Non-performing China

Hope springs eternal when it comes to investing in the Chinese NPL (non-performing loan) market. The China Banking Regulatory Commission (CBRC) is testing a trading platform which allows banks to sell loans to a ‘wider range of investors’, according to a Reuters report last month.

Apparently this will create a virtuous circle where ‘price discovery’ via trades will enhance transparency, draw in more investors and round we go. This is supposed to reduce the NPL problem, a problem whose size and even existence has been a topic of fierce debate over the years, and thus reduce the eventual cost to the Chinese state as it recapitalizes the banks.

This sounds wonderful. It has it all: an enhanced investment opportunity, trading efficiency, transparency, private capital involvement. It hits all the buttons for us free-marketeers and arch-capitalists in the world of private debt.

Alas, words of caution must be aired before private debt investors start queuing up to join this platform. Questions need answering, such as: Who will be included in this ‘wider range of investors?’ Will foreign investors be welcome? How do you achieve ‘price discovery’ on a heterogeneous pool of loans via an electronic trading platform which by definition precludes the level of due diligence usually conducted on such loans?

Tackling these questions in reverse order, it is one thing trading problem mortgage portfolios or unsecured personal loans in the US and Europe on a similar platform.  The data is detailed and available, documentation is standardised and pricing is a blend of science in terms of statistical analysis and art in terms of determining the level of competition.

Compare this to trading even one domestic corporate NPL owed by a Chinese company. Will the loan and collateral documentation be fully available? Will there be recent believable collateral valuations available so that a potential buyer can forego their own due diligence? Even trading platforms for much more standardised and well documented international corporate NPLs have struggled with these challenges.

Apparently asset-backed securities will also be traded via the mooted platform. However given these Chinese ABSs do not currently exist in any notable form due to domestic restrictions, they will first have to created.

On the subject of a wider range of investors and whether foreign investors will be welcome, surely we have heard this all before? Back in the early 2000s international investors in NPLs salivated over the thought of the Chinese market opening up to them. The Asian Crisis of 1997-98 had whetted their appetite for Asian bad debt and many, having cut their teeth and made serious money in the US savings and loan debacle of the 80s and early 90s, were now looking for the next giant pool of NPLs.

The Chinese government unveiled the big four Asset Management Companies (AMCs) in 1999 and 2000 and began the transfer of NPLs to these bad banks from each of the associated big four domestic banks.

Foreign investors were invited to begin discussions with the newly-created AMCs. Two of the investment banking titans, Morgan Stanley and Goldman Sachs, who had made billions of US dollars of profit on NPL portfolio purchases in Asia and the US, spent three years of serious brain damage pioneering the first private sector NPL portfolio purchase from the Huarong AMC. After all the effort and time invested, they by all accounts made a killing.

One of the largest global NPL investment funds built a large origination and servicing team in Beijing in anticipation of the new investment opportunities. Other investment banks began bidding in auctions for large portfolios from the AMCs. More international fund investors began pitching their tents in Beijing and Shanghai, ready for the great buffalo hunt and then, in essence, nothing happened.

This was down to three reasons. First, the Chinese authorities discovered they didn’t really like seeing foreign capital making a fortune buying up their bad debts. Second, some of the outcomes for obligor firms which tended to be state owned enterprises (SOEs) were undesirable from a stability point of view (understandably a key concern both then and now). Lastly, the AMCs themselves quite fancied transforming being traditional bad banks to becoming distressed debt investors. This last point reminds me of an accelerated version of KAMCO (Korean Asset Management Company), which went from being an effective bad bank holding NPLs, to a co-investor with foreign investors on Korean NPL deals, and then to competing against them in Korea and Taiwan.

So then you had AMCs with effectively no real cost of capital all bidding for each other’s NPLs, not something foreign investors with minimum IRR hurdles could sensibly compete against. The game was basically over for any large NPL portfolio investments by foreign investors. Some hardy souls continued to invest, sometimes successfully, in much smaller regional portfolios or discrete loans typically with attractive underlying real estate collateral. The golden land of billions of US dollars of investment opportunities had disappeared into the mist, never to be sighted again… until now.

Given the jaded nature which is the natural state of the distressed debt investor, I will wait to see with little optimism if this trading platform ever comes to pass, and whether it can avoid becoming another route for the AMCs to play pass the parcel whilst local groups and individuals with the right connections cherry pick choice NPLs.

It should noted however, before we start singling out the Chinese NPL market, that very few nations historically have welcomed waves of foreign capital investment into their local problem loans. Foreign investment by the Japanese and Europeans into the savings and loans portfolios raised hackles in the US, US investment into Japan and elsewhere ex-China post 1997 was not exactly welcomed and more recently European policymakers have vilified private capital solutions as the region’s banks flounder under their NPL burdens.

I hope the authorities in China have finally realised that a controlled and fair route for foreign capital to invest in their banking sector’s problem assets will be of net benefit to the country and will free up the banking system. Let’s hope so for all our sakes as it will take genuine private capital solutions to resolve the Chinese banking NPL burden, not more window dressing.