Really Bad Banks: China’s Asset Management Companies

The idea of a ‘bad bank’ is valid. It was used successfully by the Resolution Trust Company (RTC) in the US after the Savings and Loan melt down. What happened was similar to bankruptcy except the depositors were protected. The mechanism was that the RTC would take over the defunct S&L (sometimes referred to as Thrifts). The value of the shareholders and any bond holders would be wiped out. The RTC would then take possession of the assets, mostly real estate mortgages, (sound familiar?) and transfer them to a series of public-private partnerships with financing from the RTC. The cost of the program was projected to be over $300 billion, but the program worked well and the final cost to the US taxpayer was ‘only’ $90 billion. Started in 1990, the RTC wound up its business five years later.

Sweden had a similar problem. It deregulated its banks in the mid 1980’s. The new bankers ignored the risks and made bad loans to industry and property developers. By 1992, their bad loans had wiped out their capital. In response, the Swedish government recapitalized the banks. The shareholders were wiped out, but the bond holders were protected. The dud loans were transferred to a bad bank called Securum, an asset management company. Securum was given the task of cleaning up the mess. The process was to last for 15 years, but was accomplished in 5. It helped lower the cost of the clean up to 2% of GDP.

The reason why the RTC and Securum worked so well was that they both heavily involved the private sector. Securum was not staffed with bureaucrats, but with real estate and business professionals, which minimized government interference. The new managers were given performance-related bonuses. They distinguished between the viable companies and the insolvent. The insolvent companies, which comprised about 70% of the total, were liquidated. For viable businesses, the old management was fired and replaced. After the reorganization they were sold off.

The bottom line for both bank clean ups is clear: hire professionals not bureaucrats, keep the government out, sell at market prices, and do it quickly. Both methods worked extremely well and hopefully something like them will be emulated with the most recent disaster. Unfortunately that is not what happened in China.

Originally, it wasn’t supposed to be that way. In 1999 like most of the rest of world, the Chinese economy suffered a major recession. With the exception of the shadow banking system, the Chinese banks are almost entirely state owned. The four largest include Bank of China, (HKG 3988 SHA 601988), China Construction Bank (CICHF.PK) (HKG 0939 SHA 601939), Cinda, Industrial and Commercial Bank (HKG 1398 SHA 601398), and Agricultural Bank of China (ABGEF.PK). After the recession these state owned banks were saddled with bad loans estimated to be about $430 billion or as much as 42% of all loans. To do something about it, the Chinese decided to emulate the US’s RTC and Sweden’s Securum. They set up four bad banks. These banks were called asset management companies (AMC). There are four, each one corresponding to one of the big four state owned banks. Bank of China’s AMC is called Dongfang. China Construction has Cinda. Industrial and Commercial Bank had Hurong. The Agriculture Bank of China has Great Wall.

The bad loans were transferred to the AMCs in 1999 and 2000 just like what occurred in the US and Sweden. However there was a distinct difference. In the US and Sweden, there was no consideration for the transfer. The RTC just guaranteed the deposits of the defunct S&Ls, nothing more. In China the AMC’s ‘bought’ about $205 billion in bad loans at face value. Of course no bad loans are worth face value. One of the largest problems with the present US crisis is the value of the CDOs, the vehicles for the toxic assets. Recent estimates have put their value at a high of 32% and a low of 5% or less depending on their age and tranche. Whatever the true value, no one would claim that they were worth their face value, but that is exactly what happened in the original transfer of the bad debts to China’s AMCs. In return for the bad debts, China’s banks received 10 year bonds paying a taxable 2.25 per cent per annum.

The first transfers to the AMC did not stop the bleeding. In 2002 it was estimated that the bad loans in the state banks represented the staggering amount of 42% of all loans. So in 2003, the banks transferred another $120 billion to the AMCs in exchange for more bonds. This time at least the bonds were at a discount to face value. Still the AMCs were saddled with an annual interest bill of $3.6 billion.

When they were first set up, the AMCs were supposed to act like the other bad banks. They were supposed to try and get rid of the bad loans. Collateral was to be found and auctioned off. Businesses were to be taken over and reorganized. Firms too far gone were to be put into bankruptcy. This never happened. Without a firm legal infrastructure, good public registries for interests in tangible personal property, intangible personal property and real estate, adequate documentation of the loans, it was difficult to determine who owned what, who owed what, where the collateral was and how to get it.

But that was not the real problem. The real problem as the US Treasury is discovering, is the nasty reality as to exactly how much these loans are really worth. In the beginning the AMCs were trying to sell the assets. For example, in December 2002, China Huarong Asset Management Co announced it had ‘sold’ more than $1.5bn in bad loans to investment groups led by Morgan Stanley (MS) and Goldman Sachs (GS). At the time of the announcement the use of the word ‘sold’ was premature. The deal that Huarong struck with the US investment banks was more of a contingency agreement. Morgan Stanley and Goldman were to help Huarong and other AMC’s to sell the assets in exchange for a portion of the proceeds. Huarong did hold an auction in December 2003 for 22 pools of debt, but only three were sold, because they were the only ones that met the minimum reserve prices. The rest of the debts were worth a tiny fraction and are still on Huarong’s books as assets.

Another example had to do with red chip, Silver Grant International Industries. Another AMC, China Cinda had an indirect interest of 22.94 per cent in Silver Grant. Silver Grant ‘bought’ 56.9 billion yuan of distressed assets from China Cinda Asset Management Corp for 853 million yuan, representing 1.5 per cent of the face value of the distressed assets. Silver Grant ‘paid for’ the distressed loans partially with cash and partially by convertible bonds, which if fully converted would increase Cinda’s interest in Silver Grant to 32 percent.

In the initial flurry of excitement over the prospect of unlimited amounts of Chinese distressed debt, other western companies besides Morgan Stanley and Goldman became interested. Lone Star, the private equity group that specializes in distressed assets, opened an office in Beijing and many other private equity groups attended the auctions and road shows, but over time they gave up. Lone Star closed it office. The quality of the assets on offer was awful. According to Nicholas Lardy, a senior fellow at the Peterson Institute for International Economics, a think-tank, in Washington as quoted in the Financial Times: "At the beginning there was an unrealistic expectation that they could quickly reduce the magnitude of the problem but they eventually realized the quality of the assets were abysmal"

By 2005, the AMC’s stopped trying to sell their bad assets to the outside world and just traded them between themselves. In one auction, the largest bidder for distressed assets of Cinda was its rival Great Wall. Rather than winding down as their assets were liquidated like the RTC and Securum, the AMCs made moves to become permanent. They now decided to become permanent profit-oriented financial institutions able to compete with investment banks in a wide range of services, but the bad debts remained.

Meanwhile like banks from Mumbai to Moscow, Cairo to Lagos, New York to Los Angeles, Chinese banks went on a lending spree. The first lending binge started between 2003 and 2004, when like today, the Chinese government wanted to “grow out of” the bad economy and bad loan problem. According to the rating agency Fitch, the bad loans grew at a rate of 8%. After 2006, the banks’ lending often went to fueling the stock market and real estate boom. According to an editorial published in the Financial Times on September 7, 2007, “While declared earnings growth is 75 per cent (for Chinese companies), growth in operating earnings, profit from actually running a business, is 33 per cent. Most of the rest comes from property and other investments.”

As a result of the crash in the stock and real estate market and the global recession, the bad loans in Chinese banks, like banks everywhere, will be huge. Yet despite these problems, the Chinese banks have been requested by the Chinese government to fund three quarters of the $585 billion stimulus package.

Of course through all of this the AMC’s bonds still remain on the bank’s books. The AMC’s state that they are profitable but their figures are never published. According to Mr. Lardy, "These AMCs must by now be massively insolvent because all the better assets have been sold and they have used the proceeds to pay the interest on the bonds they issued." According to the Financial Times, “China's own state auditor said it was concerned that the AMCs were no longer able to pay the interest, let alone the principal, on the bonds they had issued to the banks.” Since these bonds make up part of the banks’ capital, obviously their capital is far more impaired than is generally assumed. The first bonds issued by the AMCs come due this year.

The only response so far is an announcement from Industrial and Commercial Bank of China that it would inject at least US$1 billion into China Huarong Asset Management and China Construction Bank Corp that it would also pay at least US$1 billion to buy into China Cinda Asset Management. So instead of relieving the Chinese state owned banks of bad loans, the bad banks are getting bailed out by the same state owned banks.

In the US there has been a lot of debate about the idea of nationalizing insolvent banks. The process of nationalization is nothing new in the US. The process of the government coming in, taking over a bank, getting rid of the management, disposing of its debt and then selling it off, has been used successfully before in several countries including the US by the RIC during the S & L crises. There are pitfalls. Senator Schumer speaking on Meet the Press on Sunday March 8^th pointed out; “the danger of crony capitalization, you know, the federal government or some powerful senator, president, someone saying, "Do this because I believe in this project or that," it's noneconomic. Bad.”

State owned banks everywhere have this problem. They lend for political reasons and not for profit. Worse, they are not using taxpayer money; they are using depositors’ money. The difference is that depositors would eventually like to be paid back. As the global economy gets worse, bad loans will increase in state owned banks in Russia, Egypt, India, and especially in China. Worse, since these banks are controlled by governments, getting accurate information on the extent of the problem will basically be impossible. Zombie companies and massive bad loans dragged the economy of Japan down for almost 10 years. No doubt the problems of state owned banks will do the same in whatever countries they exist.

Disclosure: No positions in any Chinese equities.

Comments

[Dragoman:]

The Emperor has no clothes?

Mar 10 03:03 PM

[William Gamble:]

Markets are about choice. To make an informed choice you need accurate, timely and complete information. To get accurate, timely and complete information you need protected speech.

Mar 10 03:10 PM

[Dana H.:]

Thanks for the very interesting article, and the comment, with which I agree completely. (It's nice to see someone who understands the link between political and economic freedom.)

In light of your article, what do you think of Peter Schiff's bullish position on China? As a non-expert, I see what appears to be a long-term trend of more freedom in that country. Yet it remains a dictatorship. With regard to Schiff, I respect and agree with much that he says about what ails this country. But I'm not so sure that the alternative investment locales he recommends are all that great.

Mar 10 03:39 PM

[William Gamble:]

I see political and economic freedom as a corollary to the principal concept that sustainable economic growth needs an economically efficient legal infrastructure. (although my second book is named Freedom) In other words law. Not ‘rule of law’, which can mean anything. Law can be used two ways. It can extend power or it can limit it. I believe that it is economically efficient if it limits power.

The most important use of law in investing is to help protect investors by predicting the future. If law limits the power of government to act in arbitrary ways, then investors have a better chance to know sufficient facts to predict risks of a particular investment or contract.

I disagree with the concept of long term trends of freedom. I do not believe that wealth automatically requires reform. Quite the contrary. Every political party every power group everywhere seeks power and economic benefits for its members. (see Mancur Olson’s Rise and Decline of Nations and Power and Prosperity). It doesn’t matter if you are AARP, the UAW, the AMA, the Pharm industry, big oil or the Chinese Communist Party. The first five will use lobbying. political contributions and votes to get what they want often at the expense of the general public, but their wishes are limited by law. The CCP can and does make it up as it goes along to benefit itself and its members. What economic or political reason would they have to pass laws that would limit their power?

I have not specifically read Schiff’s views on China, but I am always amused that economists who love the free market feel that the Chinese government does a better job managing what is basically still a socialist economy (EU report). Professor Huang of MIT once estimated that the true number of private business in China was less than 14%. Why? Again, if you were a political party would you give up economic as well as political power?

What most economists ignore are the rules (the law). They do not consider that an economy will act differently if the rules are different. I think the concept is rather obvious.

China is what is called in game theory a relationship based system (see Princeton's Avinash Dixit’s, Lawlessness and Economics) Of course there is a spectrum, but other examples of relationship based systems like the Asian Tigers growth declined from over 5% pre Asian crises to less than 3%. The power groups that control relationship based systems tend to make the economy very inefficient, which is what is happening in Russia.

In China as the AMC story shows, it is very difficult to reallocate capital from failed inefficient state run companies to efficient private companies. So the economy becomes less efficient. Like my home in Rhode Island, the state employees tend to grow and grow, because there are few limits or market discipline to be efficient.

Mar 10 04:21 PM

[Dana H.:]

Thank you very much for your detailed reply.

"I disagree with the concept of long term trends of freedom."

Just to clarify, I did not mean to imply that there is any driving force or historical necessity here. Rather, I was stating what (I think) is the empirical fact that the people in China today are more free, and as a result more prosperous, than they were, say, 20 years ago. And one question (which I'm not sure it's even possible to answer) is whether they'll be still more free 10 years hence.

I agree with you that the ruling party certainly does not want to give up power. And therein lies one of the country's contradictions. The leaders want prosperity, but they're only willing to go so far in implementing its legal and political preconditions. (On the other hand, they are adamant about NOT passing such wealth-destroying restrictions on freedom as a carbon tax, which puts them ahead of us in that regard.)

Mar 10 04:37 PM

[William Gamble:]

Yes, there is no question that the Chinese people have more freedoms now than they did 20 years ago. As one dissident put it, the cage is bigger so you tend not to notice.

My focus though has more to do with how law affects the economic systems. For example, it is generally assumed that as countries get richer they will move up the value chain and produce more high tech and expensive goods. This is indeed what happened in Japan, Korea and Taiwan.

China is definitely losing the lower end. Nike produces more shoes in Vietnam and Guangdong has lost over half of its shoe factories in the last 5 years.

The problem with China's ability to move up the value chain is that its intellectual property protections are very weak. Worse it gets about 8% of its GDP from intellectual property piracy, everything from Gucci bags to bubble wrap. Since intellectual property laws are not enforce, it is difficult to move up the value chain but if they are, a lot of people are out of work.

So as the rules change so do the economics and the investment opportunities

Mar 10 05:02 PM

[Dana H.:]

Interesting. Are China's IP protections equally weak whether or not the IP originates within China? I could imagine the authorities turning a blind eye to piracy of foreign goods, while enforcing some protection of IP developed domestically.

Mar 10 05:23 PM

[William Gamble:]

You are correct. Intellectual property property protections arise when the local water buffalo gets gored. When there is a large local intellectual property industry, then the leaders of that industry have a large economic incentive and they can buy the political power to increase enforcement. For example, India with a booming IT industry has been better at increasing intellectual property protections.

Most likely the IT industry arose in India by mistake. It existed and became powerful before the bureaucrats even knew it was there. So they lost their chance to regulate it.

In China most patents are granted to domestic applicants are known as "utility model" patents for incremental improvements. Often patents that exist are owned by state owned firms that make up at least half the economy (see Prof Yasheng Huang MIT) perhaps much more which creates the problem of the commons. If everyone ones it, no one owns it.

The Chinese government has passed laws and been vocal about protections but the fines have been minimal and enforcement spotty. The economic incentives work the other way.

Mar 11 09:34 AM

[William Gamble:]

More bad loans

March 10 (Bloomberg) -- Chinese home prices fell by a record last month, paced by a 15 percent plunge in the southern export hub of Shenzhen, where factories closed as growth in the world’s third-biggest economy slowed.

The 1.2 percent decline in prices in 70 major cities is the most since the government started issuing the data in August 2005, according to Bloomberg’s compilation of National Development and Reform Commission figures. New-home prices fell 1.8 percent, the commission said on its Web site today.

Mar 11 01:38 PM