Will Bank of China continue to lag behind peers

after posting slowest growth?

Bank of China posted the slowest profit growth among the nation's biggest lenders in the second quarter because of subprime mortgage losses and said it holds $10.5 billion of securities backed by U.S. home loans.

Net income at China's third-largest bank rose 15 percent to 20.5 billion yuan ($3 billion), based on figures released in a statement. The company said it holds $3.64 billion of securities tied to subprime mortgages and disclosed $6.9 billion of additional home loan investments.

“All these investments are time bombs if the situation in the U.S. gets worse,” said She Minhua, a Shanghai-based analyst at China Securities.

Overseas mortgage investments limited Chairman Xiao Gang's ability to profit from a domestic economy that grew 10.1 percent in the quarter. Industrial & Commercial Bank of China became the world's most profitable lender this year as it avoided the global credit contagion that led to more than $500 billion of losses globally.

Profit growth at Bank of China slowed from 85 percent in the previous three months. Bigger competitor ICBC boosted net income by 41 percent in the quarter.

Bank of China said it held $7.5 billion of debt issued by Fannie Mae and Freddie Mac as of Aug. 25, and $5.17 billion of mortgage-backed securities guaranteed by the two largest U.S. home loan providers. It held $1.83 billion of securities backed by so-called Alt-A mortgages and $5.08 billion of other “non- agency” home loan investments. Bank of China said 99 percent of the latter category of securities carries AAA credit ratings.


Biggest Subprime Loser
Bank of China wrote down the value of subprime investments by $405 million in the quarter. The bank has booked $522 million of losses on securities tied to Alt-A loans to date, and another $599 million on other mortgage investments.

All told, investments in U.S. mortgage securities have led to $3 billion of total losses at Bank of China since the credit crisis began a year ago, making it the biggest loser among the nation's lenders.

“I hope BOC has learnt a lesson about the cost of seeking yield pick-up over U.S. Treasuries,” said Winson Fong at SG Asset Management Hong Kong, which oversees $3 billion and doesn't hold Bank of China shares.


Maintain Profit Growth
The bank will closely monitor investment in Fannie and Freddie and “act accordingly,” President Li Lihui said. The debt won't have significant impact on second-half profit, and full-year earnings growth is expected to match the gain in the first half, Li said.

Credit market losses in Asia are dwarfed by those in Europe and the U.S. The region's financial companies have suffered a combined $23 billion of losses, compared with $230 billion in Europe and $254 billion in the U.S., according to data compiled by Bloomberg.

Optimism that a wider footprint would benefit Bank of China turned to concern last year as rising U.S. mortgage defaults spawned a worldwide credit contraction, derailing global growth while China's economic expansion stayed above ten percent.
Shares in Bank of China have dropped 40 percent in Shanghai and 16 percent in Hong Kong over the past year, underperforming bigger competitors ICBC and China Construction Bank.

Bank of China trades at 1.5 times forecast end-2008 book value, below the average 2.05 times among the nation's 14 publicly traded banks, according to Bloomberg data. Citigroup, the biggest U.S. bank, has a price-to-book multiple of 0.87.


'Substantial' Losses
Investors should avoid Bank of China regardless of its low valuation, Core-Pacific Yamaichi analyst Yuk Kei Lee wrote in a July 24 report. He cited the risk of “substantial” foreign exchange losses, and the possibility that U.S. banks will default on their debts. The yuan has climbed seven percent against the dollar this year, the best-performing Asian currency.

Bank of China operates 689 outlets overseas, six times more than ICBC, the world's largest bank by market value. Operations abroad accounted for 43 percent of Bank of China's profit in 2007, compared with 3 percent for ICBC.

“Bank of China is facing a very serious challenge to its strategy and business mix,” said Wang Yihuan, a Beijing-based analyst at China Asset Management, which manages the equivalent of $36 billion. “Its overseas operations and large foreign exchange holdings have been and will continue to be a drag on profit, and management can't fix that quickly.”


Lending Profitability
Net interest income, or income earned on loans after deducting interest paid for deposits, at Bank of China rose 15 percent to 81.5 billion yuan. Fees and commissions gained 45 percent to 22.4 billion yuan. Its net interest margin, a measure of lending profitability, widened to 2.72 percent in the first six months from 2.66 percent a year earlier.

The bank expanded loans by 13.8 percent in the first half to 3.24 trillion yuan. The non-performing loan ratio narrowed to 2.28 percent from 3.12 percent at the end of last year.

Royal Bank of Scotland owns 8.25 percent of Bank of China, Temasek Holding owns 4.13 percent and UBS AG holds 1.33 percent.

BOC Hong Kong (Holdings), a Bank of China unit, reported that first-half profit fell five percent to HK$7.09 billion ($908 million).


Will a revamp in strategy help save some of BOC's capital? Which aspect of the strategy should the lender prioritize?