How China is bailing out its shadow banks

From Credit Suisse via FTAlphaville:

The widely expected waves of defaults in the middle of 2014 did not materialize. Indeed, we note that the trust fund industry suffered a liquidity drain and rising NPLs in 2014, but it has employed three measures to keep the problems in hand for the time being. (1) Local governments have exerted influence on banks to make short-term bridge loans, typically from the local banks. (2) Trust funds sold part of their assets to asset management companies or other third parties, to make payments to investors. (3) Trust fund shareholders used their own equity to fill the gaps created by NPLs to avoid haircuts to investors. There were 8,547 trust funds due for repayment, and 14 cases reported a delay in payments or defaults (see Exhibit 49). This is a better-than-expected result, in our view, especially considering the downward pressure in the economy and tight liquidity in the real economy.

…We expect larger problems in 2015 for the trust industry, with bigger repayments due, aggravated by further downward pressure on economic growth, the property market and commodity prices. Not only does the trust fund industry face NPL pressure, it also faces competition from broker asset management and mutual fund subsidiary asset management companies. These two new forms of shadow banking entities, with a total size of RMB11.7tn versus the trust funds’ RMB13.9tn under management, tend to be even more aggressive lenders.

Meanwhile, capital inflows into the trust funds have softened significantly, with 28% yoy growth in 4Q 2014, in comparison to 47% average growth since traceable data started to be published in 2011. The lack of momentum in capital inflows makes the liquidity situation stretched in a sector traditionally kept afloat through an influx of capital. We expect negative net capital inflows in 1Q 2015, amid a robust equity market, stretching liquidity even more before the next repayment peak season in 1H 2015.

…We have screened every trust company licensed by the China Banking Regulatory Commission in an attempt to identify the liquidity situation and the parent company’s access to credit for a potential bailout. Our findings show that nearly 90% of trust funds are in the hands of at least one parent company of a large SOE or local government. For the sake of social stability and for reputational reasons, we assume that in the event of these trust funds facing liquidity problems, the parent companies would deploy bank credit or their own capital to facilitate a bailout, as was the case in mid-2014. The remaining 10% of trust funds, however, those without a parent company’s deep pockets or standby bank credit, may face the default threat. The size of the latter is estimated at RMB1.0tn to RMB1.3tn.

…According to Use-Trust, a financial database, 20% of collective trusts involve the real estate sector. Another 20% went to infrastructure projects that are largely debtfinanced through local government investment vehicles(LGFVs). There are about RMB30bn in collective trust products directly issued by the mining sector based on data available. We also think that the collective trusts related to real estate, mining and LGFVs may be greater than what the data suggest as they may be masked under other names. These are the areas where lending default risks are on the rise and the repayment schedule is pressing. We observe that many collective trust funds stopped lending in 2H 2014. Trust funds unable to return proceeds to investors on time may become a real challenge in 1H 2015, in our judgment.

…Booming capital markets is the second reason for us to show a little more sangfroid with the situation. Chinese capital markets have turned visibly more active in the past few months, highlighted by transaction volumes that set a new record in the modern history of the world. We believe that there is a sea-change in Beijing’s view about the capital markets. As banks are unwilling to lend and shadow banking activities are shrinking, the capital markets are now becoming a key channel to pass on liquidity to the real economy, in our view. This is not only about the equity market, but also other channels of capital markets, to be used to lower the funding costs in the real economy.

We expect to hear much more about “securitization” in 2015. Banks are likely to securitize their loan book. Local governments are expected to securitize their fixed income generating infrastructure projects. Through the process of securitization, the authorities hope to iron out the duration mismatch and fund cost mismatch created by the boom of shadow banking and infrastructure construction. In essence, the government is attempting to continue to direct savings from the private sector (China has a 52% savings rate by individuals and corporates) to plug the holes in the public balance sheet. The difference now is that the redirection is through public or semipublic trading platforms, versus shadow banking previously which has transparency and regulatory issues. By doing so, funding costs will probably decline.

This may not necessarily remove the default risks eventually, in our view, but may delay the eventuality. Banks trading potential NPLs by buying securitized assets does not change the nature of the bad debt, but for a while, these potential NPLs are moved from the loan book to the investment book. Individuals who buy securitized assets still have similar default risks, but those infrastructure projects can be rolled over, perhaps at lower funding costs and more sensible duration…

Shadow banking underwent a major mutation in 2014, with a surge in mutual fund subsidiary management companies. The change in the regulatory environment, in our opinion, was the direct cause of such mutation. The China Banking Regulatory Commission has tightened regulations on the ‘old-style’ shadow banking over the quarters since the middle of 2013, leading to derisking among wealth management products and a drastic decline in capital inflows to the trust funds. In the meantime, the regulatory environment surrounding broker and mutual fund asset management has remained relatively relaxed. Indeed the China Securities Regulatory Commission, has encouraged the development of an asset management industry. That has helped to overcome the hurdle of acquiring licenses for fund raising and lending. Consequently, the number of special-purpose vehicles has soared, under brokerage asset management and subsidiaries of mutual fund asset management.

By the end of 2014, the brokerage asset management companies has reached nearly RMB8tn in AUM, in contrast to RMB500bn two years ago. The mutual fund subsidiary asset management companies have now reached RMB3.7tn in AUM, in contrast to zero two years ago. Typically, these SPVs raise funds through banks and other financial institutions and then lend to high yield borrowers in the property and commodities industries, as well as to local government investment vehicles. They tend to be even more aggressive in lending with even sketchier due diligence processes.

The presence of brokerage asset management and subsidiaries of mutual fund asset management has helped to push back the timing of default, but has probably further increased the future risk. First, transparency is even poorer, in an even less regulated environment. Some financial products we assessed reveal an extremely complicated structure and multiple layers of ownership. Second, these SPVs have very thin equity behind them, typically RMB20-50mn in capital for a RMB1-2bn fund. The parent companies’ ability to provide a bail-out seems more stretched than for trust funds.

And I guess that’s a long-winded way of saying never underestimate China’s capacity for extend and pretend…