Bad-debt investment products present new risks in China
As asset managers securitise more bad debt, risk in the financial system gets harder to spot
No matter how you bundle it, structure it or sell it off, bad debt is bad debt.
That argument might be lost on China’s state banking sector, which is having a go at making bad loans fade into opaque financial products that the banks themselves eventually buy back.
Collateralised loan obligations (CLOs) have a bad rap after malpractice in the industry helped bring on the financial crisis in the United States in 2008. So much so that China froze issuance that year.
Issuance of CLOs, or pooled loans that are resold as structured products, has picked up pace this year and is set to rage on with financial institutions as a driving force.
Data from Moody’s showed that CLO issuance was the main force in China’s securitisation industry in 2014 and 2015, with the volume of products issued in the first nine months of the year nearly outpacing the more than 250 billion yuan sold during all of last year. Bank of Beijing and China Development Bank sold about 38 billion yuan in CLOs in September.
The majority of the underlying assets in these products are not bad loans. Banks still don’t have regulatory clearance to issue CLOs backed exclusively by bad debt.
But the state-controlled Asset Management Companies, or AMCs, the firms created to unload bad debt from state banks, are issuing products packaged with at least some of the bad debt that they have bought up from banks.
So far the products are backed by restructured non-performing loans, according to Yang Junhao, a senior analyst at mainland rating agency CCXI.
“By the time they go into the pool they are considered standard assets, so these are still normal CLOs,” he said. The asset management companies have issued 9 of these products in total.
Regulators are expected to allow banks to create products backed by just non-performing loans and Yang is one of many experts cheering for the bad debt to enter the CLO pool.
Asset quality is deterioratings on the balance sheets of China’s biggest banks. Securitisation is a viable way to free up balance sheet and clean up bad debt, Yang says. He also expects AMCs to issue more of the products and eventually ones backed entirely by bad debt.
But adding non-performing loans to the market has also led to concerns among some analysts.
Securitising bad debt makes it increasingly difficult to assess the true level of risk facing banks and AMCs.
Banks scrape bad debt off their balance sheets by selling it to AMCs. As more of that debt enters into the CLOs, those products are sold largely to state-owned financial firms, including the banks.
“The risk perception and capital requirement are lower now that banks hold these [as asset backed securities], not loans,” said CLSA analyst Patricia Cheng.
Also, the products can only pay out to investors if the loans can be recovered.
“The recovery process in China may not be robust and it may also take a long time for recovery,” said Helen Wong, a senior director for structured finance at Fitch Ratings.
Visibility on many CLO deals in China is murky. Fitch says that typical CLO deals in China might include the debt of between 20-50 companies, compared to 150-200 in the US. The Chinese deals are also highly concentrated towards single borrowers, industries and regions, making a default at one company or an economic slowdown in one region more likely to upend the whole product.
The recent default case of China Shanshui Cement Group has revealed the fragility of the system.
A subsidiary of Shanshui is one of the obligors of a product issued by Tianjin Bank in July. The 200 million yuan in debt owned by the subsidiary made up about 16 per cent of the transaction’s outstanding principal balance, according to Fitch. The resolution of that product will be a test for the market.