China’s collapsing real estate market is beginning to threaten the country’s largest banks as bad loans continue to erode their balance sheets.

Bank of Communications, China’s fifth-largest bank established in 1908, reported this week that the share of bad loans in its property portfolio shot up to 4.99% at the end of last year from 2.8% the year before.

So-called special mention loans—which provide an early warning of potential trouble down the road—spiked 23% to 9.88 billion yuan ($1.4 billion).

Bank of Communications vice president Yin Jiuyong blamed the lender’s troubles on China’s three “grey rhinos,” a reference to the country’s demographic crisis, debt bubble, and decoupling with other large economies.

The bank should “further step up risk control” of its property portfolio, he said, as reported by The Business Times.

Meanwhile, local competitor Industrial and Commercial Bank of China reported this week that its share of residential mortgages that have gone bad increased by 9.6% to 27.8 billion yuan ($3.8 billion). Its commercial property segment also soured.

Elsewhere, the Agricultural Bank of China also witnessed a 4.7% increase in bad residential mortgage loans in 2023.

Overall, Chinese banks were sitting on 3.2 trillion yuan ($440 billion) worth of bad loans by the end of September—a 33% increase from pre-Covid times.

What these banks are going through is far from an isolated event. China’s property downturn has exposed the banking sector to all sorts of risks, including the threat of a “Lehman moment” that rivals the 2008 financial crisis that began in the U.S.

China’s property crisis enters third year

China’s bloated property sector was decades in the making, as consumers and businesses preferred to invest their savings in real estate. As land and property values surged, developers began to borrow rapidly, expecting the gravy train to continue indefinitely.

That all began to unravel in 2021 as developers faced financial turmoil due to overbuilding and new regulations to curb excess borrowing. Evergrande was the canary in the coal mine, with the developer reporting a net loss of $66 billion in 2021, followed by a $15 billion hit the following year.

Today, Evergrande has more than $300 billion in liabilities.

“With the property downturn in its third year, progress in downsizing the sector has been rapid in some respects,” wrote IMF analysts Henry Hoyle and Sonali Jain-Chandra, referring to China’s property market.

“Housing starts have fallen by more than 60 percent relative to pre-pandemic levels, a historically rapid pace only seen in the largest housing busts in cross-country experience in the last three decades. Sales have fallen amid homebuyer concerns that developers lack sufficient financing to complete projects and that prices will decline in the future,” they explained.

The Chinese government has stepped in to support banks with exposure to bad property loans, something experts say should help the country avoid its “Lehman moment,” which was particularly painful for the U.S. banking sector in 2008.

“The Lehman moment was actually a reminder of how financial instability can be really damaging - the economic fallout of subsequent years was enormous,” said Jan Hatzius, Goldman Sachs’ chief economist.

“Chinese policymakers are very focused on avoiding that. They will be willing to provide financial support for the banks and for the sectors that are directly affected by the weakness in the property market,” he explained.

Unfortunately, policymakers can only do so much, leaving banks to pursue unusual methods to deal with the mess they made.

Offloading bad loans

Amid these woes, banks have responded in unconventional ways by packaging their bad loans into securities—a move that allows them to offload distressed assets tied to mortgages and other non-performing loans.

Data from the Chinese credit rating agency CCXI found that this form of securitization jumped 37% to 42.5 billion yuan ($6 billion) in the year to Dec. 17. That’s the highest since record-keeping began in 2016.

“Securitization has become a regular tool for Chinese banks to dispose of bad loans. It's efficient, flexible, and regulators are giving relatively faster approvals for such products,” Kan Zhou, head of structured finance ratings at S&P Global (China) Ratings, told Reuters.

Some of the biggest banks to pursue securitization include China Citic Bank, China Construction Bank, China Guangfa Bank, China Everbright Bank, and Bank of Jiangsu.

Issuance is expected to climb this year “because in an economic downturn, there’s growing supply of non-performing assets,” Zhou explained.

“China’s economy is showing multiple signs of weakness,” according to the Center for Strategic and International Studies, a bipartisan research group. “Actual growth seems below the official figures; there is substantial deflation; the housing market has yet to stabilize; and the domestic stock markets have fallen significantly.”