Fitch: Rise in Property Collateral Makes Real Estate China Banks' Biggest Weakness

Property exposure is the biggest threat to the viability of China's banks because of the banking system's reliance on real estate collateral and the strong linkages between property and other parts of the economy, Fitch Ratings says in a new special report. 

The agency estimates that for Fitch-rated banks, loans secured by property - residential mortgages and corporate loans backed by property - have increased 400% since end-2008, compared with 260% for loans overall. Loans secured by property now make up 40% of total loans in these banks. 

Residential mortgages have more than tripled since end-2008, and corporate loans secured with property have increased almost five-fold in the same period. 

The use of property collateral is predominant not just among loans to property developers and local government financing vehicles, but also increasingly common among corporate and micro-and-small-enterprise borrowers. 

Collateral is supposed to reduce bank risk; but the rise of property collateral in corporate loans may actually increase the chance of bank failure. This is because the widespread use of such collateral has lowered the perceived risks of lending, fuelling China's credit build-up and spreading real-estate risk to other sectors of the economy. 

Banks generally place high confidence in their property collateral to provide reliable and timely protection in the event of default, and consider that low loan-to-value (LTV) ratios provide an adequate buffer against a property-market decline. 

Fitch believes, however, that a low LTV ratio may not necessarily shelter banks from large losses.  Recent history of financial crises show that appraisal of property collateral can be highly misleading as the value of property fluctuates substantially, and corrections often happen abruptly. The value of such collateral in China could also be seriously compromised by hurdles to enforcement.

Fitch views a protracted downturn in property markets as a low probability, but high impact, scenario that could result in a credit crunch and force a chaotic deleveraging process for corporate borrowers. 

A steep fall in property prices would diminish the value of collateral, weaken banks' lending capacity and increase borrowers' default probabilities. 

A protracted downturn in property markets could therefore threaten the solvency of Chinese banks, given their modest loss-absorption capacity.  

The full report is available on www.fitchratings.com or by clicking the link in this media release.