World - Chinese banks brace for housing aftershock

Keith Bradsher

Thursday, October 23, 2008
SHENZHEN, China: A soft-spoken electronics engineer with an aversion to parties, Liu Shirong does not mind living in a complex where only 50 of 780 apartments are occupied and the swimming pool is eternally empty.

"I have peace and quiet at night," he said.

Liu may like that tranquility, a rarity in this city of 12 million. But the vacant apartments are a nightmare for the mainly speculative investors who bought them when the complex opened a year ago - and they are part of an emerging problem for Chinese banks.

As in the United States, Britain and Spain, the real estate bubble in China has turned into a bust in many cities; only one of the two dozen towering cranes at projects near Liu's home was in operation one recent afternoon.

Banking experts and economists expect the bust to produce, by next spring or summer, a sharp increase in loan defaults that could erode the high profits earned by Chinese banks over the past three years.

The Chinese government announced a series of measures late Wednesday night to bolster real estate prices. The central bank ordered commercial banks to reduce mortgage rates and down payments for borrowers obtaining their first mortgage, beginning next Monday. And the Finance Ministry reduced the stamp tax on real estate purchases, effective Nov. 1, but only for first-time home buyers acquiring an apartment of less than 90 square meters, or 970 square feet.

But real estate professionals and economists said the measures were too narrow to reverse the growing gloom in the Chinese housing market. Prices have already fallen by up to one-third in some neighborhoods of Shenzhen, the city most affected by the real estate bust.

A national index of real estate prices released by Beijing on Wednesday showed a decline of 0.1 percent in September compared with August, the first drop the government has acknowledged. But experts inside and outside China say that actual declines have been much greater, and that municipal officials have been reluctant to reflect this in the data they send to Beijing.

Under the new rules announced Wednesday, mortgage interest rates will be reduced by 0.27 percent for first-time buyers, to 4.59 percent for mortgages of five years or more.

The new rules also leave in place China's many punitive policies toward people who buy real estate as an investment.

"Things are still getting worse," said a top executive at a real estate developer with a variety of projects. The executive insisted on anonymity, citing the government's sensitivity about the housing market.

Real estate problems could also extend beyond banking, complicating efforts by officials in Beijing to maintain economic growth while fighting inflation. The Chinese central bank, for instance, has come under intense pressure to lower interest rates and ease restrictions on banks' lending to developers.

But a rapid or broad relaxation of monetary policy in response to real estate difficulties could reignite inflation, which rose to 8.7 percent at the consumer level in February but was at 4.6 percent in September.

"Real estate developers are threatening the People's Bank of China, saying, 'If we die, the banks die first,"' said Yu Yongding, a former member of the central bank's monetary policy committee and now an adviser to the cabinet.

According to Yu, developers are exaggerating the dangers that bankruptcies could pose for banks. "If the government bows to this kind of pressure, we lose all the benefits of what we did before" to control inflation, Yu said.

Paradoxically, the relative lack of sophistication of the Chinese mortgage system could keep its real estate bubble from expanding into a credit and financial crisis like the one that has engulfed the West.

Though the Chinese banking system has many problems, including being subject to political influence and fraud in corporate lending, mortgage lending is still more tightly regulated than in the West.

The mortgage market remains closer to something out of the 1946 Frank Capra movie "It's a Wonderful Life" than to the home loans with no down payments and practically no credit checks that proliferated in the United States over the past few years.

In China, roughly half of all home buyers still pay cash for their homes and do not obtain a mortgage at all - although they might borrow some of the cash from friends, families or neighbors. For those who do obtain mortgages, the down payment is 30 percent for buyers taking their first mortgage and 40 percent or more for buyers who have a mortgage on another home.

Under the measures announced Wednesday, the down payment will fall to 20 percent for buyers seeking their first mortgage. But many cities, including Shenzhen, had already lowered the down payment to 20 percent for buyers obtaining their first mortgage.

One Chinese regulation, which would never be allowed in the United States, is widely accepted here as simple prudence: the term of a mortgage must end when the borrower reaches a certain age - 55 for a woman, 60 for a man. This means that a 52-year-old man can obtain a mortgage of up to eight years and that a 52-year-old woman can get a mortgage of up to three years. (Since the 1950s, women in China have retired at an earlier age, as it was thought necessary to protect women's health. Some experts in China are now calling for parity.)

Short durations of mortgages mean that homeowners quickly build up equity in their homes with their monthly payments. That makes them reluctant to mail the keys to the bank and walk away if the market weakens, although a few speculators do so anyway.

It is also nearly impossible for Chinese banks to foreclose on homes. Instead, banks tend to renegotiate monthly payments for borrowers who can clearly demonstrate financial strain.

Chinese banks hold the mortgages they issue instead of following the U.S. practice of bundling them together as securities and reselling pieces to various investors. That process, known as securitization, is now making it hard for homeowners in the United States to renegotiate their mortgages.

For years, U.S. bankers and lawyers urged China, unsuccessfully, to allow securitization, but they have curbed such pleas in recent months after seeing the global financial crisis unfold.

"That's one area where I've always been very critical of Chinese government policy, but now it's not looking so bad," said Joel Rothstein, a partner and real estate specialist in the Beijing office of the Paul Hastings law firm.

U.S. officials are still urging China to pursue more financial innovations, but they have not specifically discussed securitization, said David McCormick, under secretary for international affairs at the U.S. Treasury.

Tao Wang, an economist for UBS in Beijing, calculated that for the average mortgage at publicly traded banks in China, the principal still owed to the bank is equal to half the original purchase price of the house.

With the real estate bust, analysts say some small and medium-size banks with greater exposure to the sector could face difficulties. But large banks, which have been forced by regulators to limit their real estate loans since 2004, are expected to remain somewhat profitable over all.

Most big banks in China are publicly traded, with the government owning a large majority of the shares.

"The chances of a systemic financial crisis in China in this cycle are extremely, extremely low," said Arthur Kroeber, managing director of Dragonomics Research, a consulting company in Beijing.

Leo Wah, a China banking analyst at Moody's, has not downgraded banks in China but is closely watching the weakness in real estate and related industries.

"We do not believe that it would cause a serious problem, but if property prices fall some more, it won't be the only sector that has problems," he said.

Already, construction is slowing, and that is starting to hurt other industries. With a sudden drop in Chinese steel consumption, steel makers are rapidly stepping up exports to the United States, despite the risk of fanning trade tensions between the two countries.

For their part, Western banks and real estate funds have made only limited loans and other investments in Chinese real estate because of government restrictions on flows of money into the country. But in some cases, Western investors have started hiring lawyers to serve notices of default to Chinese partners who have fallen behind on payments.

"Until six or eight months ago, we really didn't have this for the China deals," Rothstein, of the Paul Hastings law firm, said.

Chinese banks are flush with cash, with capital equal to 12 to 14 percent of assets, compared with the international regulatory standard of 8 percent.

More important, China has a heavily regulated market that guarantees banks some of the widest margins in the world. Banks raise most of their money through short-term household deposits on which they pay an interest rate of just 0.7 percent. They lend at rates of 6 percent or more.

U.S. regulators were reluctant to prick the real estate bubble that had developed in the United States until last year. But starting in 2004, Beijing officials tried to limit real estate speculation through administrative measures, by setting quotas on real estate lending done by each bank.

In August 2007, as the severity of the crisis involving subprime mortgages in the United States started to become apparent, Chinese bank regulators took the somewhat more market-oriented approach of fine-tuning the heavily regulated interest rates that banks charge for mortgages.

In addition to requiring larger down payments for second and third homes, banks charge interest rates that are up to 3 percentage points higher for these homes than for first-time home buyers.

Even before the policy changes announced Wednesday, few people other than first-time home buyers were buying real estate. "Last year, people were grabbing whatever they could get their hands on," said Liu Nan, a real estate broker in Shenzhen.

"This year, it's mostly people who want to live in them," Liu said.

Keith Bradsher reported from Shenzhen late last month and later added additional reporting from Hong Kong.