Welcome back, another quick update on Evergrande.
Today I want to discuss the Ponzi like nature of the Evergrande wealth management products
and also go over what an unwind might look like.
Obviously, we will have a lot more information tomorrow when a big interest payment is due
on one of their dollar denominated bonds.
Evergrande – as I’m sure you know - is Chinas second largest property developer and
they have over $300 billion in liabilities, and as I’m sure you have seen in the news,
the company is in the throes of a liquidity crisis.
Tomorrow will be a big day for Evergrande as they have an interest payment on a dollar
denominated bond of $83.5 million that comes due.
This is on an 8.25% five-year dollar denominated bond.
There is a good chance that they are going to miss this payment, but this will not actually
count as a default as according to the bond’s covenants, there is a 30 day period before
a missed payment is considered a default.
They also need to pay $36 million dollars on an onshore bond on the same day.
This one is more likely to be paid (that doesn’t mean it is extremely likely that it will be
paid, just that it is likely to be more of a priority).
In total they have $669 million in coupon payments coming due through the end of this
year.
$615 million of that is on dollar denominated bonds.
Now I mentioned in my earlier videos that they have a wealth management affiliate that
offers financial products to Chinese investors backed by the company’s credit.
There is about 6 billion dollars’ worth of these products outstanding.
Although 6 billion is a small fraction of the $310 billion of total liabilities which
has been rattling the global markets, investor fury within China has made these debts a flashpoint.
This type of investment is not at all unusual in China, Other large Chinese developers have
also sold wealth management products, including Baoneng, Country Garden, Sunac and Kaisa.
Most Chinese investors are very leveraged to property investing in one way or another,
as due to financial repression, there is no where else for them to invest.
Now, these wealth management products were pitched with yields of around 12%, and investors
were given gifts like Dyson air purifiers and Gucci bags to invest.
This combined with the guarantee of China's second largest developer, meant that around
eighty thousand individual investors put their life savings into these products.
In an interview with local media, an Evergrande financial adviser said that the products were
a type of “supply chain finance”.
The financial advisor explained that in years past the money from retail investors would
have been used to pay Evergrande’s suppliers, but this was no longer the case.
“Proceeds from the wealth management products have been used to bridge various funding gaps
faced by the parent company.”
The executive said that “There is no need to thoroughly examine where the money actually
went.
Some proceeds were used to repay previous products but then sales plummeted, making
it difficult for the business model to continue.”
This is basically the definition of a Ponzi scheme.
The 12% return is even the same as Bernie Madoff paid.
Evergrande financial advisers marketed these products widely, including to homeowners in
its apartment blocks.
It’s managers also persuaded employees to invest – often as a condition of their employment.
One executive has been quoted as saying that the products were too “high risk” for
ordinary retail investors and should not have been offered to them.
This was said yesterday during a meeting, with angry investors who went to the company’s
headquarters to try to get their money back.
The sales pitch was that these were Safe and stable returns backed by Evergrande.
“Our products were not for everyone, according to the executive.
But our grassroots salespeople didn’t consider this when making their sales pitches and they
targeted everyone in order to meet their own sales targets.”
I should note that it is not clear if Evergrande has included this $6bil of wealth management
products among the liabilities on the balance sheet.
Nigel Stevenson of GMT Research is quoted in the Financial Times as saying that it is
unclear how Evergrande accounts for the wealth management products.
“Once the lid is lifted on its financials, it’s possible that more horrors will be
discovered,” he says.
OK, so what is likely to happen going forward?
Well, a lot of things can happen – so essentially - anything I say here is almost guaranteed
to be wrong.
(i would encourage you to of course come back to this video in a few days and tell me that
it aged like milk.”
I think it is extremely likely that Evergrande will miss their interest payment on dollar
denominated bonds tomorrow - and markets might not react well to this.
This is simply because missing this coupon won’t be counted as a default for another
30 days, and Evergrande will be trying to buy as much time as possible to negotiate
and will only make the payments it absolutely has to.
I don’t think me saying this is much of a surprise to anyone – the company’s credit
rating has been implying it for months.
I do think that Evergrande will be allowed to collapse, and that competing (and equally
overleveraged) developers will buy up the parts – most likely - with the help of loans
from a consortium of Chinese banks who will do this with the help of a liquidity injection
from the Peoples Bank of China.
This could be a bit like when JP Morgan was encouraged to buy Bear Stearns.
Evergrande being wrapped up should not solve all of the problems though.
According to the Bank for International Settlements the debts of China’s companies are, relative
to its economy, twice as large as those of American companies.
American companies are not known for their prudent fear of leverage, so this could be
a long-term issue for China.
Evergrande’s problems are simply highlighting this issue of excess leverage which has been
building for decades.
Evergrande defaulting on its own is unlikely to cause a credit crisis in China.
The main risk for China’s financial system would be if other highly leveraged developers
were to default at the same time.
This is of course a real risk.
Speculative excess in real estate is not, generally, something that happens with just
one developer or real estate investor.
Evergrande owes a lot of money to suppliers, if Evergrande defaults on these debts there
could be all sorts of knock-on effects too – these suppliers might need some sort of
bail out in the event of a default.
Over the last five years Chinese real estate has on average gone up in value by around
50%, and of course this has a wealth effect causing people to borrow and spend.
The Chinese authorities, have been clamping down on the real estate industry specifically
because they don’t want an economy entirely built on paper profits on houses.
This is a bit of an issue all around the world, where governments claim to be upset if housing
is unaffordable, but then if there is any sort of a dip in property prices they panic
that a slowdown could kill growth.
This is very much an issue in China where real estate is the most important sector in
the economy.
The government don’t want a bubble, but they also don’t want an economic slowdown
Finally, to what extent will this impact markets in the west?
As we know, the global financial crisis quickly spread from the united states to Europe, with
China being the second largest economy in the world, it could be a concern that a slowdown
in China could severely impact the rest of the world.
It is worth noting though that Chinas markets are significantly less interconnected with
world markets than American markets are with European markets.
This is however a developing situation, and your guess as to how things will work out
is as good as mine.
I’d love to hear your thoughts on the situation in the comments section below.
If you need more information and haven’t watched my other videos on this topic here
is a link – they are fairly short videos like this and I aim to keep them fairly information
dense.
Talk to you soon.
Bye.