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Greentown and China's Real Estate Rescue

06-08 11:28 Caijing

The property market bubble burst last year, but developers are still afloat thanks to governments, banks and a 'subprime' solution.

By staff reporters Zhang Yingguang and Gong Jing

(Caijing Magazine) The case of Greentown China Holding Ltd. (HKSE: 03900) illustrates the extent to which local governments and banks have intervened to prop up Chinese property developers following last year's sharp contraction in the real estate market, analysts and industry executives said.

The contraction appeared "out of the blue," said Shou Bonian, vice chairman and chief executive of Greentown, the largest builder in Zhejiang Province.

Greentown faltered in the fourth quarter 2008 and stood on the brink of liquidation early this year. But it survived after a bank agreed to refinance foreign debt and a local government approved a grace period for land payments. Moreover, trust funds that use what at least one expert called a "subprime" scheme offered flexible financing for development projects.

Shou said his company has dodged the crisis. But he admitted that pulling through 2008 was extremely difficult. Indeed, Greentown saw a 10 billion yuan gap between its 2008 sales target and actual results. And debt payments loom for 2009.

Industry executives think similar, short-term rescues for major property developers have occurred more frequently in recent months than generally acknowledged. For evidence, they point to the absence of high-profile failures in the industry.

It's possible the Greentown rescue is simply the only case of government-bank intervention that's come to light in the property sector – so far.

Trinity Deal

Actually, it looked like a lot of developers were poised for default or court administration at the beginning of 2009. Even as the Chinese New Year arrived in late January -- the annual deadline for settling outstanding construction expenses, land premiums and bank loans -- it wasn't clear which developers would have enough cash, a Ministry of Construction official told Caijing, citing a ministry survey.

Yet the uncertainty quickly vanished when new financing schemes rode to the rescue.

"We did not expect so many developers to get extensions on their debt payments from banks, and we did not expect (local) governments to no longer press for land payments," Pan Shiyi, chairman of Beijing-based developer SOHO China Ltd. (HKSE: 00410), told Caijing.

Local governments "bailed out developers at a critical juncture," Pan said.

And for good reason: Local governments own land, and banks provide development funds. So when a developer gets in trouble, local governments and banks may be inclined to panic – and act.

The rescue of Greentown is an example of how a trinity of banks, local governments and real estate developers typically work together.

Greentown's Crunch

The Greentown crisis began when the company came close to violating covenants on US$ 400 million in overseas-floated senior debt. It got in trouble as its capital base weakened, a situation reflected by a high liability to asset ratio of 140 percent – twice the industry average.

In addition, Greentown had violated an agreement with overseas creditors that set a limit for project investments not completely controlled by the developer. Greentown had exceeded the limit by more than 100 million yuan.

Greentown could have been forced into liquidation by 25 percent of its creditors. But overseas creditors would not have benefited from that process, since most of Greentown's assets -- including projects under construction -- have been mortgaged to banks that would be paid first in a liquidation process.

Greentown announced April 21 that it would buy back bond debt at 85 percent of face value. Some long-term investors who bought bonds at face value were reluctant to accept the deal, while other institutional investors who had grabbed notes at low prices during the financial crisis were eager to cash in.

The notes had fallen to a low of 40 percent of face value at the height of the global financial turmoil. An investment banking source told Caijing that acceptances were strong because, even notes bought at the highest market price of 70 percent of face value -- the level to which they bounced back -- would yield a profit of 15 percent of face value.

By May 19, Greentown had repurchased 90 percent of the notes at 85 cents on the dollar, against the 109 cents it was to have paid on maturity in 2013. The buyback is expected to cost Greentown US$ 312 million.

New Financing Phase

To fund the buyback and ongoing construction projects, Greentown raised nearly 2 billion yuan through a trust that sold most of the notes to the Industrial and Commercial Bank of China (ICBC).

But ICBC did not use its own capital. Rather, the bank sold the trust in pieces to clients who accepted an 8.5 percent interest rate, pocketing the difference between the client rate and the 14 percent charged to Greentown. It also transferred risks to these investor clients.

These moves prompted some analysts to observe that China's system of finance appeared to be entering a new phase. They said more companies might be allowed to retire overseas debt using funds raised from domestic sources.

Greentown maintained flexibility with the help of the trust funds, which provided funds for construction projects and freed up the company's cash for debt payments.

Shou said trust funds are "not for paying back debts, but are tightly connected to debt." Thus, after a trust fund gets involved in financing a construction project, Greentown can shift project capital to pay creditors.

According to its 2008 report, Greentown's obligations included 3.9 billion yuan in bank loans and 2.7 billion yuan in bonds due to mature this year. It also reported 1.7 billion yuan in cash at the year's end.

Money raised through trust funds is expensive, however, and Shou said he's not happy with the terms.

Greentown is paying an annual interest of 14 percent and using two property projects as collateral. Furthermore, one trust bought 25 percent equity in a project, while the other trust bought a 45 percent stake in a separate development. And if Greentown's status deteriorates in the future, according to financing agreements, remaining equity has to be sold to each trust for just 1 yuan.

Accepting these harsh terms underscores the developer's eagerness to avoid a technical default on senior notes. Nevertheless, Shou expressed appreciation that the trust funds are giving his company more freedom than banks, whose loans are earmarked for specific projects.

Chinese Subprime 

Separately, Greentown said early this year that banks had extended the company's credit line by 20 billion yuan for new developments. That level of credit would have been unimaginable just one year ago, when the central government was urging state lenders to tighten credit, citing an overheated market.

But the credit line has strings: New bank loans will be limited to new project developments. To get around these limits, Greentown turned to trusts for liquidity.

It may seem unreasonable for a developer to borrow money domestically at a 14 percent interest rate to pay back foreign bonds pegged at 9 percent interest. But the government is available to mediate if anything goes wrong, said Zhao Hangsheng, a real estate scholar at Zhejiang University. And neither domestic creditors nor local governments want to see liquidations.

Nevertheless, the trust fund-ICBC financing arrangement that saved Greentown has raised the specter of a Chinese version of the recent collapse for real estate financing in the United States.

Wang Jizhou, an investment company executive, described a practice he described as "China's subprime mortgage" system. He said he once adopted the practice by helping CCB International (Holdings) Ltd. design a financial derivative product that converted real estate company debt into financial products, which were then sold to investment clients.

Indeed, loan extensions and other forms of relaxed credit saw developers through recent difficulties. But these concessions in the troubled property sector may be part of a broader pattern aimed at rolling over or reclassifying loans to prevent defaults.

Some analysts have even taken a second look at the stunning reports from the banking industry in recent months that showed record low levels of non-performing loans in early 2009.

Fitch Ratings, citing the way Chinese banks categorize risky loans, recently said credit quality is deteriorating rapidly in the nation's banking system. A credit surge during the first three months of the year raised risks, Fitch added.

Fitch also joined other analysts in noting that NPLs are climbing at Chinese branches of foreign banks, which observe more stringent credit rules.

Risky Model

Besides, despite a momentary respite, Greentown's long-term problems remain. The firm borrowed heavily to fund aggressive land acquisitions over the past few years. Its land holdings swelled to 25.2 million square meters by the end of 2008, from 8 million square meters in July 2006, when the company launched an initial public offering.

Land Greentown bought at the height of the property boom in 2007 became idle inventory when the market ground to a halt in 2008. By the end of last year, Greentown reported 6.3 million square meters of space under development, with an estimated value of 23.3 billion yuan, according to its annual report.

The inventory buildup has weighed heavily on Greentown's liquidity, an investment banker who declined to be identified told Caijing. Greentown's problems became rooted in that episode of unchecked borrowing during the boom era.

The banker said that when the credit crunch arrived, banks and local governments had little choice but to help lift Greentown and other developers out of the hole. Such moves were also necessary to preserve the governments' financial positions.

Particularly helpful for Greentown was the city of Hangzhou, the developer's home base. The government voluntarily deferred by six months the deadline for its land payments.

But six months pass quickly. By the end of this year, Shou said, the company will be expected to pay more than 6 billion yuan in land premiums.

Can Greentown bounce back? The market for first-time home buyers has improved in recent months thanks to government incentives and low interest rates. But so far, the high-end market where Greentown does business has been slow to recover from last year's downturn.

Greentown's first quarter sales were not very encouraging, said company Vice President Qiu Jianping said. Meanwhile, the China Real Estate Chamber of Commerce said foreign firms and other institutional property investors that were key buyers of Greentown's properties in the past are now sitting on the sidelines.

1 yuan = 14 U.S. cents

Full article in Chinese: http://magazine.caijing.com.cn/2009-05-24/110170613.html

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