A punt on China's Cinda is still a shot in the dark From the ashes of disaster grow the roses of success - so sang the old men in Chitty Chitty Bang Bang. And so it has proved for Cinda Asset Management. The disaster of the huge pile of bad loans in China's biggest banks in the 1990s has now bloomed into Hong Kong's most sought after new listing since AIA, the insurer, listed in 2010. It is the first among China's four bad banks to pursue an initial public offering and investors have been seduced by its novelty value both as a type of company and as a large, relatively liquid stock, according to bankers. This has generated up to $40bn of orders for less than $1.5bn worth of shares up for sale. Cinda is selling about $2.5bn shares in total, but $1.1bn of those are going to cornerstone investors. But the success of this listing, which has valued Cinda at more than $16bn, has come in spite of the lack of detailed information about whether its business is actually any good at growing its own roses. Its roughly 800-page prospectus tells us very little. What is clear is that its returns have declined dramatically in the past three years. Return on equity has fallen from 25.5 per cent in 2010 to 15.8 per cent last year, while return on assets has declined from 6.3 per cent to 3.4 per cent. Both have edged lower over the first half of this year. Returns were unusually high in 2010, the prospectus says, in part because assets were marked up significantly when Cinda became a joint-stock company instead of a simple arm of government. It also sold a chunk of equity in formerly distressed companies and realised very large gains. However, it never details the individual assets that were sold or marked up in a way that could help investors judge whether such things are repeatable. RoE was pushed lower last year because Cinda expanded its equity base with investments by strategic shareholders including UBS and Standard Chartered. Huarong, the next bad bank likely to go public, is trying right now to get similar investments. But another potential factor in Cinda's fantastic performance in 2010 was the wholesale removal of Rmb247bn in liabilities from its balance sheet by the Ministry of Finance. To put that number in perspective, its total asset base now after three years of strong growth is Rmb283.6bn. These liabilities were part of its original funding to buy loans from China Construction Bank when Cinda was created in 1999. Cinda still contributes to their repayment, as does CCB, but only through corporate taxes, which it would pay anyway. The MoF pays the rest. Huarong last year appears to have enjoyed a similar debt jubilee, with Rmb138bn of what it owed suddenly being paid down, according to information in the annual report of ICBC, the bank that Huarong was set up to take bad loans from. These bonds were wiped out because Cinda and Huarong simply were not making enough money to repay them. Before 2006, according to government data uncovered by analysts, the average cash return on the bad debt these groups bought was about 20 per cent of what they had paid. After 2006, there is very little public information on any of the bad banks until Cinda's prospectus. One of the key reasons to invest in such a business is the management's skill in pricing and selecting the bad loans it buys. The Cinda prospectus gives a lot of boiler plate on process, but no details of assets the group has actually made profits from. A punt on Cinda's management remains a shot in the dark. Reworking bad debts into good assets can be highly profitable, but it is always a complex, risky and very lumpy business. There is expected to be a wave of bad loans in China following the credit boom of 2008-09, however this may not be the best bread and butter business for Cinda or its rivals. China's smaller banks are facing a funding squeeze as regulators crack down on the explosion of interbank lending. Smaller banks have been using this as a way to get around loan quotas - they swap ordinary loans for interbank money on a short-term basis and have so far been allowed to remove the risk from their balance sheets. For banks like Minsheng and Industrial Bank, this will affect up to 25 per cent of their assets, according to Mike Werner at Bernstein Research. For a slew of others it will affect between 8 and 15 per cent of assets. When the funding squeeze comes, banks will have to sell loans. The biggest market in loans in the next few years could be in good debts discounted by these cash-starved smaller banks. For investors in Cinda and its rivals, that would mean more predictable income, but with the corollary of still lower returns. Fewer ashes will mean smaller, weaker roses.