For many trust investors in China, losing money did not even seem to be a real possibility because of the implicit repayment guarantee by trust companies.
They probably need to reconsider.
This is particularly true for those who bet on two trust products sold by Citic Trust, the nation's largest trust company in terms of asset value.
In a rare move, the firm has refused to guarantee any type of payment to investors when the trusts ran into problems. Instead, it has taken legal steps against the borrowers behind the trust loans, and said that this was investors' last hope of getting their money back.
One of the trusts, which raised 710 million yuan in 2010, was tied to a real estate project in Qingdao by property developer Shieldspeare Group. Citic has used a court order to put up for sale the land used as trust collateral.
Repayments for the other product, due in mid-January, have been postponed for three months, giving time for Citic to negotiate with the borrower, a Sichuan-based company that produces paint coating for steel products.
If talks do not work out, chances are that the manufacturer's collateral would be put on the auction block as well.
Selling collateral means the trust company was really "at the end of its rope," an executive from a trust company in Shanghai said.
A trust company would not normally let its trust product default on investors, though in most cases it does not have any debt obligation to them, because the firm's reputation, which is vital for business, is at stake, said Li Yang, analyst at Use Trust Studio, a consulting firm.
So in the past, a trust company would make sure investors were repaid, even in cases where the borrower did not pay back its loan on time, he said.
That would explain why no one in China has ever lost money on their trust investment, though the sector has combined assets of 7.4 trillion yuan as of 2012, second only to the banking industry.
In worst cases, payments were late, but within a contractual grace period.
A trust investment contract usually involves a clause that allows the trust company to postpone repayment for up to six months over liquidity concerns, provided that more than half of all investors agree, said a source from a trust company familiar with the arrangement.
The practice is in line with the Trust Law, he said, and "as long as payments are made within the period, the delay does not count as a default."
A trust firm would try all means to avoid a default, even if that requires using its own money to pay investors, one executive at a trust company said.
More commonly, he said, the firm would try raising money by either selling a new trust or finding an asset management company willing to take over the failing product.
Typically, the yield of the trust to be transferred would increase by five to seven percentage points, providing a decent risk premium for the acquiring party, trust professionals said.
Wake up Call
But neither tactic worked for the two Citic trusts. In January, the firm was forced to auction the collateral for the Shieldspeare project. The other trust has missed its repayment schedule, and the firm's deputy general manager, Li Zimin, has said that Citic would not tap into its own coffers to repay investors.
Citic is "not obliged to use its own money to make payment when expected investment return cannot be delivered," when the trust scheme is lawfully sold and managed, he said on January 22.
That attitude is a break from industry norm, and the banking regulator seems to approve.
An official from the trust sector's regulator, the China Banking Regulatory Commission (CBRC), said it encourages and supported trust companies to defend their legal right of not being held responsible for the debt of a trust product.
That is, of course, when the trust company has not done anything that violated regulations or breached a contract, he said.
The attitude also won some applause from people who said it was time for spoiled investors to grow up.
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A wake-up call is necessary because Chinese investors are very immature, an executive of a trust company said. "They have no appreciation for market ups and downs, want higher values all the time and have no tolerance for loss."
Some were concerned that this may be the turning point for the trust business. At the end of 2009, it was a small market with 1.5 trillion yuan in aggregate assets. Three years later, the figure has nearly tripled.
"We are a business that has reveled in bubbles," said the Shanghai trust firm's executive.
Had Citic or any other trust company refused to guarantee repayment two or three years ago, the situation would have been different, he said. "Now the bubbles have started popping, all trust companies need to face reality."
Without guaranteed payment from trust companies, investors would lose money if collateral did sell for a good price.
Li assured investors that that would not be a problem for Citic's trust products. The collateral for the one tied to the steel manufacturer, he said, was a parcel of land valued at more than 3 billion yuan, which was more than enough to cover the repayment of a 1 billion yuan trust.
The other product's collateral land was offered for 789 million yuan on January 8, at an almost 40 percent discount from its appraised value, and higher than the 710 million yuan raised by the trust.
But the auction failed because no one bid. Citic said there would be another auction, but a date was not set.
Some analysts said potential buyers balked at the deal partly because the project faces an uncertain future in the midst of tight government regulations on real estate development.
"The overall property market in Qingdao is not good," a source familiar with the situation said. "There is oversupply, and that was why Citic's trust ran into problems."
Apart from Qingdao, many other second-and third-tier cities face the same problem, he said.
Last year, almost 22 percent of newly issued trust products, which raised a combined 164 billion yuan, were tied to the property sector, data from Use Trust shows.
There is no official estimate as to how many of those products may have had trouble repaying investors because the CBRC is yet to establish an industry-wide system for monitoring bad loans in the trust sector.
Several analysts said they were concerned that a great amount of trust products would come due after March, and that would put more financial strains on both the developers and the trust companies.
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However, one analyst said a trust loan was usually capped at 30 to 50 percent of the value of the collateral. So even if the collateral is sold at half of its appraised price, trust investors would still be able to recover their investment in full.
Meanwhile, the CBRC official expressed optimism on the bad debt issue, saying that it was natural for some products to fail when the overall size of the industry has grown so large.
Assuming that the trust sector has the same bad debt ratio as the banking industry, which was 0.98 percent in 2012, about 70 billion yuan worth of trusts would fail. The figure would be acceptable, he said.
What concerns regulators, however, was local governments raising money through trust companies. Nearly 29 percent of trust products issued last year were invested in infrastructure projects, data from Use Trust shows.
Companies that build infrastructure are usually sponsored by local governments. It was difficult to gauge the risk of these trusts, an analyst said, because those companies often used the government's reserve lands, which were not appraised yet.
"Last year, even trust companies in third-tier small cities started selling infrastructure trusts, and they don't limit businesses to their own province anymore," an analyst from Zhonghai Trust said.