During the past two decades, investors have been following the global trail of nonperforming loans from one economy to another.
These days, that trail is leading to China, where investors who see opportunity in troubled loans have been buying such loans, or NPLs — many of which were spawned more than 10 years ago. And now the market could expand further if China is hit with another wave of defaults driven partly by the large amount of debt created by the country’s recent real-estate boom, says Jack Rodman, a Beijing-based partner at Ernst & Young LLP.
While this could be unsettling for Chinese financial institutions, it is good news for international investors looking to buy troubled loans or distressed real estate at a discount. There are plenty of risks. For one, the murkiness of China’s legal system can make it difficult to complete due diligence on these transactions. “It’s an opportunity, but not for everyone,” says Mr. Rodman. “It’s high-risk and high-return.”
The ups and downs of China’s NPL investment market are highlighted in a report scheduled for publication today by Ernst & Young. The report discusses how this niche market has evolved from its early days following the meltdown of U.S. savings and loans in the 1980s to the more active markets today, such as Germany and China.
For now, the NPL market in the U.S. remains relatively small, according to Ernst & Young. Most economists aren’t predicting a crash in the broader U.S. housing market that would lead to widespread defaults on residential mortgages.
Generally, NPL investments work like this: Banks or large lending institutions want to remove defaulted loans from their books, so they sell them to investors at a discount. The investor typically allows the borrower to pay off the loan for less than what the borrower owed to the original lender, but more than what the investor paid for the NPL. Many loans are backed by real estate. If the borrower can’t pay back the loan, then the investor can go to court and foreclose on the real estate, or try to negotiate a settlement.
Mr. Rodman says the returns on NPL investments in emerging markets, such as China, range between 25% and 30%. The trade-off is that it can take longer to complete the deals in these countries, he says.
Phil Groves, founder and president of DAC Management, an investment firm with offices in Beijing, Hong Kong and Chicago, has been investing in troubled loans and distressed real estate in China during the past five years. He recently bought a Ramada Inn in the northern city of Dalian after the bank foreclosed on the property.
A big challenge with these investments can be confirming who holds clear title to the property, Mr. Groves says. Also, the Chinese government may have part ownership in a company and a “certain loan may have importance to the government,” he adds. “I am still learning new things every day and I am five years into it.”
The NPL investment market grew out of the savings-and-loan crisis when the U.S. government bought out failed loans from lenders and sold many to investors. Nearly a decade later, NPL investors migrated to Asia, after the financial crisis there in 1997.
Now, China has started to accelerate the disposition of its NPLs as the country seeks to overhaul its banking system, according to Ernst & Young. A UBS Investment Bank research report in January said that “our best guess is that the Chinese banking system has created nearly $850 billion in bad debt over the past 15 years” but cautioned that “it’s virtually impossible to gauge the actual NPL number with any accuracy.”
Many of the Chinese loans made during the past few years have fueled the country’s massive industrial expansion and also spurred its real-estate boom. It is unclear what the fallout could be. The government has been taking steps to crack down on real-estate speculation, and investors including Mr. Groves aren’t expecting a real-estate crash. He is focusing more on distressed assets that were created a few years ago.
Meanwhile, the NPL-investment market remains strong in Germany, according to Ernst & Young. These troubled loans could be attributed, in part, to the sheer number of banks doing business in Germany, and to overall sluggishness of the German economy.
As of the end of February, international investors have closed on at least $28.4 billion in nonperforming-loan sales in Germany, according to the Ernst & Young report. “It’s been a stampede of investors who, in some cases, have redeployed from other regions” to Germany, says Chris Seyfarth, an Ernst & Young partner.
Write to Michael Corkery at michael.corkery@wsj.com
