Spending 94 Trillion Won of Public Funds on Stabilization... The Monster Real Estate PF [Song Seungseop's Financial Light]

PF Market Shaken, Tens of Trillions in Government Guarantees
Advanced Countries Evaluate PF with Own Capital
Korea Recklessly Grants Loans with Guarantees Alone
Recession → Construction Firm Bankruptcies → Financial Sector Collapse Chain
"This Structure Causes Systemic Risk"

Did you know that the government is spending 94 trillion won to stabilize the real estate project financing (PF) market? This was revealed by the government on the 3rd in the '2024 Second Half Economic Policy Direction.' To prevent the instability of real estate PF from spreading throughout the financial market, 30 trillion won will be directly invested in guarantees. In addition, 10 trillion won will be allocated for construction guarantee associations, and 5 trillion won for pre-completion unsold loan guarantees, among others. What exactly happened in the PF market that has led to such a massive injection of public funds for stabilization?

Project financing has no specific definition. Each person explains it differently, and the scope of the term is loose. There are various types of PF, but the common feature is that funds are lent without collateral. You might ask, what do they rely on to lend money? They look at the project. Whether it is construction or business, they assess what kind of project will generate income in the future. If the project is judged to be sufficiently promising, even without collateral, they lend money based on the high likelihood of future cash flow.

The primitive origin of PF dates back a very long time. In 1299, the British royal family lent money to the Italian merchant Frescobaldi, who owned a bank, for the development and exploration of silver mines in the Devon region of England. The condition was that if the development project succeeded, repayment would be made with the mine's production. Although there was no collateral, it was a kind of PF based on the expectation of the project's success. PF was also useful in the 17th century, known as the 'Age of Discovery.' Wealthy investors and banks provided funds for voyages and trade explorations, and profits were made when the cargo ships returned.

Trans-Alaska Pipeline System in the United States.
[Image source=Yonhap News]

The modern meaning of PF became widespread around the early 20th century in the United States. Especially after the 1970s, the PF method became popular in the oil and gas industry. Energy extraction projects like oil or gas can yield enormous wealth if successful but require huge initial costs. Traditional financing methods could not cover these costs, but companies could borrow money using PF by securing future massive cash flows as collateral. The construction of the Alaska pipeline and exploration and development of North Sea oil fields were made possible thanks to PF.

The Peculiar Korean PF That Started with the Foreign Exchange Crisis

What about Korea? In fact, PF was an unfamiliar concept in the early 1990s. Various civil engineering and construction projects were actively carried out in Korea at the time, but the roles of construction companies and developers were not divided as they are now. Construction companies handled everything from securing funds to actual construction, managing almost all development tasks. The money needed for construction was raised by the construction companies issuing bonds or through other means, and PF was not common.

The introduction of PF in Korea was triggered by the foreign exchange crisis. When the Korean economy fell into crisis in 1997, borrowing money from the International Monetary Fund (IMF), companies with high debt ratios went bankrupt. Construction companies and banks, which had exchanged large sums of money in construction, were no exception. As a result, the developer system emerged in the real estate industry to separate the risks of development projects and the field market. Construction was carried out by construction companies, while the overall process of land acquisition, design, and sales was handled by developers, establishing the current system.

Since developers borrowed money, construction companies could manage their debt ratios stably. However, there was a problem. Developers needed to borrow money, but there was no way to mobilize large funds by traditional methods. They were neither large like construction companies nor had collateral to pledge. Therefore, the PF method was adopted. Although collateral was weak, repayment was made from profits generated by building and selling properties. Laws were also changed to allow banks to invest funds in real estate acquisition and development, making PF a common financial system.

Flowchart of Real Estate Development Project Financing in Korea. Photo by Korea Institute of Finance

In the early days of PF introduction, there were no particular problems in Korea. The real estate market was considered a business that could hardly fail. Buildings were quickly sold upon completion, and housing prices tended to rise every year. Major banks actively engaged in PF. It was one of the means to achieve high profits in promising development projects, not just construction. In fact, Kim Seung-yu, the head of Hana Bank, stated in 1997, "We plan to increase unsecured credit loans in the form of project financing for promising development sectors such as venture companies."

However, Korean PF had a unique form unlike advanced countries. Originally, PF is a system that lends money based on the project's feasibility, but financial companies demanded joint guarantees or completion responsibility agreements from construction companies during real estate development. Since developers had very little equity, this was a strategy to share business risks with construction companies. Developers borrowed short-term funds from secondary financial institutions like savings banks during the initial development phase, and once project permits were obtained, they refinanced with low-interest loans from primary financial institutions.

'Everyone Fails Together in a Recession'... Risk Exposure of 135 Trillion Won

The unique Korean PF had a terrifying weakness of chain bankruptcies. Since construction companies also bore significant development risks, a recession could lead to a domino effect: developer → construction company → other project defaults → financial sector defaults. This weakness was fully revealed during the 2008 financial crisis. When the real estate market began to decline, developers collapsed, and about 20 mid-sized construction companies went bankrupt. Savings banks that lent money to them also went bankrupt. At that time, the PF loan balance was 76.5 trillion won, with savings banks lending 11.5 trillion won.

Real Estate PF Exposure by Year. Photo by Korea Development Institute (KDI)

Following the savings bank crisis and a prolonged real estate market slump, PF revived in 2015 as the real estate market began to rise again. Especially, securities companies started participating in the PF market. They played various roles such as structuring project financing, securitizing PF bonds, and providing unsold collateral loans. As a result, the PF loan balance steadily increased to 135.6 trillion won in 2023. According to Korea Credit Rating, the domestic and overseas real estate financial risk exposure that the securities industry must bear amounts to 10.3 trillion won.

Consequently, our PF market is again fraught with risks. Various reports continuously warn that financial institutions and the construction industry involved in PF loans may simultaneously face insolvency risks. In particular, Saemaeul Geumgo, which was not captured in statistics, has recently seen delinquency rates soar due to extensive real estate PF lending. In July last year, news broke that Namyangju Dongbu Saemaeul Geumgo was merging after failing to resolve a 60 billion won bad PF loan, triggering a bank run with 17 trillion won withdrawn within a month.

Despite experiencing past PF crises, Korea's financial sector and real estate development industry have repeated the same problems. Experts point out that this is because the low-equity, high-guarantee structure has not changed. In advanced countries, at least land is secured with equity, and only construction costs are borrowed through PF, limiting risks. However, in Korea, developers with almost no capital jumped into real estate development aiming for a quick profit. Banks, wanting both high returns and safety, demanded various guarantees from construction companies, trust companies, and securities firms. Since banks had guarantees even if developers collapsed, they had no incentive to properly evaluate project feasibility. Financial companies likely saw issuing as many PF loans as possible as the best choice. This is why Korea has faced another PF crisis in just over a decade.

The risk from the PF loan crisis is borne by the public. Due to reckless projects by the real estate industry and financial sector, innocent taxpayers must provide funds to stabilize the market. Hwang Soon-joo, head of the Financial Innovation Research Team at the Korea Development Institute (KDI), pointed out, "The low-equity, high-guarantee structure leads to poor project evaluation, blind investment, and increased macro volatility, ultimately causing systemic risk and socializing the risk. To prevent the spread of systemic risk, the government inevitably uses public funds directly and indirectly, such as guaranteeing PF loans and providing emergency liquidity support."