A mega apartment complex dominates the landscape of Haeundae District in Busan. Most funding for the country’s large-scale construction projects come in the form of bank loans secured against the potential future cash flows upon the project's completion, rather than from credit extended against physical assets. This practice, called project finance, has been a primary concern for constructors and lenders in the aftermath of the global financial crisis in the late 2000s. / Korea Times File

Non-performing loans in project finance feared to explode soon

By Chung Hee-hyung

“Non-performing loans in project finance are a time bomb that could blow apart the country’s real estate market at any moment,” Financial Services Commission (FSC) Chairman Kim Seok-dong warned last year.

The warning galvanized the government and financial institutions into making various efforts aimed at preventing the financial detonation. A full year later, however, there is mounting evidence that the project finance (PF) time bomb is indeed ready to blow on short notice.

Experts say that unless an all-out effort is made on debt liquidation and a program of self-reform, the ticking bomb could destroy the entire construction industry.

High risk, high return

The history of project finance dates back to the development of the Panama Canal in the early part of the 1900s, and ever since, the scheme has been in widespread use in the West for large scale infrastructure development, initially in the oil and gas industry but later in commercial real estate projects as well. However, it took nearly a century for project finance to arrive in Korea.

“Before the Asian financial crisis of 1997-98, Korea’s real estate development was rather primitive,” said Kim Jong-bo, professor of law at Seoul National University.

“The construction companies borrowed money from banks, with the land on which a building was scheduled to be built used as collateral. Under such circumstances, it was difficult to undertake large scale development projects because the sole source of cash came from the collateralized land.”

The introduction of project finance changed much of the country’s real estate landscape. The 1997-98 financial crisis battered the construction industry particularly hard, and the government introduced project finance to boost domestic demand. The expectation was that the brand-new financial scheme would stimulate investment in large-scale construction projects.

Under project finance, financial institutions provide loans to construction firms based not on the value of their collateral, but on the projected future cash flow of their ventures. The cash flow could come from numerous sources _ rent paid by tenants in a residential building, toll fees of a bridge or highway, or down payments on apartments.

Companies with promising development schemes in their portfolios would be able to secure financing even though they might not have enough assets for use as collateral.

It was certainly a more advanced way of providing cash for real estate development, and project finance was supposed to infuse fresh capital and financial expertise to the underdeveloped Korean real estate market. But it also carried a dangerous seed.

“Project finance is essentially high risk, high return,” said professor Kim. “Its financial basis is far more tenuous than loaning collateral, because the loan is paid back almost entirely from the projected cash flow. When the cash flow doesn’t materialize, as in a case when not enough rent-paying residents move into a residential building, the consequences can be quite serious.”

The situation could be even more critical because most project finance loans are non-recourse, which means that lenders’ recovery is limited to the amount of money emanating from the cash flow.

It cannot seize any other assets or hold the borrower personally liable to recover the unpaid debt.



What went wrong?

The peculiar nature of Korea’s real estate development added additional complications. “For project financing to be successful, it should meet two conditions,” said Kim Jin, an associate research fellow at the Seoul Development Institute (SDI).

“You have to be sure how much it would cost, and also how much cash it would generate. Unfortunately, project finance in Korea has problems in both.” Kim said that it is difficult for the country’s developers to make a reasonable forecast of development costs.

“Even a slight delay in getting the government’s approval could push up the cost inexorably, because each day lost means that the project would take that much longer to complete. Of course, it is not always easy to get approval from the authorities, because in many construction projects several interests are at stake. The net result is a seriously delayed project whose cost has spiraled out of control.”

The undue delay of the authorities in granting approval led many developers to give up projects altogether, said Kang Woon-san of the Construction and Economy Research Institute of Korea (CERIK).

“Local governments are given wide discretion in approving or rejecting development proposals. Unfortunately, in many cases this discretion has been abused to such an extent that developers simply pulled out of their projects instead of waiting for approval that may never come.”

As for the forecast cash flow, Kim said that such estimates can be highly speculative. “The future cash flow could be changed by many factors, and when a truly unforeseen event happens, it could disrupt an otherwise smooth flow of cash.”

Development projects for the country’s ubiquitous apartment complexes are a case in point. Korea is a cramped country, and most urban residents live in large apartment blocks. And as in every other real estate market, location is of paramount importance. Sites slated for construction could be especially popular if they were located around the Seoul metropolitan region, not least because most of the land adjacent to the capital is designated as a “green belt” and thus protected from further development.

Assuming the apartments would sell out as soon as they were put up for sale, most developers marketed units well in advance, sometimes even before a project had been outlined on the drawing board.

And lest any potential buyer be turned away by the high purchasing prices, in many cases developers allowed buyers to make an initial down payment before they moved into the apartments. The buyers were expected to pay back the remaining amount in installments.

Unfortunately, the global financial crisis in 2007 turned the rosy assumptions upside down. As a developing country, Korea came out of the crisis relatively unscathed but the recession still put a severe strain on the country’s housing market.

Many households went under as the debt they owed exceeded the value of the house they owned and were unable to pay back the loans they borrowed from banks.

As a result, many buyers failed to make the remaining portion of their payments, suddenly draining the steady stream of cash flow to developers. Some developers still managed to pay back their loans, but many others went bankrupt, sending yet more shockwaves through the already battered housing market.

The insolvent project finance loans were equally disruptive to lenders, because these dramatically increased the non-performing loans on their balance sheets. Some savings banks had as much as 30 percent of their outstanding loans in project financing alone.

To avoid such situations, professor Kim said it was imperative that lenders make accurate valuations of cash flows that should supposedly come from development projects. Unfortunately, lenders were not willing to go through the arduous task of pouring over development proposals to make sure that the projects could plausibly generate enough cash to pay back the borrowed money.

Instead, when developers submitted their proposals, financial institutions usually demanded builders guarantee payment in case developers defaulted. “Most lenders essentially substituted builders’ loan guarantees for their own valuation,” said Kim of SDI.

“In project finance, Korea still lags far behind developed countries,” said Lee Hyun-suk, professor of real estate studies at Konkuk University in Seoul.

“In the West, most real estate financing comes in the form of pension funds or real estate investment trusts (REITs). They are mostly long-term, and thus more stable and less prone to market fluctuations. In Korea, on the other hand, the money usually comes from short-term bank loans, with developers borrowing the money while the builders guarantee the developers’ payment.”

Lee warns that this distorted structure could start a chain reaction of defaults if the developer somehow fails to pay back its loans. “Builders, even though they took no part in coming up with the development plan, are forced to bear a disproportionately large risk. This could discourage active investment in development projects,” said Lee.

Defusing the time bomb

The government, of course, has not sat idly since FSS Chairman Kim warned that a PF time bomb is ready to explode. Last year, the government established the Project Financing Stabilization Bank, more commonly known as a “bad bank,” designed to buy up non-performing loans made by real estate developers.

It was closely modeled on the practices of the U.S. Federal Reserve which in 2010 bought up large amounts of mortgage backed securities to ease the financial strain on the housing market.

Similarly, the Korean government hoped that the aggressive purchase of non-performing loans would stabilize both the ailing banking sector and the construction industry, containing any systemic risk posed by these loans. Nonetheless, outstanding PF loans still grew on the balance sheets of the lending banks. More than 28 trillion won ($ 24 billion) in outstanding PF loans are currently sitting on the lenders’ balance sheet, and financial regulators estimate that one third of them are set to expire this year.

This would put severe stress on both sides, since borrowers would be hard pressed by the banks to pay back the outstanding loans precisely at a moment their cash reserves had already run dry.

“Just as consumers having large debt but little cash find it difficult to pay off their bills, we are forced to borrow money here and there merely to pay interest on our outstanding loans, to say nothing of the principal,” said an official from a construction company.

“Banks are reluctant to lend us money unless they are sure to get back the amounts they issued.”

Lenders, on their part, are anxious to maintain the capital level required under the standards of Bank for International Settlements (BIS). Otherwise, the banks could get negative ratings from credit agencies, a scenario they would like to avoid at any cost in the current recession. Thus, banks have little inclination to heed plead from borrowers that they are unable to pay back their debts at the moment. Requests for extending maturities for non-performing loans had mostly been turned down.

To remedy the situation, the government plans to liquidate 2 trillion won of non-performing loans by the end of this year. The construction industry, for its part, is doing all it can to secure enough cash to weather the financial storm by offering large discounts on their unsold apartments, issuing corporate bonds and sometimes even selling controlling stakes in other companies.

Choi Sam-kyu, head of the Federation of Construction Associates, thinks that a long-term solution is necessary.

“So far, builders and developers alike simply assume that the real estate market will continue to expand just as in the good old days before the global financial crisis,” said Choi at a speech commemorating the 22nd anniversary of the national Construction Day. “Such practices will no longer do.”

Choi said that construction companies should change their business practices altogether. “Firms should start to make a rational assessment of potential market demand for their real estate projects. Just building yet more apartments with the expectation that they will somehow sell out will no longer work.”