Mainland developers are ‘money mills’ that rely on spiralling asset prices
To understand why HNA Group paid such an insane price for Kai Tak land, we need to take a closer look at its business model
In late December Money Matters wagered HK$100 that HNA Group would win its third piece of land in Kai Tak. Now, I owe you.
The bet erred in its assessment of the risk appetite of mainland corporations, not for over estimating, but under estimating. Their game is far more aggressive than expected.
In what was the final land auction of 2016, the Kai Tak site was snapped up by rival K Wah International Holdings, the developer controlled by casino tycoon Lui Che-woo.
First, let’s recap my thinking ahead of the New Year holiday. The argument was if HNA pledged its two overly priced land plots in Kai Tak for loans, it would bid for the next one at a high price to prevent its house of cards from collapsing.
To quote a mainland banker, this thesis reflects a “sheer ignorance” of how mainland firms operate their money mills.
Let us use the numbers of HNA’s HK$8.8 billion winning bid for its first Kai Tak land plot as a hypothetical illustration of the leverage game.
Step one: Pledge a mainland asset with a mainland bank for a standby letter of credit (SBLC) which is a promise by the bank to pay. Use the SBLC to get a HK$8.8 billion loan in Hong Kong.
Since it’s a deal to pay off a piece of land publicly auctioned by the Hong Kong government, approval from the mainland regulators will be easy.
Step two: Pledge the Kai Tak land with the banks in Hong Kong. Many may find the bid - 70 per cent above market estimate – rather risky. Yet, it won’t be too difficult to find banks to provide a HK$3 billion loan which is only 40 per cent of the land cost.
Step three: Pledge the HK$3 billion cash with a bank in Hong Kong for a SBLC.
Step four: Use the second SBLC as security at a mainland financial institution to purchase debentures and bonds with annual returns of over 6 per cent or above.
Step five: Pledge the HK$3 billion worth of debentures with mainland banks for another SBLC. Given a routine discount of 30 per cent for financial products, the bank will issue a promise to pay HK$2 billion.
Step six: Use the third SBLC as collateral and get a HK$2 billion loan in Hong Kong. Repeat step three to five and so on so forth.
These steps may sound a bit complicated. But in many cases, these steps are all done among the mainland and Hong Kong branches of the same bank, though occasionally several banks are involved to dodge regulatory hurdles.
The result is swift creation of capital. In the first round the result is HK$8 billion, which is comprised of HK$3 billion land loan, HK$3 billion worth debentures and a HK$2 billion loan. The second round result is HK$6.4 billion, while the third round leads to an additional HK$3.8 billion. Ultimately, the tally can be as high as HK$25 billion.
This collaboration of the capital markets on the mainland and in Hong Kong also satisfy another wish of many mainland companies nowadays – moving money out from the country. In our hypothetical case, the outflows amount to HK$14 billion.
It may sound outrageous. Yet the formula illustrated makes use of conservative ratios only.
The money “created” can be poured on hotel chains in Europe, office towers in the United States, golf courses in Japan or to acquire controlling stakes in listed companies.
Therefore, it won’t hurt to overpay as long as the new assets will keep the ball rolling.
Neither does it really matter that a plot of land next to you is sold cheaper than what you paid. Since the land loan is only 40 per cent of the valuation, there is sufficient cushion to keep the banks happy. You also have lots of money to pay off the unhappy ones.
The only thing that matters here is whether you have the connections and know how to get the money in and out of China.
Despite Beijing’s pledge to tighten its grip on currency outflows, things remain fairly relaxed for HNA and many others so far. The companies regularly transfer multiple billions of dollars worth of yuan across the border. We are talking about daily, not weekly or monthly here.