Evergrande is China’s largest property development company
and was (up until recently) one of the most valuable companies in the world.
However most analysts are now predicting that this company
is on the verge of insolvency and won’t be able to meet its mountainous debt
obligations without direct government intervention within the next few weeks.
For those of you who are not already aware
this has the potential to be far more than a run of the mill corporate bankruptcy.
The company employs over 200,000 people directly while also providing work for as many as 4 million
subcontractors who work to erect thousands of buildings for the company every year.
Beyond just job losses, the company is also holding deposits for 1.5 million properties
that may not be delivered to regular Chinese
citizens who were just looking for a home or an investment property.
Now loosing a home is terrible in ANY country, but perhaps nowhere more so
than in China. The value of these properties compared to the incomes of people buying them
is astronomical, and it often takes multiple family generations to save up for a deposit.
Because of this, real estate has become basically the only thing that most people invest in,
and over a million people losing that investment will have massive knock on economic impacts beyond
just putting people out on the streets (as is that wasn’t bad enough already)
Despite these social issues and the apparent threat to the national and global economy
the Chinese government has said that they are not prepared to bail out the company.
Why? Well politics… but there are a few things that you need
to understand about this crisis as we watch it play out in real time.
The first is how this collapse actually
started in what looked like an otherwise very healthy company.
The second is how bad could this get if the government DOESN’T step in.
And the third is, Will this all be contained?
Or could this leak out and cause an economic collapse in countries outside of China?
Well it’s time to learn how money works so you can have a better understanding about
what all of these alarming headlines really mean. This is video was brought to you by
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Alright, so many people are calling this China’s Lehman moment,
in reference to the American investment bank Lehman Brothers which was allowed to
go bankrupt in 2008 effectively kicking off the 2008 Global Financial Crisis.
There are a lot of similarities here.
Both of these companies are very large, they both have a lot of debt on their books, that debt is
being offset with assets that may not be nearly as valuable as people might think, and finally
they both look to have been left for dead by their governments which have decided to let them fail.
Now of course Evergrande is not a bank, it’s a property development company,
but in China that’s almost worse.
Property is basically the only thing that average citizens invest in
so it’s as if you took the us financial market and housing market and rolled
them all up into one for people to speculate on… sort of like in 2008.
Now the regulators knew this, and they saw the problem of an asset
price bubble having the potential to cause major economic factors.
It’s because of this, that the story of Evergrande’s problems
actually start more than a year ago in august of 2020.
Property is never “owned” in China, it is leased from the government for a set amount of time
most commonly 70 years. These land leases are then purchased by property developers like Evergrande.
The property developers will then design apartment buildings and pre-sell the units they designed to
regular investors who will put down a deposit and wait for the buildings to actually be finished.
The developer can then take this money and use it as a down payment to borrow even more money
to either buy up more land leases, or to use on the actual construction of buildings on that land.
This system works very well for rapid expansion and it is in theory a win-win for everybody.
Evergrande and other developers were able to buy up more 70 year leases and build more houses,
regular investors were able to get access to properties that were far cheaper than
existing apartments for sale in china, and the banks and non-bank lenders were able to give
money to an institution that was offering good returns on a secured line of credit.
Most of these lenders figured that in the extremely unlikely scenario that
a company like Evergrande defaulted on it’s debt’s they could just yoink
the properties they had on their books and easily cover all of these loans.
Now… Evergrande had seen that properties in China were appreciating at a rate of about 10 – 15%
per year so they wanted to push this limit to the extreme.
They wanted to borrow more money, buy up more land rights, presell more apartments
all in an attempt to grow as fast as possible.
This DID work well, the company was highly profitable, it always had more assets than
liabilities and continually gave consistent returns to both equity and debt investors.
But all good things must come to an end and that brings us back to August of 2020 when the Chinese
government introduced new laws in to control the amount of debts that developers could take on, and
also how the money that companies like Evergrande were getting of pre-sales could be used.
This was a big problem because it radically altered the high growth business
model that the company had become reliant on.
The company basically needed a constant stream of new money coming in from property buyers to
keep the whole operation running, but it did have a backup plan.
If this money ever slowed down the developer could just lower
the prices on their pre-sales to attract more buyers and prop
up the system again. Sure they wouldn’t make as much profit, but it’s better than nothing.
In a worst case scenario the company just kept certain properties on their own books as real
estate assets. This meant that they could borrow even more against the value of these finished
properties and never need to realise a loss by selling a property for more than it cost to build.
This was not a bad strategy considering property price growth in China meant
that the company only ever needed to hold onto these properties for a few
months at most before market forces made them profitable to sell again.
However these new regulations meant that the company was forced to hold
onto more and more existing properties while also needing to sell off their
new developments at increasingly steep discounts to keep the money flowing in.
This caused two problems, for starters it
undermined all of the holdings that they had to offset their liabilities.
I said at the beginning of this video that the company had more assets than it did liabilities,
and that is technically true, but only if you accept that HUNDREDS OF BILLIONS OF DOLLARS
worth of residential real estate holdings are worth as much as the company says it is.
Even if we ignore the propensity of Chinese companies to… “massage”… their figures a bit, this
is an alarming number because these assets are NOT liquid… which leads us to the next problem.
The new regulations have made it harder for the company to borrow money to complete the
projects it was working on. This has meant that they company has had to sell more presales to
fund existing projects which are in turn going to be even harder to get funding for.
The questions raised about the true value of the companies real estate holdings has
meant that the company has had to seek finance from not one or two banks like most companies,
but from over 128 different banks and hundreds of other non-bank lenders.
This started to raise alarm bells with individual property investors
who were waiting on their homes to be finished.
Potential investors were starting to see these massive real estate
development projects (that used to sell out within a matter of hours)
were now being discounted over and over again to try and attract buyers.
Even if their overall attitude towards the real estate market was bullish,
it only made sense to sit back a bit and see if they could snag themselves a bigger discount.
This closed the faucet on the cash injector that kept everything going causing bigger discounts and
bigger question marks over how much the companies inventory of property was actually worth.
Now the company is in a situation where it lacks the funds it needs to pay for day to day
operations beyond the next few weeks. Of course it could sell off these existing real estate assets
as a last ditch attempt to free up some cash flow but it would now be at a massive discount given
the bad press and the fact that they wouldn’t really have time to negotiate too hard on price.
Now that leads us onto how bad this could get.
…
If the government did not intervene at all the company would go into liquidation,
the 1.5 million people that have paid their deposits for homes that have not
yet been built would lose that money and the properties on the companies
books would be sold off as quickly as possible flooding the market with properties for sale.
Even in a company as hungry for real estate as China this would inevitably drive down prices.
It would simultaneously put more eyes on the other
property development companies who would inevitably be in a similar situation.
If property prices fall then their inventories are going to be worth less too,
meaning they will have less assets to secure loans against, which means more difficulty
completing projects, which means more trouble paying off loans which means more liquidations.
If you replace the words “Chinese Apartments” with “Mortgage Backed
Securities” it is easy to see why people are calling this a Lehman Moment.
Which leaves just one final question… Will this impact markets in the west?
The GFC quickly spread from the US to Europe and then on around the world. China is the
second largest economy in the world so it’s not unreasonable
to be a little concerned with the same thing happening here right?
Well yeah, we should all be cautious of what this could mean,
but I wouldn’t be overly worried just yet. China’s markets by design are very
closed off to the outside world which means that they are much less interconnected with
American markets than say American markets are with European markets.
What’s more is that it’s hard to believe that the Chinese government would let it
get quiet that bad. The strength and unfaltering growth of the Economy has
been the linchpin of the current government. If they were to loose that they would not only
have to deal with an economic catastrophe, but also widespread civil unrest as well.
As I said, this is a developing situation so your guess about what comes next is just as
good as mine, but at least you know the nuts and bolts of the problem that they are facing.
Now if you want to learn about something a little bit more light-hearted go and watch my video
on why jellyfish have secretly been used as a global reserve currency for the past few decades.
A regular video will still be coming at some point this week, so this one is just an extra
to keep you all up to speed on this situation. These video’s are made possible by my amazing
channel members and patreon supporters. If you enjoy these video’s please consider supporting
the channel directly so that everybody can keep on learning How Money Works.