Amid the rise of nonperforming loans and Special Mention loans, the Chinese government has instructed banks to securitize these bad assets, raising concerns reminiscent of the 2008 global financial crisis. Back then, banks securitized bad assets, classified, packaged, and sold them to investors, triggering a financial crisis.
Nonperforming loans, loans that borrowers cannot repay, saw a significant increase last year, particularly in the real estate sector. The nonperforming loan ratio in the housing mortgage loans of major banks like the Industrial and Commercial Bank of China surged to 9.6%. The sharp rise in nonperforming loans in the real estate sector is particularly worrying as China’s real estate contributes about 20% to the economy and over a quarter of the loans held by major banks.
While the overall nonperforming loan ratio across all industries appears to be 1.6%, slightly higher than the United States’ 1.4%, it is on par with many developed economies. However, China’s classification system masks the true extent of potential loan issues. Special Mention loans are considered to carry greater risks than nonperforming loans but have not yet been classified as such. Differences in classification may result in China’s reported nonperforming loans being lower than the actual situation, potentially hiding underlying nonperforming loans within Special Mention loans, posing greater risks to the banking system.
Chinese banks collectively held $620 billion in Special Mention loans last year. With the implementation of new transparency guidelines, many Special Mention loans need to be reclassified as nonperforming loans, leading to a significant increase in the nonperforming loan ratio. Therefore, the total ratio of nonperforming assets (including nonperforming loans and other assets such as foreclosed real estate) is expected to reach 5.5% to 5.9%.
The surge in nonperforming and Special Mention loans can be attributed to various factors. Slowing economic growth in China makes it harder for borrowers to repay loans, while sluggish home sales hinder developers from recouping investments. Rising youth unemployment, delayed marriages leading to a decline in home sales and consumer spending, uncertainties from the U.S.-China trade war, and tightened credit conditions by the central government further limit some borrowers’ access to loans.
Nonperforming and Special Mention loans are heavily concentrated in the real estate sector, posing greater risks to Chinese banks. Should borrowers default, banks resort to foreclosure, potentially incurring losses in a slowing market. With reduced recovered loans, funds available for lending by banks will decrease, leading to a more cautious approach to lending to the real estate sector and restricting financing for new development projects, hindering Beijing from using real estate to escape the current economic downturn.
To address this issue, the central government has instructed banks to securitize nonperforming loans. Securitization essentially involves categorizing bad loans into different risk categories (high, medium, low), packaging them into financial instruments, and selling them to investors. Nonperforming loans can be securitized into bonds, mortgage-backed securities, asset-backed securities, debt-backed securities, and even derivatives. It is projected that this year, China’s issuance of securities packaged with nonperforming loans will increase by about 40%, with lending institutions selling bad mortgage loans, overdue credit card debts, and distressed consumer loans.
The benefit of securitization is that banks can recover some loans while spreading the risk to multiple investors who purchase the securities. However, this does not eliminate bad debts or address the fundamental issues in the Chinese economy that lead to borrower defaults. Another concern with securitization is that it exacerbates the existing opacity issues in the Chinese banking system. Once debt is securitized and sold, tracking and quantifying the proportion of nonperforming loans or the actual risk faced by banks becomes nearly impossible, just as assessing the economic situation based on individual default rates is.
Diversifying risk may seem like a good idea but could lead to risk spreading. Due to the likelihood of borrower defaults, securitizing nonperforming loans carries high risk, akin to the global financial crisis. Back then, mortgage-backed securities created from subprime mortgages (home loans issued to borrowers who couldn’t afford them) were bundled and sold. These securities were then sold to investors who underestimated the associated risks.
The eventual burst of the real estate market bubble led to a decline in housing prices. Consequently, the default rate of subprime mortgages sharply rose, leading to a drastic drop in the value of mortgage-backed securities. By securitizing mortgages and selling them to investors, risks were transferred from banks to other economic sectors, such as pension funds, insurance companies, mutual funds, and individual investors of all sizes.
In conclusion, the Chinese economy has clearly slowed, evident from declining consumption and home sales and rising default rates. Regardless of how the Chinese government handles the reported nonperforming loan ratio, the underlying causes persist, from decreasing exports and factory activities to aging crises, debt bubbles, and reduced foreign direct investment. Attempts to cover up evidence cannot eradicate the fundamental problems.
(Note: loan classifications include “Pass,” “Special Mention,” “Substandard,” “Doubtful,” and “Loss.” The latter four categories, excluding “Pass,” collectively referred to as “problematic loans.”)