|Shares Out. (in M):||1,000K||P/E||0.0x||0.0x|
|Market Cap (in M):||15M||P/FCF||0.0x||0.0x|
|Net Debt (in M):||0||EBIT||0||0|
China Development Bank is a commercial bank and a policy bank at the same time.
In 2008, China Development Bank had 300 billion RMB of registered capital; 51.3% held by ministry of finance, 48.7% held by Huijin Investments, the sovereign wealth fund of China. The bank received an additional 10 billion RMB from the social security fund in 2011. The Banking Policy change dated December 23rd, 2008 transitioned CDB from a governmental financial institution to a state-owned, independently operated commercial entity responsible for its own risks and P&L. The most recent loan survey ranks China Development as the 5th largest loan provider in China with approximately 10% of market share. The bank had gone through an exponential growth phase over the last 7 years as seen through its balance sheet. Total assets ballooned from 1.57 trillion RMB at the end of 2004 to 6.25 trillion RMB at the end of 2011. The most recently released set of financials show the balance sheet of CDB is above 7 trillion RMB at the end of first half of 2012. The bank has not raised any additional equity since 2007 aside from a 10 billion RMB injection from State Social Security Fund. The balance sheet more than doubled in five years while shareholder’s equity rose less than 30%. Even though China Development Bank has transformed into a commercial bank, its funding model differs significantly from deposit taking institutions such as ICBC, China Construction Bank, Bank of China and Agricultural Bank of China (The Big Four). CDB’s funding model is primarily driven by selling bonds into the hands of commercial banks. Per its own disclosure, CDB alone accounted for 21% of domestic bond market in China. Due to its prior existence as an official government branch, the Chinese banking regulator currently allows Chinese commercial banks to hold CDB papers with zero weighing when calculating risk-weighted assets.
|In Billions RMB||2011||2010||2009||2008||2007||2006||2005||2004|
|Total Shareholders' Equity||445.3||402.5||379.9||348.5||348.2||158.2||130.5||107.5|
The original policy for allowing the zero weighing was to ensure a smooth transition for CDB into its newly established commercial status. The policy note issued immediately after its transition into a commercial bank gave CDB the ability to issue debt with sovereign status until the end of 2010. Since then, the policy has been periodically reviewed and extended repeatedly. Most recently, the Chinese banking regulator allowed all debt issued before the end of 2013 zero risk weighing at commercial banks and will reevaluate the status of CDB’s future bond issuance.
I recommend a short position in long-dated CDB bonds or a long position in its 5-10 year CDS as I believe the credit risks of CDB is significantly mispriced given the quality of its credit portfolio, its funding structure and the significant key man risk the bank faces.
Why is CDB more risky than it appears? The drastic balance sheet expansion is probably an alarming sign for any financial institution investors. China Development Bank organically grew its balance sheet by two folds over the course of the last four years; the balance sheet further expanded another 13% in the first half of 2012 and probably stands very close to 8 trillion RMB today. That’s almost tripling its balance sheet for a loan-making institution that is supposed to evaluate the credit worthiness of every dollar of loan it makes to governments and corporations. The balance sheet growth rates of all other deposit taking Chinese commercial banks are significantly slower than the growth rate at CDB. For example, China Construction Bank grew from 7.5 trillion in total assets to 12.2 trillion in total assets over the course of 2008 to 2012.
If loan growth in itself isn’t alarming enough, the bank’s exposure to local government financing vehicles (LGFVs) is certainly concerning. Many experts on Chinese economy view debt problems associated with LGFVs as the most significant intermediate term risk to China’s economic prosperity.
“Local government debt the biggest medium-term risk” is a section extensively discussed in a recently published research note by Barclays. China Development Bank on average is about 3-5 times more exposed to such risks compared to a big four commercial bank according to the LGFV bond prospectuses I studied. Further, China Development Bank suffers from the lack of effective regulations. The governor of the bank, Chen Yuan, is a princeling who wields considerable more power within the communist party than anybody in charge of regulating banks. Furthermore, the fact China Development Bank finances so many local and provincial projects further bolsters his standing among party officials. Incentives are simply not aligned to making prudent and sensible decisions on loans as evidenced by multiple struggling projects and ghost towns.
On the surface, China Development Bank looks to be the healthiest bank in the universe. For the year 2011, its NPL is only 40bps of its total loan portfolio and it appears the credit quality of its loan portfolio has been steadily improving since 2008. However, the underlying quality of such loan portfolio is much more questionable. If you think the U.S Congress is good at kicking cans down the road, multiply that by ten times, you get the Chinese banks. Questionable and problematic loans are rarely dealt with in a default situation. Instead of taking the pain right now and restructure the underlying assets and liabilities, the terms of the debt will typically get extended. It is especially true when projects are semi-government in nature. China Development Bank doesn’t formally disclose its loan portfolio and even name who are its biggest debtors, but most of its loan growth and loan portfolio are undoubtedly related to infrastructure construction. If you remember watching the ghost towns on 60 minutes and question how such a project could ever get financed, look no further than China Development Bank. The ambitious Manhattan project in Tianjin with Twin Tower and Rockefeller Center that’s left empty right now had a 59 billion RMB line of credit from CDB. Multiple Chinese reports related to troubled Express way construction projects in the Hunan and Yunnan provinces are also mostly backed by CDB. By my estimation, CDB on average commits 3x more in commitment as well as loans outstanding to such LGFVs than an average deposit taking commercial bank such as ICBC. For Fujian Expressway Corp. for example, the total amount of loan outstanding for the company is 101 billion RMB and CDB accounts for 44 billion of that. By comparison, the second largest creditor of the company is ICBC at 12 billion RMB. How risky is Fujian Expressway Corp? It has about 70% debt to asset ratio at the end of first half of 2012 and the interest coverage ratio is approximately 1.08. The project can barely afford interest payment but believe it or not, it is probably one of the much higher quality projects. The two other provincial expressway companies, Hunan and Yunan Expressway Corp, are in much worse shapes. In 2011, news reports indicated Yunan Expressway Investment Corp had sent a notice of default to its creditors and China Development Bank is on the hook for 54 billion RMB, three times the amount of its second largest creditor, China Construction Bank.
The list goes on and on. I was able to identify almost half a trillion RMB worth of loans and the repayment prospects for most of them are questionable at best. While the four large commercial banks are all significant creditor in those projects, the credit extended and the credit line provided by China Development Bank are often multiple folds of what is extended by a big four bank. (Most of the LGFVs financed by CDB also raise money in the bond market in China and the bond prospectus tells a very detailed story of the credit quality of the LGFVs on a stand-alone basis).
Given the relevant bond prospectus and loan documents, China Development Bank’s loan portfolio is a highly risky one. The local and provincial governments are supposedly the implicit guarantors for all such LGFVs but on an independent basis, the LGFVs are all debt laden GMs in 2008 and will undoubtedly go bust without governmental support. Further evidence that CDB’s loan portfolio is questionable comes from personal experience. Board members should remember in 2011, it’s none other than CDB which provided financing for Harbin Electric to go private. While a myth at the time, it’s later reported in Chinese media that Chuan Yuan’s son used to work as an associate at Abax Capital after graduating college.
Given the fact that CDB is designed to be a policy bank, it may naturally engage in lower quality loans to support policy objectives. The funding model employed by CDB multiplies its risks. As discussed previously, CDB primarily secures funding through the domestic bond market, issued 1 trillion RMB in bonds in 2011 alone. Such funding model is flawed for at least two reasons. One, it relies heavily on commercial banks’ willingness to purchase. The current regulatory environment is favorable in allowing CDB debt to be accounted for as risk free asset for commercial banks, providing them incentives to purchase. The regulatory environment is far from certain as CDB is not born with such status. The Chinese banking regulator grants the status on a year to year basis. Should the regulator change its policy back to a traditional 50% weighing for commercial banks, CDB’s cost of capital will likely increase. Secondly, as evidenced in the subprime crisis in the U.S, the bond market could be shut down for an extensive period of time in any form of liquidity shocks and CDB has significant outstanding credit commitment to various entities who will very likely draw on their credit lines in such events. Without a stable deposit base, China Development Bank could potentially face a liquidity shock and that’s much less of a risk for a traditional Chinese big four commercial bank.
Finally, the key man risk for China Development Bank is growing more significant. At age 68, Chen Yuan is due to retire this year after the party congress. He’s most recently named the vice chairman of the legislative consulting body of the CPC. The success of China Development Bank is in large part due to his clout within the party. Being the son of one of the founding fathers of PRC, Chen Yuan has direct access to politburo members and is able to shift policies, such as the policy which allows zero risk weighting for commercial banks’ holdings of CDB debt. The banking regulators simply aren’t on the same level politically to be able to regulate the CDB. The situation may shift as Chen Yuan steps aside from the day-to-day operation of CDB and become more removed politically over the course of the next few years.
|Entry||03/13/2013 10:44 AM|
Given the ownership - even if the credit quality is as bad as you claim - and by the way I can well believe it given the "previous" in this sector as detailed below:
given the ownership structure - is it ever going to satisfy the technical requirements for a default and a payout?
I am not arguing with you on the loan quality issue - if I were a betting man I'd say there is a decent chance that there are serious problems over there at some point in the next 10 years.
Reason I don't say in the next year or two is that obviously it is a command economy, so would opine that the situation you saw in, say, the US, the UK or Spain where the market could see there was an asset quality issue and turned it into a funding issue quite quickly is somewhat less likely in China. Less open economy, the funding mechanisms you mention are in place, etc.
Say it is a proper disaster - what is to stop a controlling stake in all of the big 4 being taken by the government and the big 4 then just continuing to fund CDB? Obviously it is probably the wrong solution for the people of China, but I doubt the top brass in the government are that bothered about that if it helps their mates. And the CDS would probably not be triggered.
It is a lot more expensive, but why not just buy a very long-dated, out of the money put on the listed equities of the big 4. If you are that sure that the scenario you have in mind plays out (and I am not arguing that it won't on a long enough timeframe) then you remove the uncertainty of whether you actually get paid out this way.
IIRC from reading The Greatest Trade Ever, Paulson had a big enough headache with this and prices on the structured products being rigged on US mortgage products, and this was in a relatively open market - I shudder to think what it would be like in China.