The Bank of China, one of the country’s biggest lenders, has revealed that it held a $9.6 billion exposure to securities backed by American sub-prime mortgages although all of them are highly rated.

China’s two other large, publicly listed institutions, ICBC and China Construction Bank have each disclosed sub-prime holdings above $1 billion.

In the very unlikely event that the entire investment were to prove worthless the Bank of China would be hit badly: 18% of shareholders’ equity. Not a probable scenario. But neither, according to The Economist, is it likely that the $151m the bank put aside for such a possibility will cover potential losses.

Chinese banks are hugely profitable: among the biggest banks, earnings are growing by more than 40% a year and non-performing loans have shrunk from about a quarter of the total several years ago to less than 4%.

Still it is something of a worry. Bank of China’s investments in iffy American mortgages are almost as much as the amount it raised in a Hong Kong share offering last year.

Moody’s, a ratings agency, reckons that the loan-to-deposit ratio for Chinese banks is a modest 68%. For Bank of China the number is lower still, about 60%.

This poses a huge investment challenge for the banks, because lending should be their most lucrative business. Typically, they earn 7% on a loan, compared with 3% paid to depositors. So the banks went hunting abroad and unfortunately found the American sub-prime mortgage market which is now in a state of confusion and doubt as borrowers default on their mortgages.
Source: The Economist