China, The "Sick Man Of Asia"
Part 1: Evergrande Reveals The Rot In Real Estate
The financial media story of the day has been the slow—but accelerating—collapse of Evergrande, China’s 2nd largest property developer by sales and the world’s most indebted company, with total debt in excess of $300 Billion. Many observers have referred to Evergrande’s downward spiral as China’s “Lehman Moment”, a reference to the 2008 bankruptcy and liquidation of the investment firm Lehman Brothers, an event commonly perceived as the beginning of the “Great Financial Crisis” of 2008-2009, while others dismiss the analogy.
Yet, as is all too common in the mainstream media, the “story” manages to miss the real story, which is not that Evergrande is/is not a Chinese version of Lehman Brothers, but that it is but one symptom of a much larger sickness. The story of Evergrande is that it reveals the rot in Chinese real estate, and puts into real terms how China is “The Sick Man Of Asia”
Lehman Brothers Was Not A “Moment”. Neither Is Evergrande
We begin by injecting a bit of historical context, which is that the Lehman Brothers bankruptcy was never a “moment” in the normal sense of the word. As Peter Tchir, Head of Macro Strategy at Academy Securities, points out, the erosion of subprime mortgages in the United States did not start with Lehman Brothers and did not end with their demise:
I believe, that had Lehman been “saved” the problems we faced would still have been result, we just would have taken a more circuitous route. That an inexorable chain of events had been started before Lehman and would have continued regardless of saving Lehman or not.
An examination of the Lehman Brothers bankruptcy and the events leading up to it certainly seem to support this assertion. Like all bankrupt firms, Lehman Brothers was in parlous financial shape for quite some time in advance of the bankruptcy, with the visible warning signs appearing as early as March of 2007—nearly 18 months before the filing:
In February 2007, Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion.5 But by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent. Defaults on subprime mortgages began to rise to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. Following the earnings report, Lehman said the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings.
What only became apparent later was that Lehman’s difficulties were part of a larger burgeoning credit crisis, triggered by the bursting of the housing bubble in 2006, which resulted in a cascade reaction through financial markets as defaulted mortgages tainted derivative securities based on those mortgages.
The 2007–2008 credit crisis was a meltdown for the history books. The triggering event was a nationwide bubble in the housing market. Home prices had been rising rapidly for years. Speculators jumped in to buy and flip houses. Renters were anxious to buy before they got priced out. Some believed prices would never stop rising. Then, in 2006, prices hit their peak and started to decline.
Well before then, mortgage brokers and lenders had relaxed their standards to take advantage of the boom. They offered subprime mortgages, and homebuyers borrowed well beyond their means. "Teaser" rates virtually guaranteed that they would default in a year or two.
This was not self-destructive behavior on the part of the lenders. They did not hold onto those subprime loans, but instead sold them for repackaging as mortgage-backed securities (MBS) and collateralized debt obligations (CDO) that were traded in the markets by investors and institutions.
When the bubble burst, the last buyers, who were among the biggest financial institutions in the country, were stuck. As the losses climbed, investors began to worry that those firms had downplayed the extent of their losses. The stock prices of the firms themselves began to fall. Inter-lending between the firms stopped.
Lehman Brothers had been one of the largest dealers in these mortgage-backed securities, and was left holding one of the largest bags when the market for those securities abruptly reversed. Having placed big bets in that market, they lost big.
This illustrates the extent to which Lehman Brothers was not a catalyzing event to the Great Financial Crisis. The housing bubble had already burst and derivative markets had been in turmoil for well over a year by the time of the Lehman bankruptcy. With or without the Lehman bankruptcy, housing prices were headed downward, and taking the derivatives markets with them. Whether Lehman had not filed, been bailed out, or even had merged with another investment bank would not have changed the fundamental trajectory of the markets at that time.
Similarly, Evergrande is less a catalyst than a symptom of a more extensive rot in Chinese real estate markets. Beijing has been working quietly (and not so quietly) to stabilize and strengthen property markets for the better part of a year, while simultaneously extending its regulation over those markets, restricting loans to developers and limiting investment by private firms.
Long before Evergrande’s debt defaults became inevitable, Chinese real estate was on the rocks. Long after Evergrande’s bankruptcy is realized, Chinese real estate will still be on the rocks.
Evergrande Is More Than Just Lehman. It Is Also Enron.
Evergrande is in many respects a larger phenomenon than Lehman Brothers, as there are also parallels to an earlier epic bankruptcy in American finance: Enron, the one-time high-flying energy trading giant that collapsed amid a slew of recriminations and criminal charges. In the Enron debacle, the core of the corruption that doomed the company was an accounting practice known as “mark to market”, which allowed the company to book extraordinary revenues even when assets had not even entered productive operations.
By the fall of 2000, Enron was starting to crumble under its own weight. CEO Jeffrey Skilling hid the financial losses of the trading business and other operations of the company using mark-to-market accounting. This technique measures the value of a security based on its current market value instead of its book value. This can work well when trading securities, but it can be disastrous for actual businesses.
In Enron's case, the company would build an asset, such as a power plant, and immediately claim the projected profit on its books, even though the company had not made one dime from the asset. If the revenue from the power plant was less than the projected amount, instead of taking the loss, the company would then transfer the asset to an off-the-books corporation where the loss would go unreported. This type of accounting enabled Enron to write off unprofitable activities without hurting its bottom line.
The mark-to-market practice led to schemes that were designed to hide the losses and make the company appear more profitable than it really was. To cope with the mounting liabilities, Andrew Fastow, a rising star who was promoted to chief financial officer in 1998, developed a deliberate plan to show that the company was in sound financial shape despite the fact that many of its subsidiaries were losing money.
Recent news revelations show that a measure of corruption in play at Evergrande as well, with senior executives secretly selling their personal holdings in the company seemingly in violation of company rules and potentially Chinese laws as well.
In an apparent response to rumours that riled investors, the company on Saturday vowed "severe punishment" for six managers found to have redeemed their investment products ahead of maturity dates.
Additionally, Evergrande staff were being pressured to both sell and invest in the company’s “wealth management products”, a sort of pseudo-security Evergrande used to raise capital to fund its other debts.
Disgruntled Evergrande staff told AFP they were pushed to ramp up sales of financial products promising generous returns -- or to invest more themselves.
Rates of return ranged from seven to nine percent, according to staff and advertisements seen by AFP.
"They wildly encouraged us to boost performance, giving us rewards," said an Evergrande Wealth sales consultant on condition of anonymity.
But she claimed it became impossible to reach managers in early September, when the company started facing trouble making repayments -- triggering alarm.
The Ponzi-like appearance of these wealth management product investment vehicles is underscored by one brutally stark reality: the money is gone.
Nor were the financial irregularities confined to questionable sales of opaque securities. In 2018, Evergrande founder Hui Ka Yuan approached European mega-bank Credit Suisse for both a $1.8 Billion bond issuance, which went through, and then a loan using the bond as collateral, which Credit Suisse denied. The bond was to fund a special dividend to investors, and Hui was compelled to put up $1 billion of his own money to push the debt issue through. According to Credit Suisse, it appears he attempted to then get that money back through a loan secured by the bond.
Evergrande had recently raised a $1.8bn bond to help pay a special dividend to investors. Hui, then China’s third-richest man, had to put up $1bn of his own money to support the deal due to lack of demand, the Financial Times reported at the time.
Hui then approached Credit Suisse for a loan that would be used to purchase Evergrande securities, offering the bond as collateral. When the transaction was submitted for review, risk managers criticised the structure for having characteristics of circular financing, people involved told the FT.
While there is no reporting of any securities laws being violated by these transactions, either in Europe or in China, as described by Credit Suisse they have the appearance of an highly questionable level of self-enrichment by Hui. They at the very least are ethically questionable even if legally permissible.
Most If Not All Of China’s Real Estate Firms Are Over-Extended
Still, while Evergrande’s problems are large, they are not unique. Returning to the Lehman parallel, where Lehman Brothers shone a spotlight on the dangerously illiquid nature of derivative securities, Evergrande is bringing uncomfortable attention to the over-leveraged and overextended balance sheets of many, if not most, Chinese real estate firms.
"If as expected Evergrande is defaulting on its debt and goes through a restructuring, I don't see why it would be contained," Michel Lowy of banking and asset management firm SC Lowy, which focuses on distressed and high-yield debt, said.
"There are other developers that are suffering from the same problem of no access to liquidity and have extended themselves too much," Lowy added.
These problems are threatened by the prospect of a fire sale of Evergrande’s assets, which are large enough to push down real estate prices across China, putting fresh financial pressures on already-strapped developers. Over-extended and without ready access to fresh funding to sustain operations, a crash in real estate prices could push several other firms into bankruptcy as well.
China’s “highly distressed” real estate companies are at risk of collapse as the country’s highly indebted developer Evergrande is on the brink of default, warns AllianceBernstein’s Jenny Zeng.
Speaking with CNBC’s “Street Signs Asia” on Friday, the co-head of Asia fixed income at AllianceBernstein warned of a “domino effect” from a potential Evergrande collapse.
“In the offshore dollar market, there is a considerable large portion of developers (who) are implied to be highly distressed,” Zeng said. These developers “can’t survive much longer” if the refinancing channel remains shut for a prolonged period, she added.
This is ultimately the real crisis brought into focus by Evergrande: China’s real estate firms are over-extended, underwater, and with or without an Evergrande bankruptcy face existential threats from loss of financing and liquidity resources. Many of these firms will follow Evergrande into bankruptcy.
These firms would be distressed even without an Evergrande bankruptcy. Similarly, if the real estate markets were healthy, China would likely be able to absorb Evergrande’s inevitable bankruptcy.
These problems did not arise with Evergrande, and they will not be resolved in Evergrande’s bankruptcy and demise. Regardless of the outcome to Evergrande, the rot in Chinese real estate remains.
Update: The Rot Is Reliance On Beijing To Save The Day
Since this article was first published, the news of Evergrande’s implosion has served to shine a spotlight on the rot in Chinese real estate, showing that a chief characteristic of that rot is the mistaken assumption/belief that Beijing and the PBOC will not let things get out of hand.
“There’s never been a precedent of letting a mega corporation go bankrupt” in China, said Niu Chunbao, a fund manager at Shanghai Wanji Asset Management Co. The government will not let the situation spiral out of control, he added.
China’s real estate development firms and the funds which invest in them have behaved—and appear to believe—that they are in essence playing with “house money”, that no matter what Beijing will bail out the market rather than allow the market to implode.
However, no bailout has been forthcoming. Rather, Beijing’s response thus far has been to prod various State Owned Enterprises (SOEs) to purchase various Evergrande assets, thus giving the company some of the cash it so desperately needs.
Authorities are hoping, however, that asset purchases will ward off or at least mitigate any social unrest that could occur if Evergrande were to suffer a messy collapse, they said, declining to be identified due to the sensitivity of the matter.
Moreover, it is still unclear if Beijing grasps the extent to which Evergrande is typical of corporate China. The fragility of Chinese firms has to date been a huge “blind spot” for Beijing.
At over 1,100 listed companies in China’s industrial and manufacturing sectors, receivables are piling up; cash conversion cycles are getting longer (that is, the time it takes to turn inventory investments into cash); and net short-term debt levels are becoming increasingly volatile, a Bloomberg Opinion analysis shows.
Can Beijing plausibly force SOEs to buy assets of all these distressed companies? Can China’s economy withstand such a stealth nationalization?
Yet markets on both sides of the Pacific remain convinced that Beijing has an infinite capacity to prevent corporate and market meltdowns.
So far, Beijing has held back, but especially since other Chinese companies, succumbed to the same temptations as Evergrande did and no doubt followed similar paths, action from the authorities is all but inevitable. When Beijing moves, it can take guidance form the American and European experiences in 2008-09 and earlier. These would seem to offer Beijing four options: One would include flooding financial markets with liquidity generated by the central bank. A second would involve direct loans from the government to troubled firms or forcing firms to make such loans. Third, Beijing could use forced sales of a troubled firm. A fourth would involve a kind of government-directed reorganization, such as the United States used to deal with the savings and loan crisis of the late 1980s and Sweden used in its banking crisis in the 1990s.
However, even direct intervention by Beijing will provide no comfort to the many firms to whom Evergrande owes millions—and many of whom may not survive should Evergrande default on paying its bills as well as its debts.
As Newsweek previously reported, the effects of an Evergrande collapse are expected to hit the businesses who work closely with it the hardest. While some major creditors could soon lose out on tens of millions of dollars in unpaid loans, many have the assets to come out of such a loss alive.
However, for the smaller businesses that have been sustained through partnerships attending to Evergrande's some 1,300 real estate properties, now could very well be the beginning of the end.
Much as was true of Washington, DC, during the Great Financial Crisis of 2008-2009, Beijing does not have a magic wand. Xi Jinping cannot command the problems away. What interventions Beijing can do and has done have their own reverberations and consequences.
Even if all of Evergrande’s assets are purchased by China’s SOEs, that would not provide enough cash to make all of Evergrande’s creditors whole; that would not provide enough cash to sustain the many businesses whose existence is threatened by Evergrande’s non-payment of bills. No matter what diktats Xi Jinping issues, without cash, a good portion of Evergrande’s suppliers and creditors will go under.
Evergrande is a stark demonstration of the limits of Beijing’s economic power, and a stark reminder of how markets are corrupted by ignoring the limits of government to rescue them from their own excesses.
29 September 2021: updated to reflect the latest events in Evergrande’s collapse.