Commentary

China Meets Subprime

The United States housing market has slumped, and the fallout is being felt as far away as China. The collapse of the market for subprime mortgages — the exceptionally risky mortgage investments for people with poor credit — has resonated across the American economy, leaving home-owners, lenders, financial institutions and rating agencies pointing fingers at one another.

That a crisis like this can arise in the U.S., where individuals and corporations have unparalleled access to good business reporting and are free to invest as they choose, tells you something. Imagine how much worse it could be in China, where market information is harder to come by, and investors have less freedom.

The Bank of China suffered a big blow in the market last week when it revealed that it held almost $10 billion in securities backed by subprime assets. BOC shares fell by more than 8 percent in Hong Kong, according to the Associated Press.

Subprime mortgages allow people of limited means to obtain loans for outsized amounts of money, sometimes without even informing lenders of their incomes. It sounded too good to be true and, sadly, it was. When Standard & Poor’s, one of America’s major rating agencies, discovered in mid-2006 that over 40% of these mortgages were ending in default, it began slashing ratings for bonds based on them, but many investors — including large institutions — were already in the game for a lot of money.

Chinese banking authorities immediately sought to downplay the liabilities for the PRC’s institutional investors. “Mainland banks’ holdings of subprime debt are relatively small, the credit ratings of their bond holdings are generally high and there is a risk management system in place, so any direct losses are limited,” said Liu Chunhang, vice-director of the China Banking Regulatory Commission’s Research Department, in an interview carried by Xinhua.

But in many cases, the investments’ ratings themselves are the trouble. In the last five years, each of America’s big rating agencies — S&P, Fitch, and Moody’s Investors Service — has made large profits rating bonds comprised of subprime mortgage debt. The Wall Street Journal reports that these agencies earn twice as much rating mortgage securities than other securities, because it requires more time and analysis.

So a perverse sort of symbiosis developed, in which the agencies were implicitly called on to give higher ratings than they should have to securities based on new types of mortgages without established track records. Of course, there’s nothing wrong with taking more money to rate certain types of securities, but it becomes a problem when a lack of transparency prevents investors from learning of potential conflicts of interest.

In free markets like that of the U.S., when investors find out the companies they’re investing in are taking on unacceptable amounts of risk, they can pull out their money. So the companies’ executives, who are often paid for performance, have a modus vivendi in limiting liabilities, keeping the public informed, and maintaining investors’ trust.

In China, that’s not always the case. Though Bank of China is publicly traded, it is still majority-owned by the investment arm of the state-owned People’s Bank of China. This presents problems of transparency. The Royal Bank of Scotland — which bought a roughly 8.5% stake in BOC’s IPO last year — and other private investors own a substantial minority of BOC, but being minority stakeholders, they have no way to ensure that the Bank’s managers keep them apprised of its holdings or its strategic thinking.

That adds an element of risk, and makes other would-be investors think twice before casting their lots in with Chinese financial institutions. Xinhua’s official response to the revelation that BOC held substantial investments in subprime debt, published August 25, led with the fact that the S&P hadn’t lowered its rating for BOC as a result. But as western investors now know, the ratings themselves are suspect.

In contrast to stories in the Associated Press, the South China Morning Post, the Financial Times and many other sources, Xinhua’s report didn’t seem to address the severity of the situation, and consequently, it didn’t shore up investors’ confidence. It may have made them think the reality was even worse than authorities were admitting.

When bad news breaks about companies, Americans and other western investors are culturally inclined to expect them to admit some sort of guilt in an effort to restore their credibility. For the companies, this is like taking off a Band-Aid; the quicker you do it, the sooner the pain goes away.

The BOC management has long since decided to avail itself of the benefits of foreign investment. But because that investment is voluntary, it has to persuade outside investors that it’s a good bet. Eventually, that’ll mean conducting affairs more transparently.

As U.S. firms know all too well, and BOC and its managers may be learning, any investor is going to make mistakes from time to time. The strength of free markets is that by allowing individuals to invest in whatever they choose, they can spread risks more thinly over large numbers of people, and minimize the impact of potential crises like the subprime mortgage meltdown.

In order for that to work, however, investors have to know the risks they’re bearing. So in the end, free markets can’t operate without free presses.

David Donadio is a writer and editor at the Cato Institute.