China NPL pioneer plans new $1 billion deal

Huarong AMC will launch its third international NPL auction in October, says official.

China's most innovative and dynamic asset management company (AMC) Huarong AMC (HAMC) will hold an auction of around $1 billion non-performing loans (NPL) formerly belonging to China's biggest bank, the state-owned Industrial and Commercial Bank of China ((ICBC). The landmark deal will take place in the third quarter of this year, according to a Huarong official and will be aimed at both international and domestic investors.

To date, Huarong is the only Chinese AMC to conduct an international auction and the official says he hopes prices will be higher than two previous Huarong sales, since he believes there has been a progressive reduction in the risk premium attached to the NPL recovery process on the Mainland.

He adds that the deal is currently in the planning stage, with assets being selected and assembled into portfolios. Potential investors have already been given informal notice, however.

The NPL portfolio on offer will include several asset pools at some of Huarong's participating branches, of which there is one per province. According to preliminary plans, five to 10 branches will participate. In the auction, investors will be able to bid for individual asset pools, or a combination of pools.

The official argues that this makes the process more investor-friendly, because it resolves problems of portfolios with widely dispersed assets. Given the size of the deal, it is likely that that the foreign purchaser will be in the same league as previous distressed asset investors Goldman Sachs and Morgan Stanley.

Under the AMC system, the four state banks have sold RMB 1.2 trillion ($145 billion) in NPL's to the four AMCs at face value, leaving around two trillion ($241 billion) on their books (as of end 2001).

The AMCs then have the task of disposing the loans and diminishing the losses they suffer on behalf of the banks. The AMCs pay the banks for the loans they take over mainly with government bonds guaranteed by the Ministry of Finance and a smaller proportion (17%) of loans from the central bank.

HAMC, which is tied to ICBC, then injects the assets at an agreed valuation into a JV with a foreign partner, which contributes cash and expertise. The JV then tries to recover a proportion of the loans.

There have been two previous HAMC NPL buyouts: one by a Morgan Stanley-led consortium for Rmb10.8 billion ($1.3 billion) and more recently, Goldman Sachs, which acquired RMB 1.97 billion ($238 million). The MS deal was announced in late 2001, but only approved in February this year.

Officials say the GS deal, which also recently received approval, has performed better than the MS deal, since the smaller size permitted quicker analysis. Cash is already said to have started flowing in even before formal approval.

Under the terms of the deal signed with the MS consortium, Huarong was partially paid with cash upfront (based on the value of the NPLs contributed), and via a profit sharing scheme based on future recovery proceeds.

According to Huarong, the loans injected into HAMC were valued at 10 cents on the dollar. In 2001, MS was quoted as saying that it would pay 50% upfront in cash. However, it is believed it actually paid 25% (once approval was granted) and will pay the balance in equal annual installments over the next three years.

Huarong estimates the JV will recover 25% of the face value of the loans.

Chinese bankers say they hope to structure the new JV in such a way that Huarong will not have to meet certain recovery targets before becoming eligible for a greater share of the profit sharing. Such a structure should ensure the JV has a greater incentive to focus on asset recoveries during an early stage of the work-out period.

One official points out that HAMC has spent the past year negotiating hard with numerous government agencies on behalf of foreign investors, but feels frustrated because it has not got much tangible reward, since the bulk of the early proceeds go to MS and the consortium.

He also adds that Morgan Stanley initially tried to recover the loans by going it alone, helped by its majority stake of 65% in the JV.

"MS didn't trust the Huarong branches set up around the country and tried to bypass them," he reports. "However, given local difficulties recovering assets, they're now leaning toward closer co-operation."

Huarong AMC was set up in 1999, taking over RMB 400 billion ($48.3 billion) in NPLs from ICBC that had been incurred before 1995. ICBC had a total of RMB 700 billion in NPLs ($84.6 billion) by the same date.

However, HAMC has not dealt with any new NPLs arising since then, in addition to the RMB 300 billion on the bank's books from the first batch. Given the real estate and IT bubbles that have burst since 1995, bankers estimate that ICBC‘s NPLs have certainly continued to grow.

The government is desperate to reduce NPLs to 15% from their present declared average levels of 24% before China's markets get thrown open to foreign competition under World Trade Organization rules in 2007.

AMCs, which have sold loans to foreign investors, must subsequently set up a JV with the foreign investors, since the latter are not permitted to own Chinese assets acquired from banks outright.

"Frankly, HAMC would prefer the foreign investors to be able to conduct their asset recovery on their own without our involvement," one banker comments. "Unfortunately, this isn't possible under the present legal set up."

Last month, ICBC signed a memorandum of understanding directly with GS, but the RMB 8 to 10 billion of assets involved are foreclosed assets that were previously used as collateral for loans, not loans per se.

In contrast to the relatively attractive assets ICBC could sell to GS, Huarong has to accept the worst NPLs made by ICBC, often with no collateral.

One banker estimates that despite optimism generated by the sales of the foreclosed assets to GS, which include valuable real estate, it's more in the nature of an experiment.

"It's ironic, but ICBC can't afford to repeat this kind of deal too often as actually foreclosing on assets such as those sold on to GS forces the bank to recognized losses on the initial loans."

ICBC is reluctant to sell the loans at a discount since the discount would immediately affect profitability, says one banker.