How a $144 million property default started Korea's credit crisis

(Bloomberg) — Global central bankers are in a race against the clock to tame rampant inflation. But push too far, too fast, and the markets that are key to the smooth functioning of the financial system tend to buckle.

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This is exactly what happened recently in South Korea, where the credit market suffered its worst rise in short-term yields since the global financial crisis. At the heart of the crisis was a type of short-term debt used to finance the country’s construction boom. It’s called project finance asset-backed commercial paper, or PF-ABCP.

Although securities are not considered a completely safe bet because they are tied to the property market, defaults are rare in Korea. The default rate on project finance loans was just 0.5 percent at the end of June, according to a central bank report.

So when the developer of the Legoland theme park — backed by Gangwon Province — missed a payment to PF-ABCP in late September, investors spooked.

While Korean officials appear to have hedged the crisis, their travails serve as a cautionary tale to the rest of the world about how quickly markets can go wrong.

1. What is PF-ABCP?

Big construction projects are expensive. Instead of paying for them with existing funds, in South Korea the entrepreneur often prefers to borrow the money.

Developers often try to recoup the money they have borrowed by selling properties even before they are built. But if property prices fall or units go unsold, they remain in financial trouble.

As a shield in case things go south, sponsors often use a special purpose vehicle (essentially a separate company with no assets other than the project) to raise the money, with payout linked directly to development revenue. This is called project finance.

Brokerage companies typically make loans to developers, then securitize them and sell them to investors in the money market. Such securities are called PF-ABCP. The market is estimated at about 35 trillion won ($27 billion).

2. How did the banks get involved?

Builders were the first major players in the PF-ABCP market. But as the real estate sector grew rapidly, securities firms also entered the business.

Because brokerages make loans and often sell the debt to investors, PF-ABCP is a lucrative financial stream that has grown exponentially in recent years. Revenue from guaranteeing loans to finance projects was about 1.5 trillion won at the end of June, accounting for about 42 percent of brokerages’ total revenue, up from just 3 percent in 2017, according to data from KB Securities Co.

Usually either the broker or the builder is the guarantor, although in the case of the Legoland developer it was the province. According to NICE Investors Service, about 70% of this debt is guaranteed by securities firms, while about 20% has construction firms as a backer.

4. What happened to Legoland Korea?

Gangwon Province, the municipality where the theme park is based and which was the guarantor of the securities, missed a 205 billion won payment to PF-ABCP in late September.

This happened because the newly elected governor of Gangwon, Kim Jin-tae, refused to pay off the debt, a deal made under his predecessor and political opponent.

The municipality’s decision shocked money market investors already under pressure from rising interest rates and sent short-term debt yields to their highest levels since the global financial crisis.

The case offers a lesson to the world that “one small mistake can threaten the entire economy,” Bank of Korea Governor Rhee Chang-yong told Bloomberg in late November.

In response to the market turmoil, officials in Gangwon Province later reversed course and said they would pay off the debt for the Legoland Korea project by Dec. 15.

5. What other risks are there?

South Korea’s Financial Services Commission has described PF-ABCP as the “weakest link” among the nation’s short-term debt markets.

One inherent problem is that there is a maturity mismatch between the underlying assets of project finance loans, which typically have three-year maturities, and those of commercial paper, typically issued every three months.

This means that refinancing risks have increased in tandem with aggressive interest rate hikes by the Bank of Korea. The big concern would be the spread of corporate bonds more broadly.

“This would have implications for borrowers with large rollover needs or maturing debt, who would now face higher refinancing costs,” said Anushka Shah, senior credit officer at Moody’s Investors Service. “Corporate leverage across the system, although declining, is high.”

–With the help of Ritsuko Ando.

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