And You Thought American Subprime was Bad

Timing is everything when you’re taking a long/short or event-driven approach to Asia’s banking sector. Get your short timing right when the market hits a wall, and even if the authorities play the moral hazard card in order to keep the institution’s doors open, the value of stockholder equity can go to zero, and your fund emerges the winner from everyone else’s misfortune.

As America’s subprime housing loan sector goes into meltdown, some hedge funds are generating alpha, if not schadenfreude, by shorting the shares of subprime lenders and shorting the ABX index. One of these hedge funds is Paulson and Co based in New York.

“We called it exactly right,” says James Wong, managing director at Paulson. “In February, we were up 13% net in our unleveraged merger-and-event funds and up 80% in our dedicated credit fund.”

Credit goes to Paulson & Co for that good pick, but unless your hedge fund has a macro strategy or is operational in the States, positioning yourself via a subprime angle is often outside the remit of many Asia-focused hedge funds.

On the other hand, many investors in Asia have taken long positions on America’s subprime market, not always wittingly. Investors and financial institutions in this region hold risky instruments such as collateralised debt obligations (CDOs) and default swaps on subprime instruments. Hedge fund analysts must use private networks to determine which institution is holding what toxic asset on its balance sheet.

Moreover, Asia’s financial sector is tantamount to a giant momentum trade for hedge funds, as there are no local crises or traumas. But that momentum is now slowing – not because of a problem, but simply because there are few obvious catalysts to drive earnings higher and stock valuations are no longer so compelling. New opportunities for hedge funds are creeping in, linked to volatility as well as the relative lack of disclosure compared to financial institutions in the US and Europe.

More Asian hedge funds are hiring sell-side bank equity analysts. It is a change of style for these people: having been accustomed to be able to influence the stock price through their buy/sell recommendations, they now find themselves on the other side of the fence, and with a sharper focus on performance rather than pleasing an investment banker.

“You have a tendency to get more emotional about it in a hedge fund, because it’s your ass,” one analyst explains. “You just can’t keep a buy rating on something for a year.”

So many of the analysts previously serving brokerages had steadily issued plenty of ‘buy’ ratings on Asian banks and other financial groups – and now that they are serving hedge funds with itchy trigger fingers, they are looking at the banking sector anew. Are there echoes in this region of America’s subprime lenders?

If not, then hedge funds will have little scope to do more than go long Asian banks. But some hedge funds think that if they dig deeper, they will find opportunities, which suggests that all is not as rosy for Asian banks as it now appears.

Momentum is a common way in which Asian banks govern their own lending activities. They will pile into one sector of the economy and build concentration risks. Right now this is evident in Asian gaming companies. More predictably, lending to the property sector and regional policy-directed lending remain embedded practices across the region. There may be ways that hedge funds can take advantage of these skewed lending portfolios.

In some markets, hedge funds say the banking sector has the feel of a subprime market because of opaque documentation, loose regulatory monitoring, the lack of a credit culture, the impact of cash-based underground economies and pervasive corruption. In good times such as now, institutional corruption and weakness is accepted and not investigated.

It’s hard to claim today that Asian banks are in trouble. By and large they appear to be in rude health and certainly are greatly improved ten years on from the Asian financial crisis.

“Instead of collateral-based lending they have moved towards becoming cash-based lenders. They have also learned more about matching assets and liabilities by currency and maturity,” says Tom Monaco, an executive director of FrontPoint, which has an US$800 million fund that concentrates on financial institutions.

“Skills of managers are reasonably good in Hong Kong and Singapore,” Monaco says. “In other markets they need to improve their ability to estimate and reserve against under-performing loans. Asian markets still have insolvent banks that are being kept alive artificially.”

Long/short hedge funds try to assess the burn-down value of banks, as well as performing conventional discounted cash-flow valuations. In addition to taking direct long positions in banks, hedge funds are looking at indirect ways of capturing exposure to the financial sector via interest rate-sensitive stocks. For example, if they are optimistic about Thai banks, they might look for a mass-market property developer like Land and Houses, or even take the thought process one step further and buy into a building-materials provider like Siam Cement.

This kind of applied analysis differs from the simplistic analysis that less sophisticated investors overseas might employ. One US-based hedge fund told AsianInvestor that American investors are semi-oblivious to Asia. They might avoid buying into a foreign bank like ICBC on its own merits. But they’ll note that a firm such as Goldman Sachs has a small stake in ICBC, and on that basis, buy ICBC stock. Or if they want “Asia” caught with a wide net they will buy HSBC shares.

The event-driven hedge funds are on the lookout for deal-generated transactions, which often means mergers and acquisitions, but can also include asset sales, including securitising a mortgage portfolio or restructuring a distressed loan book. To make it worth a hedge fund’s time, these events must impact at least 20% of a bank’s earnings and there must exist fundamental value.

For example, in China, returns on both assets and equity are low. Even if an event is spotted, it may not create more value. If Bank of Communications, just to pick a big name, were to merge with another big local, say ICBC, an event-driven manager might look to short those banks if he or she believed the merger would end up destroying value. But if our theoretical merger were between Bank of Communications and HSBC, which already owns a 20% stake in it, our analyst might take long positions instead.

But it’s not that straightforward. One analyst covering banks at a Hong Kong brokerage makes this wry observation: “One of the most interesting things to note is that most hedge funds think that Chinese banks are worthless, yet all own them.”

Any talk of potential mergers gets hedgies’ antennae twitching. Rumours of a deal between DBS and Standard Chartered emerge from analysts’ look at potential synergies, smoke signals from their meetings with various institutions and Singapore’s drive to host a regional champion.

Southeast Asia offers plenty of fodder for such strategies, says Paul Sheehan, a manager at event-driven fund Thaddeus Capital and a former bank equity analyst at ING Barings. “Foreign banks are now taking stakes in Thai banks. Indonesia has become a lot more professional and I think you’ll see more domestic mergers there. In the Philippines, banks have been slow about getting rid of bad assets, with the result that real estate has become illiquid, and financial institutions have been a drag on the Philippine economy.”

Event-driven funds have to gauge the snafu factor. They have to be mindful of dysfunctional bankers and regulators.

“Almost all big Korean banks have been bulldozed together by the government,” says the head of credit risk at a brokerage in Hong Kong. “There are no common systems, no common culture, no common concepts of risk management. When I talk to the Korean banks they all talk the talk, but they can’t walk the walk. They lurch from crisis to crisis, from chaebols to credit cards to SMEs and now to property. They all tell me that property exposure is under very tight control. By whose definition?”

Nor is Korea unique. This analyst continues: “In Taiwan, every analyst knows that the Taiwanese banks lie. They lie about their NPLs, which is why every so often a Taiwanese bank blows up and disappears. The government rushes to the rescue, eliminating the need to learn from the mistakes. In just the last four months, four or five Taiwanese banks have disappeared. Again, bulldozed into bigger banks and the cycle starts again, no consensus on governance, credit or anything else. One of the banks told me they had three lunch rooms, one for each of the successor institutions.”

Hedge funds perceive Asia’s financial sector as a risky arena, but one that offers opportunities. They deal with the chequered management and the inattention to credit risks. Is it subprime though? Not in the classic sense of the word. In America, people hand the keys back to their houses, sometimes without having made a single mortgage payment. In Asia, people stop paying their loans and then try to hang on to their properties, hoping the bank’s management is too inept to take the time to recover it.

This article first appeared in the April 2007 edition of AsianInvestor.