By Samuel Shen and Shu Zhang
SHANGHAI/SINGAPORE (Reuters) - China's bad debt managers, whom Beijing hopes to play a key role in resolving financial risks, are in danger of becoming bad credits themselves as the leverage crackdown that fuelled a boom in their business now threatens their own access to funding.
The practice of buying banks' non-performing loans (NPLs) at a discount and recovering them for a profit has grown rapidly in China since 2016.
It has attracted a slew of new local players as well as foreigners including Oaktree Capital Group and CarVal Investors as Beijing's deleveraging campaign and economic restructuring produces a still-rising mountain of soured loans.
But as China's economy posts its slowest annual growth in 28 years amid the Sino-U.S. trade war, Chinese vulture funds are finding themselves mired in their own liquidity squeeze.
The industry's woes not only hamper Chinese banks' ability to quickly offload bad debts to make room for fresh lending, but also increase financial risks in the system and threaten social stability as tens of thousands of retail investors lose their savings in vulture fund investments.
Prices for bad loan portfolios have weakened amid a fresh avalanche of supply, dashing fund managers' hopes for a quick turnaround of their assets.
"In the past, domestic bad loan investors borrowed a significant sum of money to buy portfolios but they're not able to borrow any more," said Ted Osborn, partner at PwC.
The deterioration in distressed asset prices is hitting the books of dozens of listed companies who rushed into the business a few years back.
Even state-owned bad debt specialists - referred to as AMCs - are suffering.
China Huarong Asset Management, the country's largest AMC, reported a 61 percent decline in pretax profit generated by its NPL business in the first half of last year. Rival China Cinda Asset Management expects its 2018 profit to fall 30 percent, its first profit decline since its 2013 listing.
Bad loan manager Zhejiang Dongrong Equity Investment Co is a case in point. It began defaulting on a series of bad loan investment products last August and is now offering goods including rice, milk and ham in part payment to pacify disgruntled investors.
The private asset manager began to ramp up its NPL business three years ago in the aftermath of China's stock market crash. In March 2016, general manager Zhang Wei told Reuters the company's short-term plan was to grow its bad loan business to "tens of billions of yuan" and forecast annualised returns of roughly 13 percent.
Today, Dongrong is sitting on nearly 9 billion yuan ($1.3 billion) worth of distressed assets and more than 20,000 individual investors in Dongrong's fund products are demanding their money back.
"I feel helpless," said Zhou Jian, who invested 2 million yuan in a Dongrong NPL fund due to mature in January but has yet to receive any money.
In a letter to investors, Ye Zhen, Dongrong's founder, said the whole industry is suffering from liquidity stress and promised to return investors' money in three years.
Attempts by Reuters to reach Zhang and Ye by phone and email were unsuccessful.
Rival Dong Fang Cheng An also cited a poor funding environment when it defaulted on a series of NPL products in December.
"Since 2018, China's NPL market has been impacted by the macro environment, with the bad loan recovery process being greatly lengthened," the asset manager said in a statement on its website.
The firm, which owes investors 7 billion yuan, said it has set up an emergency taskforce to deal with the liquidity issue.
MORE BAD LOANS
About $1.4 trillion of soured loans - including NPLs, distressed debt and loans in the "special mention" category - sit within banks and the four big AMCs, according to PwC. It expects distressed debts to grow as the economy slows and regulators push lenders to clean up their books.
"I think this is the very beginning of China's ... NPL cycle and it will have many years to run," said Osborn, who heads PwC's China and Hong Kong Restructuring & Insolvency team.
Chinese banks' non-performing loans reached 2 trillion yuan in 2018, driving the industry's NPL ratio to a decade-high of 1.89 percent, regulators say, even after lenders resolved nearly 2 trillion yuan in soured assets that year..
Thanks to increasing supply, prices of bad loan portfolios dropped more than 10 percentage points between the first quarter and the third quarter last year, according to China Orient Asset Management, another state-controlled AMC.
"Some asset managers acquired a large number of NPL portfolios previously. If they cannot dispose them quickly and recover the money, they could face liquidity risks when their short-term borrowings become due," Chen Jianxiong, vice president of Orient AMC, told a recent conference. "In a slowing economy, it becomes more difficult to dispose of NPLs. Every asset manager is under big pressure at both the funding end and the return end."
One such firm is Shanghai Morn Electric Equipment Co, a maker of electric wires and cables. It ventured into the NPL business in early 2017, buying 10.9 billion yuan in NPL portfolios for that year and earning 97.2 million yuan in revenue from that business. But in October, it warned its 2018 profit would drop as much as 92 percent because of its NPL business.
The struggles of local asset managers mean some foreign vulture funds with deeper pockets have sensed an opportunity.
Avery Colcord, Managing Director of CarVal Investors, said China's deleveraging campaign has helped wipe out some "fierce" local rivals and brought down bubbly prices.
"We feel that fundamentals are quite favourable today," he said, after CarVal completed two deals in 2018, its first since 2015.
The view was echoed by Greg Ritchie, director of LVF Capital, which launched a $500 million fund in 2017 dedicated to investing in China's NPL market.
"A slowing economy is good for us," Ritchie said. "One of the pros that western investors bring to the market is they have long-term money ... For a lot of domestic money, it's one-year money."
Shenzhen Qianhai Financial Assets Exchange data shows overseas purchases of bad loan portfolios in China nearly tripled last year to 30 billion yuan.
"Compared with domestic investors, foreign buyers are more cautious, and would seek more adequate collateral, and deeper discounts," said Li Jiaqi, executive director of the exchange's cross border division.
"They can hold assets longer, and wait throughout the cycle, for recovery."
(Reporting by Samuel Shen in SHANGHAI and Shu Zhang in SINGAPORE.; Editing by Lincoln Feast.)