(Bloomberg) -- Banks and asset managers are expecting a wave of bad loans to hit South Korea in the coming months, as the country counts the cost of an ill-starred splurge on overseas office blocks and local infrastructure.

Fund managers in Seoul were among the biggest investors in European and US commercial buildings in recent years, and the property crisis has left them with swaths of assets whose values have plunged, many due for refinancing. Others piled into domestic infrastructure projects, where defaults have already soared.

Some of the financial damage has been delayed because lenders to the project-finance funds — with backing from the Korean government — have been extending debt maturities and restructuring loans headed for trouble, according to half a dozen bankers and asset managers interviewed by Bloomberg. But with the property crisis deepening, the same people say the number of defaults is about to spiral as more real estate and loans become distressed.

While not systemic, it is the latest in a wave of financial troubles to hit Asia’s fourth-largest economy, after a run on a credit union branch and a debt crunch triggered by Legoland Korea’s default. The country holds assembly elections in April, and one of the government’s priorities is trying to cauterize the wounds from the costly misadventures in overseas property and local project finance.

“They don’t want a hard landing,” says Soo Cheon Lee, cofounder of credit investor SC Lowy, who reckons the government will attempt to clean up the balance sheets of financial institutions after the vote. “They need to support the real estate industry and then they have to restructure.”

The dangers are magnified by the large number of “nonbanks” such as securities firms, pensions and credit cooperatives that put money into foreign property and project finance at home. Some of these entities have had a “significant increase” in non-performing loans, the International Monetary Fund wrote recently, referring to well overdue loans or ones unlikely to be repaid.

Scrutiny of the securities firms that manage the funds has been stepped up. After final losses from the property spree are tallied, Korea’s Financial Supervisory Service watchdog will review whether any easing of investment rules prompted reckless behavior, according to a top FSS official. Asset managers spent tens of billions of dollars on overseas offices and risky real estate loans right before Covid and rate hikes upended the market.

“We are supervising the brokerages and asset management firms so that they do a thorough risk management process,” the FSS wrote in an email to Bloomberg. “In the future, we may consider improving the systems if needed.”

Referring to real estate projects, the watchdog said in a Dec. 14 statement that there were 120 sites available for auction and restructuring at the end of September after financial institutions found they lacked feasibility. That’s up from 70 at the end of last year.

The government will support an orderly soft landing for project finance-backed real estate through tailored responses for each site, finance minister nominee Choi Sang-mok said earlier this week. Bank of Korea Governor Rhee Chang-yong said on Wednesday that achieving such an outcome is a key policy goal for the central bank.

Read More: In London, New York and Paris, a Giant Office Bet Goes Wrong

Missing Prudence

Korean regulator, the Financial Services Commission, warned this month that individual firms may be at risk if overseas property bets go wrong, but said the probability of systemic stress is low.

“From next year, more NPLs will surface” in real estate and project financing, says Min Joo Kang, senior economist at ING Bank NV in Seoul. “Savings banks and local banks will experience the hardest damage.” Still, she agrees that a broader credit crunch is unlikely because of available tools such as the Bank of Korea providing liquidity to nonbank lenders.

The parent company of one of Seoul’s leading securities firms has begun a “full-fledged investigation” into its assets and possible losses. “If additional provisioning” or “loss recognition is needed, we plan to do it in the most conservative fashion,” Hana Financial Group’s chief financial officer Jong-moo Park told analysts in October.

South Korean securities firms saw their combined fund-related income shrink by 955.3 billion won ($730.5 million) in the third quarter, because of losses from overseas alternative investments and drops in stock prices, according to the FSS. Bond-related income jumped.

Seoul firms’ fondness for making “mezzanine” loans — which sit at the back of the repayment queue — to landlords is adding to delays around getting a full picture of the problems. It was a favored product for insurers after 2016 because of the returns on offer when compared with the cost of finance, according to one asset management executive.

The number of mezzanine investments is difficult to gauge, given their private nature, but a 20% drop in US commercial property values since the peak means many of these junior loans are now challenged, the executive says.

The FSS is alarmed, too, by the number of individual fund managers who’ve jumped from one employer to another lately, according to the official there. The fear is that this can let people avoid responsibility for poor investments.

A complex investment ecosystem also makes it hard to agree on what to do with troubled assets. Fund managers often deal with a host of owners, lenders and regulators. Several South Korean firms even sold overseas property stakes to mom and pop investors, some of whom have alleged mis-selling, according to two officials at the FSS.

More cases are expected as the final losses are recognized. “We plan to do our best to protect consumers through speedy resolutions of conflicts,” the FSS wrote in the email.

Darker Backdrop

As the government, regulators and finance industry work to contain the fallout, the overseas backdrop isn’t helping.

Frankfurt’s Trianon skyscraper was acquired by IGIS Asset Management and Hana Financial for €670 million ($722 million) in 2018. The borrowers have just snagged a standstill agreement — pausing any potential measures that typically include foreclosure — until February, according to a filing, because “the possibility of default under this loan agreement has arisen due to the decline in the value of the asset.” IGIS said it had nothing to add to the update it gave in early December. Hana said it was looking for ways to normalize the assets for investors.

Kiwoom Asset Management Co., meanwhile, has agreed to inject more equity into the City of London’s Cannon Green building to secure a refinancing, according to people familiar. The firm declined to comment.

Other lenders want to cut their losses. Bank of Ireland Group Plc is offering a loan secured against London’s Korean-owned One Poultry site at a near 14% discount, Bloomberg reported previously.

Back in Seoul, buyers of the bad loans are poised to profit, in project-finance loans as much as those made to property funds. One buyer expects a flood of sales. He says he’s already achieving 15% internal rates of return, a measure of profitability, on NPLs. That’s almost double his target.

“We believe potential defaults could surface in project financing exposures next year, as elevated interest rates are likely to sustain in the near term,” says Rena Kwok, credit research analyst at Bloomberg Intelligence. “Nonbanks such as securities firms and mutual saving banks could be vulnerable.”

--With assistance from Jaehyun Eom and Shinhye Kang.

(Updates with policymaker responses in paragraph above first subhead.)

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