When a Bad Loan Isn’t Really a Bad Loan

I recently finished a report on Chinese banks and one of the most surprising discoveries are how Chinese banks think about bad loans and data.  In most of the world, definitely those with large financial markets, the definition of a non-performing loan is taken for granted.

What is probably the most surprising revelation in recent IPO prospectuses is just how honest Chinese banks are being in admitting that their definition of a non-performing loan differs significantly from international standards.  Huishang Bank in their prospectus states that a major regulatory risk is that “our loan classification and provisioning policies may be different in certain respects from those applicable to banks in certain other countries or regions.”  The Bank of Chongqing says nearly the same thing noting that “our loan classification and impairment loss provisioning policies may be different in certain respects from those applicable to other commercial banks and banks in certain other jurisdictions.”   Harbin Bank take this warning one step further writing in their recent IPO prospectus “…profits of our Bank may decrease significantly, and our business financial condition, results of operations and prospects could be materially (emphasis added) and adversely affected…” due to non-standard non-performing loan definitions.  In short, Chinese banks are telling you that their non-performing loan classifications are not standard or accepted outside of China.

Chinese banks go to great lengths to avoid classifying a loan as non-performing with very different standards.  A 2012 NBER paper led by Franklin Allen from the Wharton School noted that “…the classification of NPLs has been problematic in China.  The Basle Committee for Bank Supervision classifies a loan as “doubtful” or bad when any interest payment is overdue by 180 days or more (in the U.S. it is 90 days); whereas in China, this step has not typically been taken until the principal payment is delayed beyond the loan maturity date or an extended due date, and in many cases, until the borrower has declared bankruptcy and/or gone through liquidation.”

Amazingly, Chinese banks not only admit their loan classification standards leave something to be desired but give specific examples.  Let me give you a couple of especially egregious examples.  Harbin Bank classifies a loan as doubtful if after a loan restructuring still cannot pay back the loan.  Bank of Chongqing classifies a loan as substandard if a building project has had no activity for at least one year and doubtful if the business has not been operational for at least 6 months.  Huishang classifies a loan as substandard, with at least a 40% loss, if the borrower is unable to obtain new funding to service their debt obligations. To summarize Chinese loans are classified as non-performing if after restructuring a firm still can’t pay, you have been out of business for at least six months, and your situation is so dire you can’t find another lender to roll over your loans.

Chinese banks however are not just defining away the problem of NPLs does arise they play accounting merry-go-round to make them disappear.  The Wall Street Journal recently wrote about a plan by large Chinese banks with investment banking arms to sell bad loans to the investment banking arm, taking the troubled off the traditional banks books, and then let the IB arm try to turn it around.  The bank does not have to report the NPL, even with incredibly loose definitions, and gets a higher than market price for the loan.  The investment bank get deal flow to boost numbers.  This however, continues to push the risk further down the road and continue the build up.

There are three final points.  First, banks appear to structure products to avoid NPL classification.  When lending for advances, the first payment will not be due for an extended period of time allowing the very real possibility for very real delays.  How long exactly?  To use a recent example, when Shanxi Zhenfu Energy roiled global financial markets with the possibility of a default on a product created by China Credit Trust, this overlooked a key fact.  Shanxi Zhenfu Energy had been bankrupt for nearly a year when the technical default occurred due to the fact that the original loan was made in the second half of 2010 but the first payment was not due until February 1, 2014.  This means that much of the debt incurred during the worst excesses of the credit expansion may not even require repayment yet, further masking loan quality.

Second, amusingly, for me anyway who has written about GDP and inflation irregularities, a major risk identified by Huishang is that “we cannot assure you of the accuracy of facts, forecasts, and statistics derived from official government publications contained in this prospectus with respect to China, its economy, or its banking industry.”  In other words, Chinese banks don’t believe official statistics.

Third, this is the reason the Chinese market and international analysts are so worried about finances in China.  For quite some time, Chinese banks stocks have hovered around P/E between 4 and 5 because the market doesn’t believe the NPL data. Banks with secondary offerings have been accepting large discounts with IPO’s cheaply priced to traditional models and falling post-IPO due to the large doubts about the accuracy of NPL data.

There are enormous financial risks and one of the largest is the lack of reliable data as described by Chinese banks about their own finances and the overall Chinese economy.

Note: This is the first post in a series of posts about the Chinese banking industry based on my paper.

Speaking on Chinese Banks

Last week I had the privilege to speak at the China International Banking Conference(in Chinese) organized by Asian Banker.  Though they did not know it when they invited me to speak, I had just finished a report on the Chinese banking system focusing on some of the unique risks.

The presentation I gave to the largely Chinese crowd is here.  While I believe there are significant risks that have not been addressed, I also try to moderate those who write like the building is on fire and everyone should leap from the building.  I will write later this week about the specifics of what I found but needless to say, there are significant risks in the Chinese banking system that simply are not being addressed.

When I spoke, a senior Chinese banker took some offense to my characterization of the risk build up in the system and what the data indicates.  After giving my data based talk with lots of information culled from IPO prospectuses and annual reports, you could sense the tension in the room.  A Chinese economist from a Chinese bank proceeded to talk and agree with many of the issues I had raised.  The tension deflating impact of these comments was palpable.

Potentially the most concerning issue to me is not the specific risks within the Chinese banking system but the current psychology of risk in China today.  China has enjoyed rapid and sustained economic growth for so long that most people seem to have forgotten the idea of risk.  If there was ever a seemingly text book case of This Time is Different psychology, modern day China is it.  The Chinese banking official who took exception to my comments about risk did not even wait for my data from Chinese sources or citations of annual reports and IPO prospectuses, but complained about my lack of understanding of Chinese culture and how this time is different.

Maybe this time will be different, but risk continues to exist and will catch up with you one way or another.

Note: I will be writing specifically about my Chinese banking report later this week covering some of the highlights in a couple of different posts.

China News

Seems like everyone is watching real estate in China.  A glut of real estate that it outpacing urbanization and real estate firm debt equal to 55% of GDP is stressing the system.  Even developers that advertise their apartments only get down to -22 C, are having a tough time selling apartments.  However, it isn’t just individuals but also business and specifically trusts that are getting cold feet about Chinese real estate.  Developers raised 49% less through trust products than in previous quarter.

Credit is even dropping for other sectors and ones that need it.  With shipbuilding facing enormous over capacity and buyers not waiting to reject ships, banks are facing the risk of losing twice on a loan: first to the shipbuilder and the second to the buyer if they reject the ship if it is late or defective.  This is causing banks to rein in credit growth to ship yards putting even more pressure on the system.

Wal-Mart is pushing back against Chinese government harassment.  They say that manufacturers that fraudulently label products they sell should be held responsible.  Did you notice Beijing has only gone after foreign firms?

Capital Use and Measuring GDP in China

A more arcane but incredibly important area of economics, that gets overlooked, is how to measure GDP.  The classical example goes like this.  Assume you have two guys who live in a country and each guy has $100.  The first offers to pay the second guy $100 to dig a hole.  The second guy tired from digging the hole, offer the first guy $100 to fill the hole back up.  According to economic accounting, this accounts for $200 of GDP even if nothing was actually accomplished.

Theoretically, GDP growth of this nature can continue infinitely.  However, in reality, this type of GDP growth results ultimately in significant losses, though it can continue for some time before it collapses.

The reason I mention this relatively arcane discussion about how to calculate GDP is that this problem is incredibly relevant to understand the potential difficulties facing China.  Let me emphasize that I do not have a good answer and the data on more esoteric  or politically sensitive issues is even worse than the baseline numbers.

In the past week there have two pieces in Quartz about the poor quality of older Chinese housing that is now collapsing and another on whether China actually has a housing bubble because so much of the housing stock is being turned over.  While it is perfectly reasonable to ask what impact China’s existing housing stock has on promoting or preventing a bubble, this overlooks two much more fundamental and important issues.

First, how efficiently is capital being allocated in China?  Analysis of Chinese finances and a potential bubble typically focuses on a housing bubble or over capacity in specific industries like steel or solar.  However, there is evidence that there is wide spread misallocation of capital throughout the Chinese economy and that the capital is poorly utilized.  Houses are being built, torn down, and rebuilt and GDP goes up but the quality of that GDP, similar to the example of holes, is in real doubt.

Second, if capital is being poorly allocated, for instance in the case of substandard housing that is destroyed relatively soon after being built, what does that say about historical GDP and capital accumulation?  Put another way, if capital is being consumed or is idle rather than deployed into productive purposes, this has the net effect of raising past GDP while depressing current or future GDP.

Let me build on the simple example from earlier about two guys digging and filling in holes.  Now let’s assume the first guy builds a house and sells it to the second guy who takes out a 30 year mortgage to pay for it.  Then after 10 years the house starts falling apart and guy #2 has to move and buy a new house.  There will be a large capital loss by the owner, a developer to purchase the house at market rate to build a new house, or an insurance company.

Consider a second scenario where the house is fine but after 15 years a developer or the city want to tear it down to build bigger, nicer, and newer houses, a very common phenomenon in China.  The developer will have to purchase at near market rate the old house in order to build a new one.  This capital cost will then be passed on to the new purchaser.

This poor allocation or destruction of capital is not limited to real estate but carries over into all other industries.  Over capacity in solar and steel where $500 billion in debt gets you $300 million USD in profits, are the obvious culprits, but under utilization of capital is rampant in China.  According to S&P data, Sinopec and PetroChina pay less than what many governments pay on their debt but also earn an incredibly low rate of return on capital and half of what ExxonMobil earns.  Put another way, in the most capital intensive industry on the planet, Sinopec and PetroChina earn a rate of return on capital that would barely break even for most competitors.

Chinese companies are coming up with ever new and creative ways to hide these capital losses.  The Wall Street Journal is reporting that Chinese banks have devised a plan to sell bad loans to their investment banking arms to try and restructure them.  The bank does not have to report a non-performing loan and receives a higher price for the soured loan than it would on the open market allowing the bank to mask the true picture.

Having lived in China, I can personally attest to the amazing misuse of capital.  Whether it is buildings being torn down ten years after being built or looking out my window and seeing half empty office buildings.  Unfortunately, measuring the “misallocation” of capital is an incredibly hard thing to do

Capital ultimately represents a cash flow, whether that is a machine that makes things or an apartment that someone lives in.  Imagine the losses incurred when you learn that more than 70% of Chinese airports are operating at a loss.  China Railway Corporation announced plans to put together a private investment fund after corruption scandals and losses forced it to give up its status as the Railway Ministry.  The losses it currently sits on are enormous and there is valid concern over its ability to profitably exist without government handouts.  The capital has to receive a stream of cash to pay for the investment or revalue the investment and the cost of the product.

Despite the pictures of gleaming skylines, brand new airports, and bullet trains the cash flows are struggling to pay for the capital used.  Whether through banks, surplus capacity, or a revaluation of the asset and the product, at some point this is going to result in significant losses.

Deutsche Bank Suspends Employee for MAS Contact

Deutsche Bank has suspended an employee for “improper communication” with the Monetary Authority of Singapore.  This comes after a wide ranging investigation by large investment banks into suspected employee rigging of the foreign exchange market.

There are a couple of interesting aspects to this case.  First, according to the article, Deutsche Bank informed MAS of this decision and reasons behind this decision, but MAS has so far opted not to disclose this to the public.  Given that the other central bank notified of potentially improper behavior, the Bank of England, “suspended a staff member” and hired an outside law firm to conduct a full investigation, it is troubling that MAS has so far avoided any disclosure of this event or outside investigation.

Second, as Deutsche Bank suspended the employee for “improper communication” with MAS, this implies some type of unethical behavior by MAS or an employee of MAS.  The report does not say that the employee passed on sensitive information to other DB employees, other banks or traders.  While MAS may be faultless, it is likely given what is known so far that there is some improper behavior by MAS or an employee of MAS.

Third, given that MAS has announced its investigation of potential foreign exchange market manipulation, it presents a clear conflict of interest to both be investigating and the investigated.  I have absolutely no sympathy for banks or traders that attempt to manipulate market prices, however, I harbor similar levels of disdain for bodies that investigate themselves and find themselves clean.

Why listen to me though, I am just an academic and a quack according to the Singaporean powers that be.


Credit Ratings in China and the World

Last week I was interviewed by Agence France Presse about my thoughts on Dagong, the Chinese credit ratings agency, that last week gave a press conference about its plans to revolutionize the credit ratings world.  Before I give my specific thoughts, I want to emphasize a couple of things.

First, I am not writing this because I feel I was misquoted in anyway, only that I want to add more detail to my thoughts.  I have been lucky to work with journalists that I feel are trying to accurately represent my opinion and better understand a story, this is no different.  Second, I am not in any way trying to defend the existing major credit ratings agencies.  I think even their most ardent supporters would admit they made significant mistakes and that the entire system needs work.

Dagong is a Chinese credit rating agency that rates a large number of Chinese bonds, a symbolic rating on the US government sovereign debt, and virtually ignored outside of China.  Dagong is seeking to make a name for itself by pounding the table about the existing major credit ratings agencies and trying to reinvent credit rating.

I have a number of thoughts on the matter.  First, I think there is a real need for increased competition in the credit rating agency world.  The three major agencies S&P, Moody’s, and Fitch dominate the credit rating world due to the quasi-monopoly they have been granted by the US government in the United States.  Given the importance of this work, this has carried over into a domination of the credit rating world in other ratings work and in other parts of the world.  Unfortunately, this has led to low quality ratings, group think, and conflicts of interest which have been detailed else where.  I think it is important to bring new entrants into this arena.

Second, the Dagong release on the “Guiding Principles of Credit Ratings” has got to be one of the most non-sensical things I have ever read.  There are three points here I would like to highlight.

  1.  It borrows major portions directly out of the communist party handbook on how to analyze the economy. It literally talks about “dialectical materialism” and credit ratings as if Marx and Engels were analyzing cash flows and repayment risk.  The document is filled with communist and party sounding gibberish that means nothing to savy investors around the world.
  2.  When it does directly address non-gibberish issues, it talks only about factors that are well known to credit analysts and economists the world over.  The counter cyclical nature of credit and industry risk outside the specific firm of repayment.  Memo to Dagong: you aren’t the first people in the history of mankind to discover the counter cyclical nature of credit expansion and contractions.  In short, despite their claims to developing a new theory of credit rating, I see absolutely nothing new in their work.
  3. Most importantly, while Dagong talks about the importance of rigorous ratings as building trust it is completely divorced from this in reality.  Just how divorced you ask?  Dagong  lowered its rating on US Federal Government sovereign debt to an A- in the fall last year.  To put that in perspective, according to JP Morgan, there is only one bond in all of China with a lower rating.  99.9% of all bond issuances in China receive a AA or higher.  Now let me emphasize, I do not approve of US fiscal policy and public finances.  There are enormous problems.  However, it strains all credibility to believe that the US government is a worse credit risk then all but one bond issuance in China.  The point being: while making headlines on the US government rating cuts may make for good headlines, they do nothing for Dagong credibility.

I believe strongly in the need for additional credit ratings agencies.  However, if Dagong wants it self to be taken seriously: stop sounding like the propaganda department in the Finance Ministry for Beijing, establish credibility with your ratings, take out the Marxism, and be willing to rate a Chinese firm as junk debt.  Then, you will be taken seriously outside of China.