Hotel Lawyer: What is happening with Chinese real estate companies investing in banks?

by Jeffer Mangels Butler & Mitchell LLP

Concerns over a real estate bubble in China

For decades, China was referred to as the “sleeping giant.” This reference is to the great potential impact of the country, its vast population, and its economy, but also to the fact that this potential was largely unrealized for hundreds of years. Well, the sleeping giant is awake! And the world financial press is now full of analysts following China and the international ramifications of its every action on the world economy.

Recently, great concern has been raised by some over the impact of the stalling Chinese economy as it drops from double-digit growth in GDP to 7.5% or less. Alarm has been raised about the bubble in the China real estate markets, particularly the housing, and now commercial real estate as well. And most recently, financial analysts worry about the shadow banking system (financing and loans by non-banks) and Chinese real estate companies’ interest in purchasing banks or substantial interests in them.

Some suggest that Chinese construction companies’ investments in banks may be with a view to getting easier loans on more questionable deals, and that when real estate projects sour, they could take down both the construction companies and their banks. Is this reminiscent of the S&L crisis and the Japanese bubble of the 1980s?

Let’s separate the issues — real estate company investment in banks and shadow banking

To begin with, one must clearly define the activity being analyzed, who the players are, and the market in which the activity is taking place. For example, current reports detail investments by Chinese real estate development companies in banks located in mainland China, Hong Kong, Australia, the United States, and elsewhere. Some of these investments are modest. Some of them are significant. Some of them appear to be newly capitalized banks with IPOs financed largely by the real estate construction companies (taking the “p” out of “IPO”).

Each country has its unique set of government and regulatory controls. It is difficult to generalize the motivation of the Chinese real estate companies in making banking investments, whether and how they will attempt to deal with the banks they have invested in, and how regulators will respond in each affected jurisdiction as to particular investments and related activities.

Will this be like the Japanese investment bubble of the 1980s or the S&L crisis?

At least two situations may serve as case studies to provide some historical perspective on the new phenomenon of Chinese real estate companies investing in banks, and the shadow banking situation. One is the US real estate bubble of the 1980s followed by the Savings and Loan (S&L) and banking crisis with more bank failures than any time since the Great Depression. The other somewhat intertwined event is the Japanese investment (by banks and related Japanese construction companies) of up to $120 billion in United States real estate (primarily in Hawaii, California, and New York), and subsequently “disinvestment” in the collapse of the early 1990s. Many believe that the Japanese investment was made at what otherwise would have been the peak of the US real estate bubble (carried by loose S&L lending and tax-driven investments that made no economic sense). The Japanese investment propelled the U.S. real estate bubble even higher for several years until the it finally became unsustainable, and collapsed in a worse crash than might otherwise have resulted.

Both the S&L crisis and the Japanese investment phenomena displayed cozy relationships of real estate companies and lenders. The Japanese banks owned significant holdings in their borrower clients, and encouraged them to buy market share with below-market loans. When the real estate market soured, the Japanese banks were hit with the double whammy of huge loans on real estate now worth a fraction of its cost, and stock investments in companies with huge losses. The leverage increased the pain for everyone participating and the lost decade (or two) has followed for Japan.

The S&L crisis was also characterized by real estate developers buying, starting or owning significant pieces of S&Ls which often engaged in related party loans or financing with the developers or a circle of developers. When the bubble burst, the banks went bust, the projects lost financing and failed, and the FDIC and the US taxpayers picked up the bill to the tune of $300 billion or more.

Charles Keating as the symbol of the S&L crisis and the excesses of that era

Recently, the NY Times reported on the death of Charles Keating at the age of 90. Prior to the S&L collapse, most people thought that Charles Keating was a financial genius. His empire was pursuing the dream that regulators seemed to proscribe for additional investment in financial institutions, and more profitable operations being opened by the Garn-St. Germain Act, so that financial institutions could get away from the stuffy and only modestly profitable business of home loans.

When the disaster struck, Keating was vilified and demonized.

What can we learn from history?

There may be several observations we can make about the past:

As seen in the S&L crisis and the Japanese bubble investments, the combination of real estate companies and banking can be an explosive and dangerous mix. Lenders need to provide the brakes on overheated investment enthusiasm. They need a dispassionate underwriting process that is not tainted with exuberant entrepreneurial profit motivation. It is one thing for a real estate company to bet its future on an investment strategy. It is can be far more dangerous for financial institutions to do so. The local and global financial impact of a bank failure may be more severe than that of a real estate company.

Both the S&L crisis and the Japanese bubble demonstrated that the association of real estate companies and banks can increase the leverage of the investments, enable more and larger loans, and intertwine the destinies of the banks and the real estate companies. Leverage increases profits in up markets and increases losses in down markets. Souring real estate loans cause banks to severely restrict credit (by regulatory oversight, liquidity issues or business limitations). Restricted liquidity can cause credit crunches and exacerbate declining values, which in turn further erodes bank collateral, capital and liquidity.

Investment to get easy loans or to capture lost profit?

Many Chinese real estate companies say that their motivation for bank investment is to capture through their investment the value created by their business that otherwise goes elsewhere. Why pay all that interest of those fees for letters of credit to another institution, when you can own part of the bank that makes money on your business? And there are extensive government regulations in the US and most Western countries to prohibit or otherwise prevent abuses of self-dealing. But when one looks at the S&L crisis and the Great Recession, one has to question the effectiveness of regulators to deal with ingenious financial engineering of entrepreneurs.

So what does all this mean?

China has unprecedented importance in the world economy, but it is not yet the dominant economic player. Its economy is still smaller than that of the European Community and the United States. What happens in China will be important but neither a panacea nor a death knell, even at the extremes of probability.

I am an optimist. I believe that moderation and a middle course outcome are the most likely scenarios.

China has serious issues, but they are manageable, and there is no reason to predict disaster. A slowing growth rate in GDP of “only” 7.5% is probably a good thing after almost a decade of double digit growth and will provide some relief on inflationary pressures. Even if Chinese GDP growth slows further, it will affect but not have a dramatic impact on the economies of the US and Western Europe.

The housing and investment bubble in China is serious, and largely fueled by the shadow banking system. But the current indications of the Chinese government that it will allow shadow banking players to fail (unlike Chinese banks) is likely to impose significant restraint on further speculative investment in this manner and in this sector.

Positive aspects of the Chinese bubble in housing include a significant outbound investment drive by Chinese real estate companies and financial investors. This diversification means fresh capital for many parts of the world, including the United States, Australia, Europe, Africa and elsewhere. When the Chinese real estate and stock values were growing at ridiculous rates, investments in other countries had little appeal at their more sustainable rates of return. Now, diversification and alternatives to the Chinese bubble are more attractive.

This development can create exciting opportunities for Chinese investors and for those with property in the target countries or markets. We assist Chinese investors in performing due diligence and acquisition structure to avoid or minimize the kind of issues that plagued the Japanese investment in the 1980s. Unlike the 1980s or the mid 2000s, the US real estate market and the US economy is not at frothy levels. We have not had super-heated levels of development. In fact, the dearth of investment capital for almost 7 years has created some significant pent-up demand and unprecedented investment and development opportunities for those who exercise reasonable care.

The key for all is to learn from the lessons of the past. Avoid the excesses of unsustainable valuations, and stay with the basics of sound investment.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Jeffer Mangels Butler & Mitchell LLP | Attorney Advertising

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Jeffer Mangels Butler & Mitchell LLP

Jeffer Mangels Butler & Mitchell LLP on:

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