China fund defaults expose foreign partners to shadow banking risk

SHANGHAI/HONG KONG Tue Aug 26, 2014 11:32am BST

A man looks at the Pudong financial district of Shanghai November 20, 2013.   REUTERS/Carlos Barria

A man looks at the Pudong financial district of Shanghai November 20, 2013.

Credit: Reuters/Carlos Barria

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SHANGHAI/HONG KONG (Reuters) - Foreign joint venture partners of Chinese mutual fund companies fear they will have to bail out investors in one of the shadiest patches of China's shadow banking system, following two defaults by lightly regulated subsidiaries peddling complex investment products.

While defaults of wealth management products (WMPs) issued by Chinese banks and trust companies have ended in some form of government rescue, there is no precedent for how problems with fund management company (FMC) subsidiaries will be resolved.

In many cases, the arms-length nature of the relationship between parent firm and subsidiary means the former may be unaware of how much risk the latter has taken on. Analysts warn that they may not enjoy the implicit state guarantee extended to other parts of the sector.

"This can lead to a capital call on the parent, and that's the doomsday scenario for a lot of these joint ventures, that and the reputation risk," said an executive at a major FMC joint venture, who spoke on condition of anonymity.

Industry insiders who spoke to Reuters saw that scenario as a likely outcome, given that the agency regulating the subsidiaries is the China Securities Regulatory Commission (CSRC), which has jurisdiction over their mutual fund parents - but none over banks - and so could force them to cover losses.

The same sources said many foreign players were already nervous about their Chinese partners' push into shadow banking - in particular into opaque and complex structured products - suggesting liability concerns could trigger the joint ventures' unravelling.

LEGAL DISPUTE

The two recent cases that have rattled foreign companies involve investment products that have been unable to pay investors interest due at maturity.

The latest involves a default by a fund marketed by a group of subsidiaries and partners of Noah Holdings, a Chinese wealth management product (WMP) company listed in New York.

Domestic media reported last week that the fund had experienced repayment problems with a 1 billion yuan ($162.5 million) WMP that was due to mature earlier this month.

A legal dispute between the participants has frozen 600 million yuan, with Noah alleging that the funds meant to pay off investors were dishonestly redirected by one of the marketing partners to invest in another project.

The dispute risks pulling in Hong Kong-based fund management company Value Partners Group, which is indirectly involved because it also owns a 49 percent stake in a firm that in turns holds a stake in one of the subsidiaries concerned.

Value Partners said in a statement that was not a party to the alleged misappropriation, and it did not expect the dispute to have "a material impact" on its business.

Noah Holdings did not respond to requests for further comment.

In a second recent case, Mirae Asset Huachen Fund Management Co, a joint venture (JV) between South Korea's Mirae Asset Financial Group Co and two Chinese FMCs, announced on Aug. 11 it had failed to pay more than 32 million yuan worth of interest due on trust loans in July due to project difficulties.

Mirae Huachen declined to comment when contacted by Reuters.

DESPERATE FOR PROFITS

There are around 68 fund management companies in China operating subsidiaries dabbling in structured products - usually a package of assets such as loans divided into tranches and resold at different rates of return - and other WMPs, nearly half of which are operated by joint ventures with foreign firms.

They include such big names as CITIC Prudential, UBS SDIC, State Street Global Advisors (SSGA), Invesco Great Wall and Bank of Communications Schroders, according to consultancy Z-Ben Advisors, although not all are necessarily dealing in high-risk products.

Invesco confirmed it had such a subsidiary but said it was not selling structured products. SSGA, which is in the process of exiting its JV according to press reports, declined to comment. The other JVs did not respond to requests for comment.

Most of the FMC subsidiaries were created to exploit opportunities in China's burgeoning high-yield wealth management sector. They have issued more than 2 trillion yuan (196 billion pounds) worth of structured investment products since they were allowed to enter the market in 2012, according to estimates from Shanghai-based fund researchers Z-Ben Advisors.

Many of those products are backed by loans given to some of the shakiest borrowers in China, analysts say, because the prime assets had already been repackaged into WMPs by earlier, better-funded market entrants such as state-owned banks.

"By the time the FMCs were cleared to enter this business in 2012, all the pretty girls were taken," said Michael McCormack, executive director at Z-Ben.

He said the FMCs in many cases had become de facto loan underwriters, arranging bank loans for desperate companies - in particular over-extended real estate developers - which were then sliced into tranches, repackaged and resold to get them off the bank's books.

Official data says that the majority of the more than 12 trillion yuan currently invested in Chinese WMPs is safely held in bonds or time deposits, but around a third are put into credit products, which includes the sort of high-risk, high-yield loans currently being carved up and repackaged.

The report said that of the 31 products issued in the first half of 2014 that lost money for investors, the "overwhelming majority" were structured credit products and offshore WMPs.

To be sure, it is not certain that foreign JVs will end up on the hook - regulators could let the investors who purchased the products take the full hit if funds blow up.

But that would risk setting off a panic among domestic investors and by extension risk a wave of bankruptcies among desperate corporate borrowers who have few funding alternatives to stay afloat.

Because the subsidiaries are technically middle-men, not lenders, analysts say they have generally skipped executing due diligence on the assets they packaged, and were only required to maintain a negligible 20 million yuan in cash reserves.

"What's about to begin is a chain of passing the hat," said Z-Ben's McCormack. "These subsidiaries weren't doing anything different from anyone else in the business. They don't do any due diligence either."

(Additional reporting by Umesh Desai in HONG KONG and the Shanghai Newsroom; Editing by Alex Richardson)

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