In the late 1990s, the U.S. government under Clinton began pushing home affordability with an upgrade to the 1977 Community Reinvestment Act. The law was originally “designed to encourage commercial banks and savings associations to help meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods.” In 1994, compliance with CRA laws became a prerequisite for mergers and interstate expansion.
This became explicit in 1999 as part of the Glass-Steagal repeal effort: “any bank holding institution wishing to be re-designated as a financial holding institution by the Board of Governors of the Federal Reserve System would also have to follow Community Reinvestment Act compliance guidelines before any merger or expansion could take effect.”
President Bush expanded on CRA goals with the Ownership Society, the cornerstone of which was home ownership. In 2005: Countrywide Ups Minority Lending Goal to $1 Trillion
Countrywide Home Loans Inc. has extended its minority and low-income lending goal by $400 billion to $1 trillion over the next five years. The company says its “We House America” initiative has been overwhelmingly successful since its 1992 launch and initial goal of $1.25 billion in loans, prompting the lender in 2001 to set a new bar of $600 billion in loans by 2010. However, Mary Duron, senior vice president of fair lending and the “We House America” lending program, says Countrywide had reached the $300 billion mark by the end of last year and decided to strive for even more minority and low-income lending. Angelo Mozilo, chairman and CEO of Countrywide Financial, says the program has helped put 2.4 million families in homes, and the number is expected to nearly triple over the next five years.
Countrywide went down the tubes and almost took down Bank of America after it acquired Countrywide in early 2008.
Besides a government-encouraged expansion of subprime lending and very willing participation by banks and financial institutions, Wall Street was looking for mortgages to bundle into MBS and CMOs. As demand for these products surged, Wall Street replaced homebuyers as a source of demand for new loans. Crooked mortgage brokers force fed low-quality loans to borrowers including to people with no way of paying the mortgage (dubbed NINJAs loans because the borrower had no income, no job). The result was a perfect storm that blew up spectacularly in 2008.
History is rhyming in China.
The government is forcing large banks to lend trillions of yuan for rental housing, at below market rates, to borrowers who can’t afford it, and banks are trying to pass of the risk by bundling these loans into asset-backed securities.
As property prices rocket across China, Beijing has appealed to the country’s banks and insurers to help accelerate the development of rental markets as a way of making homes more affordable – and rein in speculative sale markets.
The big state banks have responded by pledging more than 3 trillion yuan ($467 billion) in rental housing financing, including for real estate developers, leasing firms and tenants, according to Reuters calculations. The total value of the rental market was 1.3 trillion yuan last year.
China Construction Bank Corp (CCB)(0939.HK) (601939.SS), the second-largest lender, is the most visible example of this trend, giving loans to renters at ultra-low interest rates with long repayment periods.
These loans are popular in pricey Shenzhen.
Liu Feng, a 28-year-old product manager, was one of the first to take out a rental loan from CCB for his 90 square meter (970 square feet) three-room apartment in Shenzhen.
He said his monthly payments under the plan – including interest – came to about 6,000 yuan, less than if he paid for it himself, meaning the bank was effectively subsidizing his rent.
“The property developer leased the apartment to CCB, and CCB leased it to me,” said Liu.
In the U.S., the subprime borrower could not afford the home. The bank “subsidized” their mortgage (rent) rent because adjustable rate mortgages offered very low teaser rates for the first few years. As those rates reset in 2006, 2007 and 2008 the homeowners defaulted on their homes. Wall Street made billions selling mortgage debt that was effectively long-term loans made to short-term renters, and banks ended up owning the property.
In China, there won’t be a similar “reset” situation that blows up the market. That said, the uneconomic arrangement is no different. Lending at below market rates is a recipe for disaster because it distorts the market and accrues losses that eventually have to be made up.
Also last year Industrial and Commercial Bank of China Ltd (1398.HK)(601398.SS) launched a similar product in Guangzhou and Bank of China Ltd (601988.SS)(3988.HK) issued its first loan to renters in Xiamen. Both of the southern cities have been chosen by the central government to test real estate sector reforms.
So far, only large state banks are offering the loans. Multiple sources at mid-sized and small lenders said they were daunted by default risks, high costs and low returns.
Losses are likely, the sources said, as the loans have to be priced below market rates due to the pressure on banks to show support for developing the rental market.
Even large listed banks are not participating because they don’t have the PBoC put:
A retail loan officer at one of China’s 12 joint-stock banks said his bank had decided not to offer the product.
“After CCB launched the products we looked into it closely, but only to find that was not something we could afford – interest rates were just too low to cover the cost of funding,” the officer said, declining to be named. “Only deep-pocketed large state banks can bear the cost.”
More shades of subprime:
“The products have low bars for loan applicants, so risk control is really the key,” said Yang Xianling, chief economist at Ke Research Institute. “A credit-based mechanism needs to be introduced to carefully prevent speculators.”
The final piece of the puzzle:
To mitigate risks, banks are considering packaging rental-related loans into asset-backed securities and real estate investment trusts and transferring risk to other investors, the sources said.
And the fuse that could set off the time bomb: the Foshan model.
“We have examined more than 100 projects of all kinds, but their returns are super low,” said Cai Yu, general manager at Foshan Jianxin. “Frankly we could have earned more if the money were deposited at a bank.”
Foshan Jianxin has been ordered by local authorities to issue loans at below market price to cultivate the rental housing market and lure tenants, Cai said.
What happens as losses pile up? Eventually, these companies will start selling properties to recoup capital.
Therefore, even with the capital infusion from CCB’s subsidiary and others, the company may still have to sell houses in a few years to cover losses, Cai said.
Despite that, CCB said this “Foshan model” has been copied in 18 other cities in Guangdong province, and it could be extended to other smaller cities nationwide.
Housing affordability push by government? Check.
Banks pressured to make riskier loans? Check.
Banks offering below market rates? Check.
Short-term borrowers (renters) taking out long-term loans? Check.
Loans packaged into ABS? Check.
Potential time bomb? Check.
Being China, there won’t be a replay of 2008 because the process of taking losses is very different. There will be losses though, lots of them, and eventually it will end up on the government’s balance sheet or more likely, the PBoC. This is unsustainable credit creation that will have to be monetized down the road, driving the future exchange value of the renminbi even lower.
And while this is all going on, developers that lack government backing are starting to chase expensive overseas financing.
Chinese property companies are increasingly tapping expensive mezzanine loans as they seek out higher returns, a trend that could undermine government efforts to cool the country’s booming real estate sector and rein in debt.
Many developers are turning to offshore mezzanine loans as government measures to tighten credit and clamp down on shadow banking in China are increasingly felt, according to lenders.
Others are taking out the loans for M&A activities or to raise working capital that would allow them to prolong construction periods in hopes that the government will lift price caps on new projects, the lenders say.
…InfraRed is now talking to two smaller cap developers listed in Hong Kong for loans for a residential project in Guangzhou and an eastern city of Yangzhou at interest rates of 15 percent to 18 percent. He declined to name the borrowers as the deals are not closed yet.