China’s latest solution to soothe its ailing financial system: repackage bad loans into good bonds. Such financial engineering may have its merits, but turning trash into treasure will be harder than it seems. The People’s Bank of China said recently one of its top priorities for the year is to advance a program to let banks securitize toxic loans into asset-backed securities, a type of bond. Unlike subprime bonds that triggered the financial crisis in the U.S., the banks openly acknowledge the loans are terrible before the bond is created. Because the loans are written down to somewhere between 20% to 30% of their original value, investors need only to hope for a partial recovery. There is even a precedent in a short-lived program that ran between 2006 and 2008. At the time, China Construction Bank issued 2.8 billion yuan ($431.5 million) of these securities, promising a 6.1% yield. The recovery rate for the underlying NPLs ended up being 32%. But that bond’s assets were recovered during a massive credit-fueled economic boom, and investors were paid down in under two years, according to Deutsche Bank. It is hard to imagine such easygoing returns in today’s slower growth environment. Like many things in China, there is also the issue of oversupply. While official NPLs are at 1.7%, many estimate the real figure is well into the double digits. As a partial measure of what the financial system has to deal with, China’s largest listed banks have exposure to the country’s inefficient, old-economy sectors of between 19% and 44%, Sanford Bernstein estimates. With the supply of bad loans rising, the price banks are able to get for them is falling. That can be seen through China Cinda Asset Management and China Huarong Asset Management, entities created to clean up the last banking NPL crisis in the 1990s. Freshly capitalized in recent years, they are already choking on the supply of new bad loans, and the price they are willing to pay is falling. Then there is the issue of who will buy these bonds. Insurers seem prime candidates. New solvency regulations for insurers that came into effect this year mean investing in these securities can translate into lower capital charges. In theory, if Chinese insurers dedicated the quarter of their fresh capital they are allowed to put into nonstandard investments each year to these bonds, at the requisite write-downs, that could absorb all the currently declared NPLs in the system. But this means insurers would cease to invest in other popular nonstandard asset classes, such as infrastructure debt and other asset-backed securities like those backed by auto loans. Another set of buyers is more troubling: the banks themselves. Banks already account for just over 40% of the asset-backed securities market, making them natural buyers. But that risks bad debts being shifted around the banking system, rather than fully cleansed. The last rub is that the banks will be managing the loans that make up these new securities. If they couldn’t work them out when they were on their balance sheets, investors should wonder what will make them be able to when they are packaged in a bond. China knows it has a bad-debt problem. It is still searching for a solution. Write to Anjani Trivedi at anjani.trivedi@wsj.com
China's repackaging of toxic loans into asset-backed securities, or bonds, is likely to cause problems in the future, despite the precedent set in 2006-2008 that saw yields of 32%. At that time, assets were recovered during a boom, fueled by credit, and investors were paid within two years. However, such results are unlikely to be seen in the current slower growth environment. In addition, oversupply is pushing these bond prices down, and purchase by potential buyers, whether insurers or banks, pose problems for other asset classes and keep bad debts within the banking system. Finally, the same banks that managed the toxic loans will manage the new securities in their repackaged form, an irony that investors should be wary about.