After the collapse of Lehman Brothers Holdings Inc., the Big Three rating companies were blamed for their enabling roles in the subprime mortgage crisis. Troubled securitized products would not have been marketed and sold without their seal of investment-grade approval. In fact, investors relied on their ratings, often blindly.
Over a decade later, similar drama is unfolding with state-owned China Huarong Asset Management Co. After failing to release its 2020 financials on time amid media reports of a deep restructuring, the distressed-asset manager became a distressed asset itself. Its 4.5% perpetual bond is trading at 70 cents on the dollar, not at all aligned with its safe-as-cash ratings. With $22 billion in dollar bonds outstanding, Huarong has issues due every month into the summer.
All three rating companies are starting to head for the exit door. S&P Global Ratings and Moody’s Investors Service put Huarong on negative credit watch earlier this month, joined by Fitch Ratings which went a step further Monday, cutting Huarong’s ratings by three levels to BBB from A. China Cheng Xin International Credit Rating Co., an onshore agency that has AAA ratings on Huarong’s yuan notes, also issued a negative credit watch on April 14, amidst the broader offshore selloff.
It’s a bit too little, too late. Thanks to these rubber stamps, Huarong became one of the largest Chinese offshore issuers, despite unfavorable terms. In the event of a default, foreigners will struggle to get their money back. These bonds are not guaranteed by the Beijing-headquartered parent, but by a cash-strapped offshore subsidiary. Meanwhile, other investment-grade state-owned enterprises, such as Yunnan Energy Investment Overseas Finance Co., saw their dollar bonds tumble as well, a sign that investors are losing faith in the ratings. How did Moody’s, S&P and Fitch get China Huarong so wrong?
With an SOE, credit analysts do not simply consider its standalone financial strength, but also the likelihood of the government providing economic support. In some cases, the relationship between the two can be so tight that a standalone credit analysis is “either irrelevant or misleading,” according to a methodology report published by Moody’s last year.
As of last June, Huarong was 57% owned by the Ministry of Finance. Established in 1999, Huarong’s mandate was to help banks dispose of their distressed assets. With 2.7 trillion yuan ($416 billion) of non-performing loans in the system, the asset manager would be enjoying “very high level” of government support, according to Moody’s. As such, even though Huarong as a standalone entity deserved only a B1 junk rating, its final score got a seven-notch uplift to A3.
With score cards and joint default analyses, this kind of ratings system might sound fancy. However, it doesn’t work so well with China, where top economic priorities can shift more quickly than foreigners realize. Once-strategic areas can become unimportant overnight. Having done their dirty work for the government, SOEs can over time fall out of favor and fashion. Often, rating companies are too slow to recognize the shifting political winds.
For instance, China’s recent strong push to combat global warming — signified by President Xi Jinping’s pledge to hit zero net carbon emissions by 2060 — has pushed many coal mines into closure. No surprise, we also witnessed a wave of SOE defaults from coal-related entities. On March 9 — when Chongqing Energy Investment Group Co., the city’s largest coal operator, owned by the municipal government, was overdue on an onshore letter of credit — Fitch still had a BBB investment-grade rating. It should have seen the writing on the wall. In January, the Chongqing government issued a directive forcing closure of outdated coal plants, hitting the SOE’s financials directly.
Similarly, it’s worth asking if credit analysts considered the possibility that Huarong has become politically unpalatable and replaceable, too. In December, Beijing added a fifth bad debt manager — China Galaxy Asset Management Co. — to join Huarong’s ranks. Galaxy would be the first national bad-debt manager to be established in over two decades. In January, Huarong’s former boss Lai Xiaomin was given a death sentence, an unusual punishment for a financial crime. He was executed just weeks later.
Meanwhile, macroeconomic winds are shifting too. Emboldened by a strong economic recovery, China is going back to its corporate deleveraging campaign, launched late 2017 but derailed by President Donald Trump’s trade war and later the Covid-19 outbreak. For instance, on April 13, the State Council, the ultimate political body that governs Huarong’s majority owner the Ministry of Finance, released a strongly-worded statement on municipal budgets, forbidding the increase of implicit debt and demanding the restructuring of insolvent financing vehicles. Similar comments were made in 2018.
As of last June, the latest financial available, Huarong sat on 1.7 trillion yuan of assets and held only 168 billion yuan in equity. A mere 10% asset write-down, by a company that had gone rogue with all sorts of non-core investments such as shadow banking, would have wiped out its equity. As a result, any delay in a meaningful re-capitalization plan could see its dollar-bond holders take a deep haircut.
Of course, hindsight is always perfect. But the moment one starts to reassess the extent of government support, SOEs whose poor financials were overlooked because of their perceived strategic importance are suddenly seen in a commercial light. They look a lot less pretty under that harsh glare.
While the Huarong drama continues to fester, and credit funds that specialize in investment-grade issues nurse losses, investors will inevitably ask the rating companies: Why didn’t you give us enough advanced warning?
Bloomberg
