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Over the past couple of days, China’s “big four” state banks have reported impressive profit gains for 2010. Bank of China (OTCPK:BACHY) posted a 29% increase in net earnings over 2009; China Construction Bank (CCB) (OTCPK:CICHF) saw a 26% boost; ICBC’s profits came in 28% higher; and the newly-listed Agricultural Bank of China (AgBank) (OTC:ABGEF) reported an eye-catching 46% rise in profits.

The Hong Kong market, which had been fairly sour on Chinese bank stocks earlier this year, apparently likes what it sees. Since last Monday’s opening (March 21), ICBC’s stock price has risen by 8.6%, Bank of China’s rose by 6.1%, AgBank’s rose by 7.0%, and CCB’s — despite falling short of even rosier analyst expectations — rose by 4.1%. All four stocks are significantly above the recent lows they hit in February.

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So are these profit figures to be believed? Did Chinese banks really have such a stellar year in 2010? The short answer to both questions is No.

Banks basically have two costs of doing business. The first is the cost of obtaining funds — usually the interest rate they pay to depositors. The second is the losses they sometimes sustain when their loans don’t get paid back. That second cost is very important, because if it’s not taken into account, banks would have every reason just to go out and make the riskiest loans possible to earn the highest return — the highest spread — over their cost of funds. They’d see extremely high profits for a while, until a big chunk of those loans failed and the losses piled up, swamping the earlier gains.

The cost of failed loans is actually part of the cost of making those loans in the first place. There’s no way to avoid some lending failures, and there’s nothing wrong with making a risky loan if you charge a high enough interest rate to compensate for that risk, and still come out ahead in the end.

To determine whether it really is coming out ahead or behind on the risks it’s taking, a bank tries to estimate what percentage of borrowers are likely to default (and what percentage it’s likely to recover if they do default), and charge that estimate as a loss at the time it first makes a loan. It’s called a provision for bad debt. If the estimate is reasonably accurate, the resulting figures will give you a pretty good idea how profitable that bank’s lending business really is. If the loss estimates are too high or too low, you can get a very distorted picture of how the bank is truly performing.

The same is true for regular businesses, for that matter. The easiest way for a company to boost short-term revenues and profits is to start offering shaky customers easy terms of credit, no money down, no questions asked — and not take a higher charge against those sales to reflect the fact that a lot of those customers aren’t going to pay when the bill finally comes due. The profits are illusory, and investors who look to them are deceived.

This year, regulators required Chinese banks to maintain a reserve of 2.5% against the value of their total loan portfolios as provision for bad debt. This has been portrayed as a “rigorous” standard, compared to their miniscule rates of recognized non-performing loans (NPLs) left over after Chinese banks spent more than a decade cleaning up their books, with the government’s help.

Over the past two years, though, Chinese banks have engaged in a government-inspired stimulus lending binge that expanded their lending books by 58%. So much money was lent so quickly that Chinese bank regulators spent the better part of 2010 just figuring out where it all went. A 2.5% charge may sound impressive, compared to the tiny number of older loans that Chinese banks haven’t been able to work out, but during the last, similar round of ”policy” lending that took place in the 1990s, about 35% (thirty-five; there’s no decimal point there) of all the loans that were made went bad, with around a 20% post-default recovery rate.

There are many areas of recent lending — mortgages, real estate development loans, emergency working capital loans to keep failing exporters from going under, business loans diverted to stock and real estate speculation, business loans collateralized by land at inflated valuations — that give cause for concern. But it is loans made to Local Government Financing Vehicles (LGFVs), special companies set up to fund ambitious and often redundant infrastructure projects, that have attracted the greatest attention.

At first, China’s banking regulators brushed aside concerns — these were, after all, government-sponsored projects — but later came to view these loans with growing alarm. A comprehensive study leaked last summer from the China Banking Regulatory Commission (CBRC) suggested that only 27% of these loans could be repaid through cash flows; 23% were a total, irretrievable loss, and about 50% would have to be repaid “through other means,” presumably by calling on local government guarantees (which those governments lack the wherewithal to stand behind) or by seizing the undeveloped land pledged as collateral (appraised, all too often, at ridiculously inflated prices).

So let’s run some back-of-the-envelope numbers, based on what we know. A couple days ago, the Chairman of ICBC announced that LGFV loans accounted for 10% of his bank’s total loan book. He made this announcement in order to reassure everyone that ICBC and the other banks have the situation completely under control:

It is important that people pay attention to this problem and we should be alert to the risks,” Mr Jiang said. “[But] I don’t believe this problem poses a systemic risk to the Chinese banking system.”

ICBC reported a pre-tax profit of RMB 215 billion ($32.6 billion) in 2010, including a RMB 28 billion ($4.2 billion) charge for expected loan losses. That charge brought ICBC’s cumulative bad debt provision — its reserve against future NPLs — to RMB 167 billion ($25.3 billion), just under 2.5% of the value of its entire loan book, which stood at RMB 6.8 trillion (a little over $1 trillion) at the end of 2010.

ICBC’s chairman says that it made RMB 640 billion ($97.0 billion) in post-crisis LGFV loans, over the past two years. If we go by the estimates compiled by the CBRC, roughly 23% of these loans are just out-and-out non-recoverable, which in ICBC’s case equates to RMB 147 billion ($22.3 billion). Another 50% can be repaid only through alternative means (by seizing collateral, for example) and must be seen as questionable. That equates to another RMB 320 billion ($48.5 billion). Over that same two-year period, ICBC made provision for RMB 51 billion ($7.7 billion) in loan losses (RMB 23 billion in 2009 and RMB 28 billion in 2010).

If we look only at the LFGV loan category, and generously assume that all of the new bad debt provisions applied to LGFV loans, the results are striking. Even if only the LGFV losses that are virtually dead certain are counted (Scenario A-1 below), ICBC is understating its likely losses by RMB 96 billion ($14.5 billion). Its cumulative bad debt allowance should be RMB 263 billion ($39.8 billion), 58% higher than reported. If that correction was applied in 2010, the bank’s pre-tax profit would shrink to RMB 119 billion ($18.0 billion), down 29% from RMB 167 billion in 2009.

Let’s assume, in addition, an effective recovery rate of only 50% on the dubious repayments “through other means” (Scenario A-2). That would require a boost in ICBC’s bad debt reserves to RMB 423 billion ($64.1 billion), 2.5 times the reported figure. Taking this additional charge would create a pre-tax loss of RMB 41 billion ($6.2 billion) for 2010, and wipe out about 1/3 of the bank’s equity capital cushion.

Due to several highly profitable years, ICBC reported equity capital (assets net liabilities) of RMB 822 billion ($125 billion) at the end of 2010. If all of the bank’s “lost cause” and “repay by other means” LGFV loans (a total of RMB 467 billion, or $70.8 billion) were charged as a provisional loss (Scenario A-3, which might reasonable if you’re going to be forced to seize relatively illiquid collateral to try to make good on the loan), it would change ICBC’s RMB 215 billion ($32.6 billion) pre-tax profit for 2010 into RMB 201 billion ($30.4 billion) pre-tax loss and wipe out over half of the bank’s equity capital.

ICBC’s management might reply that their LGFV loan portfolio is stronger than average, since one of China’s largest banks might be able to cherry-pick only the best local government projects to lend to. Perhaps — although so much money was flowing out the door I doubt they, or anyone else, had time to make certain. Keep in mind, though, that this is just one category of lending that is generating worry. We’re assuming a 100% performance rate for all the other scary kinds of lending I mentioned earlier — an assumption that is as unrealistic as it is generous.

So let’s assume that this round of expansive policy lending fares much better than the last one, and just 10% of the RMB 2.2 trillion in net new lending that ICBC made over the past two years goes bad (Scenario B-1). That’s RMB 222 billion ($33.6 billion) in loan losses, more than four times the loss provisions ICBC actually made during that period. The RMB 171 billion ($25.9 billion) additional charge would reduce ICBC’s 2010 pre-tax profit by a factor of almost five to RMB 44 billion ($6.7 billion), erasing about 1/5 of its reported equity capital.

If you raise the projected NPL rate to 20% (Scenario B-2, a very reasonable estimate given both history and the more recent LGFV estimates coming from regulators), the bank registers a RMB 178 billion ($27.0 billion) pre-tax loss for 2010, destroying almost half of its capital cushion. Apply the 35% rate from last time around — hopefully not the case, but not out of the question either – and ICBC begins flirting with the prospect of insolvency (Scenario B-3).

A reporter yesterday asked me why, knowing what they know about LGFVs and other troubled lending areas, the regulators don’t just require China’s banks to recognize loan loss provisions higher than 2.5%. I could only think of that exchange between Tom Cruise and Jack Nicholson in A Few Good Men: “I want the truth!” “You can’t handle the truth!”

Maybe China’s banking regulators prefer to shield investors and other market participants from the harsh truth while they figure out how to solve the problem. However, the truth — whether investors can handle it or not — is pretty easy to calculate based on readily available information. It’s entirely possible that the scenarios I’ve outlined are too pessimistic — but it’s not obvious that they are. The various assumptions I’ve used are reasonable enough that I think you’d have to make a case for why they are wrong.

Optimists will counter that, even if ICBC and the other banks suffer destabilizing losses, the “big four” are all state-owned, and the Chinese government would almost certainly step in and bail them out. That may well be true. But there’s a big difference between making that kind of “failing but too big to actually fail” argument and accepting the claims — put forward in their latest financial statements — that China’s banks are sitting pretty and awash in profits.

Source: Chinese Banks' Illusory Earnings