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China's Banks Copy Citigroup in Hiding Bad Loans Off Their Balance Sheets

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Banks are moving loans off their balance sheets in order to dress up their accounts for worried regulators.

Only this time it isn't Citigroup (C) or State Street (SST) that's involved, but China's big banks.

In November China's banks packaged and then sold $18.6 billion in loans to Chinese trust companies, removing those loans from the banks' balance sheets, Shanghai Benefit Investment Consulting has told the Wall Street Journal. That's a huge 54% of all the new loans banks made in the month according to government figures. For the year the total of loans packaged and sold by banks comes to almost $90 billion.

The repackaging and sales come as Beijing's bank regulators have started to worry that the country's banks don't have enough capital to back all the loans they've made in 2009. So far in 2009 China's banks have made more than $1 trillion in new loans, according to government figures. Regulators have begun to press banks to raise more capital to buttress their balance sheets.

By selling the loans to trust companies, banks take them off their balance sheets. That has the effect of reducing the amount of loans that the banks look like they have made. That in turn reduces the amount of capital it looks like they need to raise to support these loans.

As explained in the Wall Street Journal, the process works like this:

The banks take a group of loans, package them together, and then sell them to trust companies in China with a promise to repurchase the loans at some point in the future. Anywhere from a few weeks to a few years later. The trust companies in turn repackage the loans into financial products they sell to clients.

Besides reducing their balance sheets so that regulators don't demand that they raise so much capital, by selling off those loans the banks have turned them into cash that they can then lend out again.

If this seems like a great way to produce a bubble, it is. Like the U.S. system of repackaging mortgages and then selling them to intermediaries who repackaged them and sold them to investors, the off- balance sheet game in China depends on the ability of the underlying borrower to repay the original loan. If they can't, the risk cascades through the entire financial system, as it did in the U.S. mortgage crisis. The odds of a panic are fairly high because, again as in the U.S. crisis, nobody knows exactly who is at the other end of any specific loan repackaging and how credit-worthy they might be.

In the U.S. the whole pyramid collapsed when housing prices fell, stopping the quick-flip-and-refinance merry-go-round that made it possible for banks to extend an ever increasing pile of mortgage debt to clients with stagnant incomes. And when those incomes went from stagnant to declining with the Great Recession, itself set in motion by the collapse of the housing bubble, what had been a retreat turned into a rout.

That scenario wouldn't seem to be a danger in China where the economy is headed to what looks like 10% growth in 2010.

But as the saying goes, History may not repeat itself, but it sure does rhyme.

The danger in China's off-balance sheet shell game is that a good percentage of the original loans have been made to companies with oodles of political clout but absolutely no chance of every repaying the loan. Nobody knows how much of the $1 trillion (by official count) in loans have gone to money-losing factories, shell real estate companies, developers who are years away from breaking ground on anything and the like. But the bet is that it's a significant part of the total. You simply can't flood a $4.3 trillion economy with $1 trillion in loans in a year (both figures at official exchange rates) without making a lot of really questionable loans.

China's regulators seem to have caught on to the off-balance sheet game. The Chinese Banking Commission, the Wall Street Journal reports, sent out a notice to trusts last month saying that it was considering steps to restrict the ability of banks to use the cash from sales to the trusts to make new loans.

That's earlier action than we saw from U.S. regulators in the mortgage crisis.

Maybe that's because with China's rudimentary bankruptcy laws, it's the Chinese government that's on the hook if these loans go sour in some kind of Great Leap Backward. Don't expect a wave of bankruptcies equivalent to the wave of foreclosures that resulted from the U.S. mortgage crisis. In order to preserve the international reputation of its banks--after all China does have the goal of turning Shanghai into a world class financial center capable of displacing Tokyo as the money capital of Asia--the Chinese government will eat these bad loans in the least noisy and least public way that it can if it has to.

It's just that Beijing would very much like not to have to.

The government has lots of better uses for its money than to extend a bailout to dead-end manufacturing companies and real estate speculations run by local government officials.

And it fears that even the least public of bailouts could dry up bank lending and stall China's economy.