Bad debts are part of any economic recession. How bad they are depends on the legal infrastructure around their collection. If the infrastructure is strong, the creditors or bond holders have some hope of getting at least part of their money back. If it is weak, as it is in many parts of the world, then bond holders are going to be out of luck.
In one of my earlier newsletters, I pointed out that Citigroup Inc. (C) and Citadel Investment Group LLC hired the huge international law firm Clifford Chance LLP to attempt to seize the assets of bankrupt FerroChina. It is estimated that FerroChina owes over a billion dollars and the creditors hope to recoup $130 million of bonds due in 2011 and $160 million of loans. If they are lucky they will collect as little as 3%.
FerroChina also owes Japan's Aozora Bank Ltd., hedge funds, Income Partners and PMA Investment Advisers Ltd., Thailand’s Bangkok Bank Pcl, Thailand's biggest lender, China Construction Bank Corp. (CICHF.PK), and Commerzbank AG (CRZBY) China branch.
Murky Legal Infrastructure
This is nothing new. Six years ago I wrote in my book, Investing in China, about the case of GITIC. The collapse of GITIC (Guangdong International Trust and Investment Corp.), the investment arm of the Guangdong provincial government, occurred on January 16, 1999 and sent shock waves through the Chinese financial system. Eight months prior to its collapse, GITIC bonds were yielding a mere 250 basis points above US treasuries. When it was closed down, it had approximately $1.93 billion in foreign debt.
The effect of GITIC’s collapse was immediate. Foreign credit for China dried up almost overnight. China experienced a liquidity squeeze similar to after effects of Lehman Bros last fall. The Chinese leadership got the point and prevented the collapse of any of the many other 'Itics'. Many were rumored to be on the brink of bankruptcy. Still it was too late for the creditors of GITIC. They recovered only 2.3% of the outstanding debts.
The reason that creditors were unable to collect any assets is simple. China and many other Asian countries have murky legal infrastructures. Although China did finally update its bankruptcy law in 2007, it may not help. Laws do not exist in vacuums. The laws need courts. The courts need effective enforcement agencies. The enforcement agencies need clear property rights. It is not just the law; it is the entire legal infrastructure.
Without an adequate legal infrastructure, the rules change and so does the leverage. Like many firms in China and throughout Asia, the Asia Aluminum Holdings Ltd., a preeminent Chinese metals producer, is apparently having hard times and must refinance. The refinancing is theoretically coming from Chinese municipal government although Asia Aluminum has not made any disclosures. A condition of refinancing is that it must buy out overseas lenders. This seems fine except the offer of the buyout is at discounts amounting to as much as 87% of face value!
Why is Asia Aluminum Holding Ltd. doing this? Any student of game theory would happily reply: Because they can! Some foreign investors are learning what they should have realized seven years ago, that the legal infrastructure will make it impossible to use law to claim their property rights. Since the law is useless, they lack the leverage to get a better deal and should take what they can get.
According to Roel Jansen, a credit analyst at ING Investment Management in Singapore quoted in the Wall Street Journal:
In cases where there are [mainland] creditors, offshore bond investors believe they face an uphill struggle and that their chances of substantial recovery in an insolvency scenario are slim.
Now they tell us!
Distressed debt investments aren't so easy
Still, apparently many people have not gotten the news. Only one fifth of the Chinese stimulus package involved taxpayer money. The rest was supposed to come in the form of bank loans and private investment. Part of the private investment has meant that bond issuance in China has more than doubled to $1.9 billion according to Thomson Reuters. These bonds have been easily sold to investors who believe in China’s long term growth story, but don’t quite get the point that a bond is debt collateralized by assets that you have to get in a legal proceeding. The recent experience with US toxic assets should have gotten the point across, but apparently did not.
There must be quite a few of these people around. Worse, they are going after the riskiest aspects: Distressed debt. I keep receiving brochures about large New York law firms who are part of panels discussing distressed debt in China. I am sure that their discussions of the Chinese bankruptcy laws are very learned.
What they don’t discuss is that even the repo man in China only collects on two thirds of the car loans. Worse, the so called smart money is in on this deal. Carlyle Group co-founder David Rubenstein told a conference in Berlin recently that his company was looking for distressed debt deals in Asia. I am sure that his investors will be very happy with his decisions.
Meanwhile, the investment bankers who made money helping these companies sell these bonds are now making money advising companies to buy them back for pennies on the dollar rather than pay interest. This is especially true of the Chinese real estate market where the bonds of Shimao Group fell to around 50 cents on the dollar and the bonds of Neo-China Land Group (Holdings) Ltd., fell to as low as five cents.
A good legal system means capital is reallocated quickly and efficiently
Besides just collecting on bad bonds, there is a larger point. Markets and market economies work because they are better than any other system at the efficient allocation of capital. Part of the creative destruction of the process is that firms that are no longer efficient go under especially in a recession. If there is a good legal system, especially a good bankruptcy system, their capital can be quickly salvaged, so it can be reallocated to more efficient firms. If these systems, these rules, do not exist, the inefficient firms remain within the system. These zombie firms take up precious resources and poison the whole system, which is what really happened in Japan.
Slow to change, slow to recover
The probability of a quick Asian rebound will be severely hampered by the lack of these systems, just as it was in Japan in the 90’s and in many other Asian countries after the Asian currency crises in 1997.
Asia will recover, but slowly and with anemic growth. It could change its legal infrastructure, but laws exist because someone with power put them there, because they benefitted. To change the law, you need to change the people in power. In Asia that happens very slowly. The Chinese Communist party has been in power for over 60 years. The LDP in Japan has been in power for over 50.
