There is a building in China's Northern Liaoning province, classified as a five star hotel, to which there are no roads. It is built in the middle of nowhere. The project was funded by the local branch of a state-owned commercial bank to the tune of millions of dollars.
After the first loans went sour, further funds were given to the developers (friends of the loan officer) to defray expenses, based on the argument that it was better to continue construction than to be left with a white elephant. However, this meant that no one had ownership of the 'expenses' in the event of the project failing.
Somewhere deep within the contract, the original borrower is identified. But terms, penalties and periods of repayment were all left deliberately vague. In any case, as construction progressed, each new floor was mortgaged off to a different lender for new loans.
This story comes from a foreign banker who has worked on Chinese NPL (non-performing loan) deals. Its familiar theme of collusion between greedy government officials holding construction permits, other officials holding the keys to the bank vaults, and private sector developer, is often used to exemplify the shortcomings of a banking system that has racked up an estimated $400 billion of non-performing loans (that is, loans that fall into one of the five categories of loans that have fallen to a greater or lesser extent in arrears).
As foreign bankers point out, the situation is indeed serious. Two of four state-owned commercial banks, Bank of China and China Construction Bank, want to list this year and the government has informed the banks they must reduce their NPL ratios to 15% by the end of 2006.
So far, the asset management companies, set up in 1999 to take over the NPLs, have taken on $168 billion in NPLs (but only those made before 1996) and have disposed of just $62 billion as at end of 2003. That leaves the SOCBs with an average NPL ratio of 20.36% as of 2003.
However, bankers' views need to be taken with a pinch of salt say some critics. They comment that while recovery of bad assets in developing markets is a difficult business, this is compensated for by fat returns. Indeed, NPLs are a hugely lucrative business, so lucrative that investment banks almost never give out profit figures.
An oft-quoted figure is that NPLs return 25% to 30% and that investors might want an extra five percentage points for operating in China.
Yet China specialists say that deals in China can be very rich indeed, far higher than even 35%.
Take the experience of a Goldman banker who worked on the first $1.5 billion NPL deal in 2001 from Huarong Asset Management, which was split between a Morgan Stanley led consortium including Citigroup and Lehman Brothers plus Goldman Sachs.
According to him, Goldman made $50 million from a $6 million investment over a two year time period. He says Goldman originally put down $16 million to acquire debt, but this was reduced to $6 million after $10 million of debt in the portfolio was collected by Huarong AMC. The debt eventually purchased by Goldman had a face value of $190 million.
Since the deal was the first of its kind, foreign bankers forced unusually favourable terms onto Huarong. The nine cents on the dollars foreign investors paid is much lower than international norms, which come in at around 30 cents.
The foreigners were also helped by the portfolio consisting of 'low hanging' fruit. That is to say, the AMC started by getting rid of the best 'bad' assets in its portfolio.
The final and most important reason for the deal's hyper-profitability was that the deal was sweetened at the last minute by the inclusion into the asset pool of a large and valuable piece of land. This land, in downtown Shanghai, was alone worth more than the amount Goldman put in the first place.
"Six million dollars is a tiny amount, less than the annual package of a Goldman partner," the ex-Goldman banker comments. "In addition, Goldman made sure they got a structure whereby they would get all the profit up to the first sixteen million dollars (the size of the original planned investment) from the debt recovery process."
This was despite Goldman having only put up $6 million in the first place. The next tranche was divided 50-50 and the third portion would go 70-30 in Goldman's favour.
The banker's verdict: "It's amazing the Chinese government agreed. It's risk-less finance for Goldman. For Goldman to lose money on the deal they would have had to get a return of less than 5% on a pool of assets worth $130 million. That's an unlikely scenario," he concludes.
And despite much feeling to the contrary, it is not always the case that foreign investors are taken to the cleaners by wily locals.
Sometimes, says the banker, the opposite can be true. A sleepy provincial bureaucracy can be roused to being unusually helpful and transparent to foreign investors, partly, admittedly, through fear.
"We once foreclosed on a piece of valuable land in the centre of a Northeastern city. In order to get title to the land we had to go through the city government for the bureaucratic and onerous process of ownership of transferring ownership. We feared the worst. But in the end, the city government served us superbly and ended up by buying the land off us at market price," he says.
Some NPL specialists now believe that deals for foreign investors have dried up because the greed associated with the first couple of deals. Analysts say that of the 14 transactions initiated by foreign investors since 2001, only four have been closed for a face value of less than $6 billion.
This means that the remaining $56 billion has gone to domestic investors, most of whom tend to be from the manufacturing rather than the financial sector. This investor base does not demand a China risk premium and is prepared to bid a higher price for assets, confident that it can realize value rather than foreclose.