chance for bad loans to grow. So, the four state-owned asset managers turned to more all-around financial services.
Then, the extensive discrepancy existing between the price at which banks would be prepared to sell and the price asset managers are willing to pay also held back the four ‘bad banks’. “In the past, the big four could have 15% to 20% profit margin from the bad loan packages; now commercial banks tend to deal with the bad debts themselves and would not provide such big discounts,” a source with the China Orient Asset Management said.
“To be honest, if an AMC just relies on banks’ business, it could hardly survive,” a source with the China Huarong Asset Management said, “Right now it’s the sellers’ market. There are too many AMCs bidding, so the profit margin has gone down dramatically.”
In most cases, AMCs would merely serve as a conduit. The source close to the central bank indicated many commercial banks would plot with asset managers to fraudulently transfer or dispose of their bad debts in order to bring down the NPL ratio. “It seems bad assets have been transferred to asset managers but they just work as a conduit to later entrusting the bad loans back to banks.”
Conduit business brings easy money, although with more local AMCs, the licensing advantage of the ‘big four’ would gradually be lost with ever-decreasing profit.
Rush of private capital
Private investments are flowing into the market by way of collaboration with national or local AMCs or gaining controlling stakes in newly set up local AMCs.
At present, private capital has entered local AMCs in provinces like Anhui, Hubei, Shandong, Jilin and Ningxia, while the AMC in Tibet are the only among all of 31 local AMCs that are wholly owned by private companies.
According to Zhang Naxin, the managing director of Sincetop Capital, cooperation between private capital and AMCs usually goes like this—private capital would seek out bad debt packages from banks and then use AMCs as a conduit to buy the packages. And then the two parties could manage the acquired bad debts together.
In purchasing bad loan packages, state-owned AMCs could help private companies with financing. In this way, except for the conduit fee, AMCs could also gain a margin of 12% to 13% for lending funds. A Huarong source explained that in the bad debt sector, AMCs have focused on providing conduit and financing services to private funds, and Huarong’s goal is to build a bond-issuing type of AMC.
According to industry analysts, from 2008, the main business of state-owned AMCs has focused on lending to earn interest rate. When the economy is strong, it’s easy to earn considerable profit and so AMCs had no intention or capabilities to revitalize assets they acquired. Now when the competition is getting fierce, market dominance brought by license and risk-free arbitrage would come to an end.
Zhang Naxin said the industry relies on capital and expertise. “It is both capital-intensive and talent-intensive. Only those pursuing a systematic strategy boasting professional assessment, evaluation, management and exit strategy could be profitable.”
Lenders deal with bad loans themselves
Commercial banks these days tend to manage non-performing loans themselves. Public data indicate bad asset packages into the open market stood at merely 300 billion yuan in the first half of 2016, while the figure for the whole of 2015 was 500 billion yuan. The sum for the past two years is no more than 1 trillion yuan, far behind industry estimates.
“Not much of the 1 trillion yuan in non-performing loans has been packaged and sold to AMCs,” a bank source in charge of asset preservation said.
These days, commercial lenders’ profits from traditional businesses have been lackluster, and ‘asset famine’ has left large sums of cheap capital with no outlet. On the other hand, commercial banks possess primary data on the customers with poor credit, so they have the information lead. “When they take a new look at bad assets, they decide to either extract the remaining value or find a new path to deal with it” said Wu Rui, “Selling NPLs in packages causes big losses, while an automated bond system, debt-to-equity swaps and asset management products could spread risk and cut losses.
It is believed that the economy has not bottomed out, so private companies don’t have a strong incentive to buy bad asset packages. “Although there are now 31 local AMCs, most of them are new players, and so are under financial pressure,” said a source from the China Cinda Asset Management.
Xia Bin, counselor of the State Council, warned openly this year that when bad assets are packaged and accompanied by other financial products for sale to common people, close supervision and full disclosure of information must be ensured.
Much cry and little wool
Investing into bad assets may be a much-vaunted business. He Guowang, a partner at bad assets data service provider laipigo.com, said that there is now limited space for adding value in the sector, considering lack of talents, expertise and good projects.
He explained that the “much cry” comes from asset shortage, with a large volume of cheap capital nowhere to go. The “little wool” has two reasons: first, the secondary market (bad assets transfer or transaction) usually features delayed response to primary market’s fluctuations; second, the transaction price of the primary market has gone beyond the expectations of the secondary market, making many investors weary of striking deals.
Analysts believe it’s now even more difficult to make profit from merely wholesaling or retailing bad debts; amid a slowing economy, distressed assets must be activated.
The several major overseas asset managers like the Oak Tree Capital and Lonestar all boast professional teams to manage and reform bad assets. For example, Lonestar Capital, which dug its first pot of gold from real estate market, is now managing $65 billion as one of the world’s biggest NPL buyers. It buys bad assets in the real estate sector and engages in consolidating and reforming the assets to bring them back to business.
He Guowang believes talent shortage in China has held back development of the industry by the elbow. He noted that the business entails expertise in many different sectors, and it usually takes long time to accumulate experience to become professional.
“If 5 to 6 trillion yuan of new bad assets emerge in the next 10 years, that would mean that 500-600 billions of assets need to be disposed annually. If one asset is around 1 million, then 500,000 or 600,000 assets need to be dealt with per year. If one professional manages 10 assets every year, then the market needs 50,000 to 60,000 people with the expertise,” He said, noting that there were only at most several thousand professionals working.
Pricing is the toughest part of the business, considering asset bubbles has become a major risk in China.
According to industry insiders, policy-based bad asset packages used to dominate, and therefore pricing was not important due to state subsidies. However, the market now features excessive liquidity and overvalued assets; once the liquidity tightens, prices would be slashed. “That is the biggest risk in the sector.”
China’s economic restructuring has also complicated the situation. Guo Xianlin, an industry analyst noted that during previous rounds of bad asset disposal, mortgage assets usually could regain value and achieve liquidation following economic rebound. Now in the context of industrial upgrading, some factories and equipment are destined to be weeded out, and even economic recovery cannot bring their value back.
A China Orient Asset Management source said that bad assets have been suppressed by devaluation pressure. “Despite a continuous supply, difficulties in dealing with the distressed assets remain. In a survey by Orient Asset, 60% of surveyed believe the biggest handicap to engage in the business is that asset prices have been declining and the negative effect of an inactive market is getting obvious.”
As a result, it is believed that except for the four big state AMCs and newly established local ones that could benefit from more quality packages, only those that have the expertise in some specialized sector could make a profit.
“There is a big cake, but no one knows who can really feast on it,” said an industry insider.
The article is based on a Caixin magazine story.